Inventory and Inventory Management Notes

Inward Delivery of Goods

Goods are distributed, received at factory premises, and then stored in warehouses. Quality control processes are applied, and quality tests are performed. The materials are then used in the manufacturing of finished products.

Inventory and Inventory Management

This is Lesson 4, focusing on inventory and inventory management.

Learning Objectives:

• Define the meaning of inventory.
• Understand the Principle of Inventory Proportionality, its purpose, and application.
• Identify the different types of inventory.
• Know examples of inventory management.
• Define what is Vendor Managed Inventory.
• Understand the Inventory Control Process.

Inventory

Inventory is defined as the goods available for sale and raw materials used to produce goods available for sale. It is the array of finished goods or goods used in production held by a company.

Inventory can be valued in three ways:

1. First-In, First-Out (FIFO) method
2. Last-In, First-Out (LIFO) method
3. Weighted average method

Inventory Valuation Methods

1. First-In, First-Out (FIFO) Method

• In FIFO, the oldest inventory (first purchased) is sold first.
• Ending inventory consists of the most recent purchases.
• Common in businesses where products have a shelf life (like food or medicine).

2. Last-In, First-Out (LIFO) Method

• In LIFO, the newest inventory (last purchased) is sold first.
• Ending inventory consists of older items.
• Often used to reduce taxable income during inflation, though not allowed under IFRS (International Financial Reporting Standards).

3. Weighted Average Method

• In this method, inventory cost is calculated based on the average cost of all units available for sale.
• It smooths out price fluctuations.
• Suitable when items are indistinguishable from each other (like liquids or grains).

Cost of Goods Sold (COGS) and Ending Inventory Calculation Examples

1. FIFO (First-In, First-Out)

Cost of Goods Sold (COGS):

• 2 units @ ₱500 = ₱1,000
• 1 unit @ ₱600 = ₱600
• Total COGS = ₱1,600

Ending Inventory:

• 1 unit @ ₱600 = ₱600
• 1 unit @ ₱700 = ₱700
• Total Inventory = ₱1,300

2. LIFO (Last-In, First-Out)

Cost of Goods Sold (COGS):

• 1 unit @ ₱700 = ₱700
• 2 units @ ₱600 = ₱1,200
• Total COGS = ₱1,900

Ending Inventory:

• 2 units @ ₱500 = ₱1,000

3. Weighted Average Method

Compute Average Cost per Unit:

• Total Cost = (2 \times ₱500) + (2 \times ₱600) + (1 \times ₱700) = ₱1,000 + ₱1,200 + ₱700 = ₱2,900
• Average Cost per Unit = ₱2,900 ÷ 5 \text{ units} = ₱580

Cost of Goods Sold (COGS):

• 3 units × ₱580 = ₱1,740

Ending Inventory:

• 2 units × ₱580 = ₱1,160

Consignment Inventory

Consignment inventory is the inventory owned by the supplier/producer but held by a customer. The customer only pays the supplier after the product is sold.

Advantages of Consignment Inventory:

For Suppliers:

• Increases market reach
• Less need for own retail space
• Potential for higher sales

For Retailers/Sellers:

• No upfront investment
• Lower risk of loss
• Variety of products without purchasing stock

Principle of Inventory Proportionality

Inventory proportionality is the purpose of demand-driven inventory management. The optimal outcome is to have the same number of days' worth of inventory on hand across all products so that the time of runout of all products would be simultaneous.

Benefits of Following Inventory Proportionality:

Purpose and Application of Inventory Proportionality

Purpose:

• Maintain equal stock levels across all products to ensure simultaneous depletion.
• Minimize inventory while ensuring availability.
• Use accurate demand forecasting instead of relying only on past averages.
• Achieve better efficiency and optimization in inventory management.

Applications:

• Inventory should remain unseen by consumers.
• Different from "trigger point" systems, where reordering occurs when stock reaches a set threshold.

Types of Inventory

1. Raw materials – building blocks to finished goods.
2. Work in process – consists of all partially finished products that a manufacturer produces.
3. Finished goods – finished products that can be sold to wholesalers, retailers, or end-users.

Recording Inventory in Accounting

Retailers: record the price they paid, including sales tax, delivery fees, and other fees.

Manufacturers: includes production costs and other costs like packaging.

Businesses use one of two different accounting systems to keep track of their goods:

Periodic Inventory System

• Simple and only requires an inventory spreadsheet to keep track of sales and goods remaining in stock.
  • Key Features:
    • No continuous record of inventory
    • Physical count is done to know ending inventory
    • Cost of Goods Sold (COGS) is calculated as: COGS = Beginning Inventory + Purchases - Ending Inventory

Perpetual Inventory System

• Highly sophisticated system that keeps track of goods as they are purchased and sold in real-time using a bar code scanner and computer system.
  • Key Features:
    • Automatic record updates
    • Uses barcode scanners or computer systems
    • You always know current inventory levels
    • No need to wait for physical count (but can still verify occasionally)

Financial Statement Presentation

• Inventory is reported on the balance sheet as a current asset.
• Presented right after cash and accounts receivable.
• Retailers list one type of merchandise, manufacturers tend to list three different categories of inventory separately.
• Using the FIFO, LIFO, or weighted average costing method

Apple Inc. Consolidated Balance Sheets Example

This section provides a balance sheet example from Apple Inc. for September 25, 2021, and September 26, 2020, showing the presentation of inventory as a current asset along with other assets and liabilities.

Inventory Management Example

• Controlling purchasing and evaluating turns helps management understand what they need to stock and need to get rid of.
• Management uses inventory and the margin ratios to measure the earnings from each piece of merchandise and stock items that are profitable.

Work-in-Process Inventory

• The cost of work-in-process includes all of the raw material cost related to the final product.
• A portion of direct labor cost and factory overhead is also assigned.
• Work-in-process is an asset and is aggregated into the inventory line item on the balance sheet.
• It is best to minimize it in the production area to avoid interference with the process flow.

Raw Materials Inventory

There are two subcategories of raw materials:

• Direct materials: materials incorporated into the final product.
• Indirect materials: materials not incorporated into the final product but consumed during the production process.

When raw materials are consumed, the accounting varies, depending on their status as direct or indirect materials.

The accounting is:

• Direct materials: debit the work-in-process inventory account and credit the raw materials inventory asset account.
• Indirect materials: debit the factory overhead account and credit the raw materials inventory asset account.

Summary:

• Direct Materials → Directly part of the product → Debit WIP Inventory
• Indirect Materials → Support production but not directly traceable → Debit Factory Overhead

Assumption of Values:

• Direct Materials used = ₱100,000
• Indirect Materials used = ₱20,000

Journal Entries:

1. For Direct Materials used:
   • Work-in-Process Inventory ₱100,000
   • Raw Materials Inventory ₱100,000
2. For Indirect Materials used:
   • Factory Overhead ₱20,000
   • Raw Materials Inventory ₱20,000

Finished Goods Inventory

• Consists of products that are ready for sale.
• Retailers don’t classify their inventory; manufacturers physically produce their inventory and have to account for it.
• Finished goods are usually worth much more than raw materials

Fred's Factory Balance Sheet Example

An example balance sheet from Fred's Factory as of December 31, 2013, is presented, showing the breakdown of assets, including cash, accounts receivable, and inventory (raw materials, work in process, finished goods).

Traditional Inventory Management vs. Vendor-Managed Inventory (VMI)

Traditional Inventory Management

• Retailers independently decide order sizes.

Vendor-Managed Inventory (VMI)

• Retailers share inventory data with vendors.
• Vendors ensure proper product display and staff training in stores.
• Shared risk: Vendors repurchase unsold inventory.
• Consumers benefit from well-informed store staff with direct manufacturer support.
• Manufacturers prevent warehouse overflow, shortages, and reduce labor, purchasing, and accounting costs.

Inventory Control

Inventory control or stock control is the process of ensuring that the right amount of supply is available within a business.

Common areas for inventory control:

• Raw materials availability
• Finished goods availability
• Work in process
• Reorder point
• Bottleneck enhancement
• Outsourcing

Inventory Control Process

An inventory control system may be divided into three parts:

1. Process of Purchasing of Materials
2. Inventory Storing Procedure
3. Process of Issue of Materials

Examples are provided for each part, such as a retail clothing store ordering fabric, a pharmaceutical company storing medicines, and a car manufacturing plant requesting engine parts.

Process of Purchasing Materials

1. Establishment of Purchase Department
2. Preparation of Purchasing Budget
   • Points to consider:
     • System to receive the materials
     • Quantity and quality of the materials according to the production requirements
     • Source of supply
     • Present balance of materials and predictions to receive the materials ordered
     • Available cash for debtors
     • Date of indent by concerned department
     • Conditions regarding the value of the materials and rebate or discount on it.
3. Preparation of Purchase Requisition Slip
4. Obtaining the tender
5. Sending Purchase Order
   • Generally, a purchase order has the following information:
     • Name of the purchaser, serial number, and date of order
     • Name of vendor and address
     • Full details of materials quantity etc.
     • Value, rebate, and terms of payment etc.
     • Time of place of delivery
     • Directions regarding packing and dispatching
     • Signature of purchaser
     • Method of follow-up
6. Receiving and Inspection of Materials
7. Returning the Materials
8. Payment of Purchased Material

Process of Issue of Materials

To control the issue of materials, the following procedure is followed:

1. Issue of materials
2. Periodical Checking of Materials
3. Physical Stock Checking of Materials

Inventory Storing Procedure

The following procedure is followed in inventory storing:

1. Receipt of Material in store
2. Issue of Material from Store
3. Return of Material to Store
4. Transfer of Material
5. Material Abstract

Inventory Control Systems

The following are the popular Inventory Control Systems that are being used by big manufacturers and the retail units:

1. ABC Inventory Control System
2. Three-Bin System
   • Once the inventory is used from the bin placed on the shop floor, it gets replenished from the bin stored in the back store. Later, the bin in the back store is sent to the supplier to get it replenished from the inventory reserved with the supplier. Then, the supplier will manufacture more inventory to fill the empty bin placed with him.
3. Just-in-Time (JIT) Systems
   • Just-in-time, or JIT, is an inventory management method in which goods are received from suppliers only as they are needed. The main objective of this method is to reduce inventory holding costs and increase inventory turnover.
4. Computerized Inventory System
   • A computerized inventory system enables a company to monitor inventory levels in real-time throughout the day. Businesses can stay updated with inventory orders, counts, and sales.
5. Fixed Order Quantity (FOQ)
   • Fixed Order Quantity (FOQ) is an inventory management strategy where a predetermined order quantity is established and replenished when the inventory level reaches the reorder point. This strategy helps to ensure that the right amount of stock is available to meet customer demand. It also helps to reduce the costs associated with ordering and holding inventory.

Inventory Management Practices

1. Determine whether a continuous review system or periodic review system is the best type of inventory management system for your business.
2. Implement a cycle counting program after considering a counting frequency, counting strategy, and cycle count management.
3. Manage your inventory by knowing the inventory levels that are most beneficial to the flow of your business
4. Implement quality control procedures so that all employees can work toward the same goals
5. Optimize inventory levels to boost efficiency and meet customer demands
6. Prepare for growth and implement inventory management best practices that will support your business goals.

Importance of Inventory Management

• It can help you keep track of all your supplies and determine the exact prices. It can also help you manage sudden changes in demand without sacrificing customer experience or product quality. This is especially important for brands looking to become a more customer-centric organization.

Inventory Management Example

A cake manufacturing shop needs to plan the quantities of sugar and flour so that it never runs out of them when it wants to make a cake. On the other hand, if too much sugar and flour are stocked and there is not as much demand for cake, the flour and sugar would go bad, which would cause financial losses to the business.

Inventory Management Parameters

Inventory management can be efficiently done on the basis of 4 broad parameters:

1. Number of units in stock
2. Cost of managing inventory
3. Availability of inventory on time
4. Location for storing inventory

Challenges of Inventory Management

1. Understanding the Inventory
2. Incompetent Process
3. Client Demand

Principles of Inventory Management

1. Demand forecasting
2. Warehouse flow
3. Inventory turns/stock rotation
4. Cycle counting
5. Process auditing

Inventory Management Software

Inventory management software is a software system for tracking inventory levels, orders, sales, and deliveries.

• Used in manufacturing to create a work order, bill of materials, and other production-related documents.
• Made up of several key components working together to create a cohesive inventory.

Features:

• Reorder Point
• Asset tracking
• Service management
• Product Identification

Inventory Optimization

• Reorder point: number of units that should trigger a replenishment order
• Order quantity: number of units that should be reordered, based on the reorder point, stock on hand, and stock on order.
• Lead demand: number of units that will be sold during the lead time
• Stock cover: number of days left before stockout if no order is made
• Accuracy: expected accuracy of the forecasts.

Purpose of Inventory Management Software

Inventory management software is used for a variety of purposes, including:

• Maintaining a balance between too much and too little inventory
• Tracking inventory as it is transported between locations
• Receiving items into a warehouse or other location
• Picking, packing, and shipping items from a warehouse
• Keeping track of product sales and inventory levels
• Cutting down on product obsolescence and spoilage
• Avoiding missing out on sales due to out-of-stock situations

Advantages of ERP Inventory Management Software

• Cost savings
• Increased efficiency
• Warehouse organization
• Updated Data
• Data security
• Insight into trends

Disadvantages of ERP Inventory Management Software

• Expense
• Complexity

Benefits of Inventory Management Systems

• Improved cash flow
• Better reporting and forecasting capabilities
• Reduction in storage costs
• Reduced labor cost
• Reduction in dead stock
• Better organization
• Enhanced transparency
• Improved supplier, vendor, and partner relationships