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Inventory Management I

Definitions
Inventory-A physical resource that a firm holds in stock with the intent of selling it or transforming it into a more valuable state. Inventory System- A set of policies and controls that monitors levels of inventory and determines what levels should be maintained, when stock should be replenished, and how large orders should be

Inventory
Def. - A physical resource that a firm holds in stock with the intent of selling it or transforming it into a more valuable state. Raw Materials Works-in-Process Finished Goods Maintenance, Repair and Operating (MRO)

Benefits for Inventories


Improve customer service Economies of purchasing Economies of production Transportation savings Hedge against future Unplanned shocks (labor strikes, natural disasters, surges in demand, etc.) To maintain independence of supply chain

Disadvantages of Inventory
Non-value added costs Opportunity cost Complacency Inventory deteriorates, becomes obsolete, lost, stolen, etc.

Inventory management
It includes planning ,coordinating and controlling activities related to the flow of inventory into , through and out of an organization . Inventory management is important because materials costs often account more than 40% of total costs of manufacturing companies and more than 70% of total costs in merchandising companies .

Costs associated with inventory


Purchasing costs The costs of goods acquired from suppliers , including incoming freight costs. These costs usually make up the largest cost category of goods for sale. Ordering costs The costs of preparing and issuing purchase orders ,receiving and inspecting the items included in the orders and matching invoices received , purchase orders and delivery records to make payments. Carrying costs It arise while holding an inventory of goods for sale .Carrying costs include the opportunity cost of investment and costs associated with storage, insurance and spoilage etc.

Stock out costs The costs that result when a company runs out of a particular item for which there is customer demand . Costs of quality It arises when features and characteristics of a product or service are not in conformance with customer specifications . Shrinkage costs The costs that result from theft by outsiders , embezzlement by employees and clerical errors etc. It is measured by difference between a) the cost of inventory recorded on the book in the absence of above incidents and (b) cost of inventory when physically counted .

Economic Order Quantity


EOQ is a decision model that under given set of assumptions calculates the optimal quantity of inventory to order . Simplest version of an EOQ model assumes - There are only ordering costs and carrying costs - Same quantity is ordered at each reorder point . - Demand , ordering costs and carrying costs are known with certainty.

Formula for EOQ = (2DP/C) Where D= demand in units for a specified period P= relevant ordering cost per purchasing order C= relevant carrying cost of one unit

Reorder point

The quantity level of inventory on hand that triggers a new purchase order Reorder point = Nos. of units sold per unit of time x Purchase order lead time

Safety stock
It is the inventory held at all times regardless of the quantity of inventory ordered using EOQ model. Safety stock is used as buffer against unexpected increases in demand , uncertainty about lead time and unavailability of stock from suppliers etc .

THE EOQ MODEL


Order qty, Q
Inventory Level Demand rate

Reorder point, R 0

Lead time Order Order Placed Received

Lead Time time Order Order Placed Received

Q. CG electronics makes air conditioners . It purchases 12000 units of particular type of compressor part each year at a cost of Rs.500 per unit . Company requires 12% rate of return on investment . Insurance and material handling cost is Rs 20 per unit per year . Ordering cost per purchase is Rs 1200. Calculate (a) EOQ for compressor parts. (b) Number of orders per year (c) If purchasing lead time is half a month , what will be the reorder point ?
Ans : (a) Relevant carrying cost per part per year : Required annual return on investment , 12% x 500 Insurance and material handling costs per year Relevant carrying cost per part per year ( C)

= Rs 60 = Rs 20 = Rs 80

Given Yearly demand, D = 12000 units Purchase order cost, P = Rs 1200 EOQ = (2DP/C) = (2X12000X1200/80) = 600 units Nos. of orders per year = D/EOQ = 12000/600 = 20 Reorder point = Nos. of units sold per unit of time x Purchase order lead time = 1000 per month x (1/2) month = 500 units

Zero Inventory?
Reducing amounts of raw materials and purchased parts and subassemblies by having suppliers deliver them directly. Reducing the amount of works-in process by using just-in-time production.

Reducing the amount of finished goods by shipping to markets as soon as possible.

Absorption costing
Absorption costing is a method of inventory costing in which all variable manufacturing cost and all fixed manufacturing cost are included as inventoriable cost i.e. inventory absorbs all manufacturing cost. Fixed overhead is expensed as cost of goods sold is written off against revenues i.e. it is inventoriable cost.

Absorption costing: how it works


Suppose production is greater than sales.
Were adding to finished goods inventory A pro-rata share of variable and fixed production costs are held back in finished goods until the product is sold Less than 100% of the total fixed overhead will be written off in the current period.

Under FIFO, the old production costs will be expensed in the next fiscal period, along with the costs of the new production that is actually sold

Absorption costing: how it works, continued


But, suppose we have the reverse situation; sales exceeds production and we draw down inventory
Now were selling all of the current production, plus some of whatever we had sitting around on the shelf As a result, well write off all of the current years fixed overhead, plus some fixed overhead from the previous year

Variable Costing
Under variable costing, 100% of fixed costs are expensed in the period incurred. Zero (zip, nada) fixed costs are charged to inventory.

In other words , fixed manufacturing costs are treated as an expense of the period.

Unit Cost computation


Number of units produced Variable cost per unit
Direct Material Direct Labour Variable manufacturing overhead Variable selling and administrative function $2 $4 $1 $3

6,000

Fixed cost per year


Fixed manufacturing overhead Fixed selling and administrative expenses $30,000 $10,000

Unit Cost computation


REQUIRED Compute the unit product cost under absorption costing method. Compute the unit product cost under variable / marginal costing method

Unit Cost computation Absorption costing method


Direct Material Direct Labour Variable manufacturing overhead
Total variable production cost Fixed manufacturing overhead

$2 $4 $1
$7 $5

---------------------------------------------------------------------------------

-------------------------------------------------------------------------------- Unit Product Cost $12

Fixed manufacturing overhead = $30,000 / 6000 = $5

Unit Cost computation Variable costing method


Direct Material Direct Labour Variable manufacturing overhead
Unit Product Cost

$2 $4 $1
$7

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Preparing Income Statement


Bruster Company sells its product for $66 each. The current production level is 25,000 units, although only 20,000 units are anticipated to be sold. Unit manufacturing costs are:
Direct materials Direct manufacturing labour Variable manufacturing costs Total fixed manufacturing costs Marketing expenses $12 $18 $9 $180,000 $6 per unit,
plus $60,000 per year

Required
Prepare income statement using absorption costing Prepare income statement using variable costing

Absorption costing method


Sales (20,000 * $66) Cost of good sold (20,000 * $46.20) Gross Margin Marketing: Variable (20,000 * $6) Fixed Operating Income $1,320,000 $924,000
-----------------

$396,000

$120,000 $60,000 --------------

$180,000 --------------$216,000

$46.20 = $12 + $18 + $9 + ($180,000/25,000) = $46.20

Variable costing method


Sales (20,000 * $66) Variable Costs:
Cost of good sold (20,000 * $39) Marketing (20,000 * $6) $780,000 $120,000

$1,320,000

$900,000 ----------------

Contribution Margin Fixed costs: Manufacturing Marketing


Operating Income

$420,000
$180,000 $60,000 --------------

$240,000 --------------$180,000

$46.20 = $12 + $18 + $9 = $39

Prepare income statements under absorption costing and variable costing.


The following data pertain to Davenport Fixtures:
Beginning inventory Produced Sold Ending inventory Year 1 -010,000 8,000 2,000 Year 2 2,000 11,500 13,000 500 Total -021,500 21,000 500

The following information is on a per unit basis: Comparing Income Statements

Sales price:
Variable manufacturing costs: Direct materials: Direct manufacturing labor: Indirect manufacturing costs:

$71.00
$ 4.00 $21.00 $24.00

Fixed manufacturing costs:

$ 4.50

Comparing Income Statements (Absorption Costing)


Total fixed production costs are $54,000 at a normal capacity of 12,000 units. Fixed nonmanufacturing costs are $30,000 per year. Variable nonmanufacturing costs are $2.00 per unit sold.

Comparing Income Statements (Absorption Costing)


Revenues Cost of goods sold Volume variance (U) Gross margin Nonmanufacturing costs Operating income $568,000 428,000 9,000 $131,000 46,000 $ 85,000

Comparing Income Statements (Variable Costing) Revenues for Year 1 are $568,000.
What is the cost of goods sold? 8,000 $49 = $392,000 What is the manufacturing contribution margin? $568,000 $392,000 = $176,000

Net contribution margin = $160,000

Comparing Income Statements (Variable Costing) Revenues $568,000


Cost of goods sold Variable nonmanufacturing costs Contribution margin Fixed manufacturing costs Fixed nonmanufacturing costs Operating income 392,000 16,000 $160,000 54,000 30,000 $ 76,000

Factors that affect the breakeven point


Under variable costing : Fixed costs - Contribution margin per unit
-

Under absorption costing : - Fixed costs - Contribution margin per unit - Production level in units in excess of breakeven sales - Capacity level chosen as the denominator to set the fixed manufacturing cost rate.

Q. In the year ended dec 31,2007,Radico khaitan sold 242000 cases liquor at an average selling price of Rs. 940 per case. Additional data given :

Beginning inventory , Jan 1 , 2007 Ending inventory , December 31, 2007

32600 cases 24800 cases

Fixed manufacturing overhead


Fixed operating cost Variable costs : Direct materials Direct labour
1. 2.

Rs 37536000
Rs 65688000 Rs 260 per case Rs 220 per case

Calculate cases of production for Radico Khaitan in 2007. Find the breakeven point a) under variable costing b) under absorption costing

Production = Sales + Ending inventory Beginning Inventory = 242400+24800-32600 = 234600 cases

Breakeven point (Q)


- Under variable costing:

Q =

Total fixed cost + Target operating income Contribution margin per unit = (Rs 37536000+Rs 65688000) + 0 Rs 940- ( Rs 260+ Rs 220) = Rs 103224000 Rs 460 = 224400 cases

Under absorption costing :


Total fixed cost +target operating income +[fixed manufacturing Q = cost rate x (Breakeven sales in units- units produced)] Contribution margin per unit = Rs 103224000 + Rs 0 + [ Rs 160 x ( Q 234600)] Rs 460 = Rs 103224000+ 160 Q - 37536000

Rs 460 300 Q = Rs 65688000 Q = 218960 cases


Difference = (224400-218960) = 5440 cases

Use of variable and absorption costing


Variable costing - Internal reporting - Short run decisions - performance evaluation

Absorption costing - Long run decision making

Undesirable Build up of Inventories


Motivation for an undesirable buildup of inventories could be because of manager bonus is based on reported absorptioncosting operating income. A manager can produce undesirable inventory which would not be easy to detect.

Methods of Undesirable Inventory Pile-up


A manager may manufacture products that absorb the highest amount of fixed manufacturing costs , regardless of customer demand. A manager may accept a particular order to increase even though another plant in the same company is better suited. To increase production, a manager may defer maintenance beyond current period.

Inventory Assume that Buildup Davenport Fixtures produced


4,400 units in Year 1 and sold 4,100. What is the production volume variance? (12,000 4,400) $4.50 = $34,200 U
What is the net operating income or loss for the period?

Inventory Buildup

Revenues (4,100 $71) Cost of goods sold (4,100 $53.50) Volume variance Gross margin Nonmanufacturing costs Net loss

$291,100 219,350 34,200 $ 37,550 38,200 $ 650

Inventory Buildup
How many units are in ending inventory?
4,400 4,100 = 300 How much cost is in ending inventory? 300 $53.50 = $16,050

Inventory Buildup
Suppose that management decides to produce 9,000 units next year. Sales remain the same (4,100 units).
What is the volume variance? (12,000 9,000) $4.50 = $13,500 U

What is the operating income or loss?

Inventory Buildup
Revenues (4,100 $71) $291,100 Cost of goods sold (4,100 $53.50) 219,350 Volume variance 13,500 Gross margin $ 58,250 Nonmanufacturing costs 38,200 Net income $ 20,050

Inventory Buildup
How many units are in ending inventory?
300 + 9,000 4,100 = 5,200 How much cost is in ending inventory? 5,200 $53.50 = $278,200

Throughput Costing
Is a method of inventory costing in which direct material cost are included as inventoriable cost. All other costs are costs of the period in which they are incurred. Is also called super variable costing as it is extreme form of variable costing.

Throughput Costing
Revenues Variable direct materials cost of goods sold Throughput contribution margin Manufacturing costs Nonmanufacturing costs Operating loss $568,000
32,000 $536,000 504,000 46,000 $ 14,000

Throughput Costing
Manufacturing Costs: Labor $21.00 10,000 Indirect costs $24.00 10,000 Fixed costs Total manufacturing costs
$210,000 240,000 54,000 $504,000

What are other nonmanufacturing costs for the year?

Throughput Costing
Nonmanufacturing Costs: Variable $2.00 8,000 $16,000 Fixed 30,000 Total $46,000

Throughput Costing
Variable costing operating income: Throughput costing operating loss: Difference in operating income: $76,000 $14,000 $90,000

How can this difference be explained?

Throughput Costing
The 2,000 units in ending inventory are valued as follows:

Variable 2,000 $49 = $98,000

Throughput 2,000 $4 = $8,000

$90,000 difference

Throughput Costing
Absorption costing operating income: Throughput costing operating loss: Difference in operating income: $85,000 $14,000 $99,000

How can this difference be explained?

Throughput Costing
The 2,000 units in ending inventory are valued as follows:

Absorption 2,000 $53.50 = $107,000

Throughput 2,000 $4 = $8,000

$99,000 difference

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