CMOF LECTURE

Inventory Valuation
Overview
• The different procedures and documents necessary for the ordering, receiving and issuing of materials from
inventory

• Calculate the value of closing inventory and material issues using LIFO, FIFO and average methods

• Identify, explain and calculate the costs of ordering and holding inventory

• Calculate and interpret the optimal reorder quantities

• JIT and Lean Manufacturing

Materials
Think of some examples
of materials which a
business might use
Examples of materials which a business might use
• Components
• Sheet metal
• Tyres
• Steel tubing
• Cleaning materials
• Chemicals
• Lubricants
• Fuel
• Etc.
• Paper
• Solvents
• Stationery
• Refreshments
 What costs are
associated with acquiring
and holding stocks of
materials?
Relevant Significant costs include:
• Purchase cost of materials
• Transport costs
• Storage costs - which include:
building occupancy costs
security costs
recording and monitoring costs
insurance costs
• Ordering costs
• Delivery costs
 In traditional manufacturing environments
Materials are received from suppliers into
stores

And issued from

stores to
The cost of materials
production.
issued to production
forms part of the cost
of the units produced
There are a number of key documents involved in the process
• Materials Requisition
• Purchase order
• Goods Received Note
• Stock records
• Bin Card
• Stores Ledger
The accounting significance
• The cost of materials affects production cost and therefore product cost

• The value put on the closing stock of materials directly affects profit

• Cost of Sales in P&L reflects goods used in sales. Not purchases. Therefore this is affected
by stock levels.

• Increasing stock means we are buying more than we are using.

• Decreasing stock means we are using more than we are buying

 Cost of Sales… The Great Cola Problem
How many cans of cola did I drink last week!

I remember there were 10 cans in the fridge on Monday morning

I have supermarket receipts for 12 cans

I can see there are 6 cans left in the fridge

 The solution!

Started off with 10

+ Bought 12
= Available to drink 22
- Left now 6

= SO! I drank 16
The solution! (in business terms)
Started off with Opening stock 10
+ Bought Purchases 12
= Available to drink Available 22
- Left now Closing stock 6

= SO! I drank Material used 16

Example – Profit and Loss

Month Ended 31 Jan 2024 £ £

Revenue x

Cost of Sales
Opening Stock x
+ Purchases x
+ Other direct variable costs x
- Closing Stock (x)

Cost of Sales (x)

Gross profit x
Expenses (indirect costs) (x)
Operating Profit x
Interest (x)
Tax (x)
Net profit x
3 Categories
• Raw Materials

• Work In Progress (WIP)

• Finished Goods
Stock Valuation
• Stock values can include more than just materials costs. [IAS 2.10]
• They can include any relevant production cost, if using an absorption method.
• E.g.
• Materials
• Taxes, transport, handling
• Production line Labour
• Production line equipment depreciation
• Production Utilities
• Production related land and buildings costs
Inventory cost should not include: [IAS 2.16 and 2.18]
• abnormal waste
• storage costs
• administrative overheads unrelated to production
• selling costs
• foreign exchange differences arising directly on the recent acquisition of
inventories invoiced in a foreign currency
• interest cost when inventories are purchased with deferred settlement
terms.
Inventory valuations affect Cost of Sales
Cost of Sales =
• Opening Stock
• PLUS Purchases
• PLUS Production overheads
• LESS Closing Stock
If the suppliers prices vary
with each batch going into
the stores how can we
determine the price of an
item issued to production?
How is the cost determined?
What price
Prices charged
Should the item
By supplier
Be charged to
Production??
Price 1 Stores

Price 2

Affects the cost of the

Product or job
Affects stock value
Price 3
Affects profit
Stores Issues Pricing
FIFO First In First Out
LIFO Last in First Out
AVCO Average Cost –
Weighted Average Price
Consider this data…

Date RECIEPTS ISSUES

QTY £/unit QTY
01-May 100 2
03-May 400 2.1
04-May 200
09-May 300 2.12
11-May 400
18-May 100 2.4
20-May 100
 Using a FIFO approach issues are priced on the basis of the first
received being issued first.
Receipts Issues Balance
Date Qty £/Unit £ Total Qty £/Unit £ Total Qty £/Unit £ Total
01-May 100 2 200 100 200
03-May 400 2.1 840 500 1040
04-May 100 2 200
100 2.1 210 300 630
09-May 300 2.12 636 600 1266
11-May 300 2.1 630
100 2.12 212 200 424
18-May 100 2.4 240 300 664
20-May 100 2.12 212 200 452
Cost of Issues 1464 Closing Inventory 452

identify the value of closing stock

the cost of total units issued
What about LIFO and AVCO?
 LIFO
Receipts Issues Balance
Date Qty £/Unit £ Total Qty £/Unit £ Total Qty £/Unit £ Total
01-May 100 2 200 100 200
03-May 400 2.1 840 500 1040
04-May 200 2.1 420 300 620
09-May 300 2.12 636 600 1256
11-May 300 2.12 636
100 2.1 210 200 410
18-May 100 2.4 240 300 650
20-May 100 2.4 240 200 410

Closing
Cost of Issues Inventory
1506 410
 Unit Price = Total Cost / Total Units
AVCO

Receipts Issues Balance

Date Qty £/Unit £ Total Qty £/Unit £ Total Qty £/Unit £ Total
01-May 100 2 200 100 2 200
03-May 400 2.1 840 500 2.08 1040
04-May 200 2.08 416 300 2.08 624
09-May 300 2.12 636 600 2.1 1260
11-May 400 2.1 840 200 2.1 420
18-May 100 2.4 240 300 2.2 660
20-May 100 2.2 220 200 2.2 440

Closing
Cost of Issues 1476 Inventory 440
Issues
• Only FIFO and AVCO allowable by IFRS, not LIFO

• LIFO risks using only most recent market prices of materials as Cost of Sales and
leaving older irrelevant costs in the stock values.

When raw material prices are rising…

• LIFO will give the highest COS and the lowest Stock Value
• FIFO will give the lowest COS and the highest Stock Value
• AVCO will be in-between both.
INVENTORY HOLDING AND ORDERING COSTS
Holding costs: Ordering costs:
– clerical and administrative costs: the
– the opportunity cost of capital tied up
total administrative costs of placing
– insurance
orders will increase in proportion to the
– deterioration
number of orders placed.
– obsolescence
– transport costs.
– damage and pilferage
– warehouse upkeep
– stores labour and administration costs.
INVENTORY HOLDING AND ORDERING COSTS
Total Annual Holding Cost = Average inventory (Q/2) x Holding cost per unit of
inventory (HC)

where average inventory held is equal to half of the order quantity Q.

Total Annual Ordering Cost = Cost of placing an order (OC) × Number of orders
(D/Q).

where the number of orders in a year is expected annual demand D divided by the order quantity Q.
Total Annual Cost of Inventory = PD + (OC × D/Q) + (HC
× Q/2)

The Total Annual Costs (TAC) is the total of purchasing costs P multiplied by annual demand D plus
total ordering costs (OC × D/Q) and total holding costs (HC × Q/2)
Illustration
A company uses components at the rate of 6,000 units per year, which are bought in at a cost of
$1.20 each from the supplier. The company orders 1,000 units each time it places an order and
the average inventory held is 500 units. It costs $20 each time to place an order,
regardless of the quantity ordered. The total holding cost is 20% per annum of the average
inventory held.

Required
Calculate the annual ordering and holding costs
Illustration: Solution
Total Annual Ordering Cost = Cost of placing an order (OC) × Number of orders (D/Q).
where the number of orders in a year is expected annual demand D divided by the order
quantity Q.

Annual ordering cost = Annual usage

× $20
Order size
= 6,000 × $20
1,000
= $120
Illustration: Solution
Annual Holding Cost = Average Inventory Held x Cost Per Unit × 20%
= 500 units × $1.20 × 20%
= $120
Reorder levels
The reorder level is the quantity of inventory in hand when a
replenishment order should be placed.

Reorder level = Maximum usage × Maximum lead time

Illustration
A company uses Component M at the rate of 1,500 per week. The time between
placing an order and receiving the components is five weeks. The reorder quantity is
12,000 units.

Required:
Calculate the reorder level.
Illustration
Reorder level = Maximum usage × Maximum lead time

Reorder level = Usage × Lead time

= 1,500 units × 5 weeks
= 7,500 units
ECONOMIC ORDER QUANTITY (EOQ)
The EOQ is the reorder quantity which minimises the total costs
associated with holding and ordering inventory (i.e. holding costs
+ ordering costs) are at a minimum.

Economic order quantity =

Where:
2 × D × 𝑂𝐶
HC √
D = Demand per annum
OC = Cost of placing one order
HC = Cost of holding one unit for one year
 The Total-Cost Curve is U-Shaped
Annual Cost

Ordering Costs

Order Quantity
QO (optimal order quantity)
(Q)

43
• Assumptions:
• Only one product is involved
• Purchase price is constant
• Annual demand requirements known
• Demand is even throughout the year
• Lead time does not vary
• Each order is received in a single delivery
Illustration
A company uses components at the rate of 500 units per month, which are bought in
at a cost of $1.20 each from the supplier. It costs $20 each time to place an order,
regardless of the quantity ordered The total holding cost is 20% per annum of the
value of inventory held.

Calculate the EOQ

 √
Economic O rder Q uantity (EOQ ) =
2 × D × 𝑂𝐶
HC
Inventory Control
Just In Time
Lean Manufacturing
Six Sigma etc.
Important
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Next Class-

• Regular session will cover Balanced Score Card as Performance

Management Technique
• Guest Lecture Session will deliver by Jonny Munby, Principal Lecturer
in International, TUIBS
THANK YOU