Collier 1ce Ch07

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 1
CHAPTER 7
Inventory
Management
Learning Objectives
 How are inventories presented on a company’s financial
statements?
 How does the flow of inventory costs differ between a
manufacturing and a merchandising company?
 What are the various methods used to value inventory?
How are these methods applied in practice?
 What are the benefits and challenges of just-in-time (JIT)
inventory management?
 Why are inventory management practices important in
controlling costs of inventory?
Introduction to Inventory
 Goods bought or manufactured for resale but unsold
 Timing difference between production capacity and
customer demand
 Cost includes all costs of purchase or manufacture to
bring inventory to its present location and condition
 On a company’s statement of comprehensive income,
the cost of inventories is recorded as “Cost of goods
sold” and on the statement of financial position, it is
reported under current assets as “Inventory.”
Inventory for a
Merchandising Company
Cost of Goods Sold: Merchandising Company
Inventory for a Merchandising Company
Statement of Comprehensive Income
Statement of Financial Position
Inventory for a Merchandising Company
The Flow of Costs in Purchasing
Inventory for a
Manufacturing Company
Inventory types
1. Raw materials – unprocessed goods
2. Work in process – uncompleted goods
3. Finished goods – manufactured or
purchased and ready for sale
Inventory for a Manufacturing Company
Cost of Goods Manufactured: Manufacturing Company
Cost of Goods Sold Statement: Manufacturing Company
Statement of Comprehensive Income
Statement of Financial Position
The notes to the financial statements would
show a breakdown of the valuation of
inventory in the current assets section of the
statement of financial position.
The Flow of Costs in Manufacturing
Valuation of Inventory
 Lower of cost or net realizable value (NRV)
 Individually purchased inventory
 Purchase cost is used to value the inventory
and the cost of goods sold when the inventory
is sold
 Similar/undifferentiated products (bulk)
 Weighted average cost
 FIFO (first in, first out)
Example
A product is purchased on three separate occasions:
Units Unit price Total cost
5,000 $1.20 $6,000
2,000 $1.25 $2,500
3,000 $1.27 $3,810
Calculate the cost of goods sold for the 6,000 units sold
and the value of the ending inventory
Weighted Average Method for
Merchandising Companies
Units Unit price Total cost
5,000 $1.20 $6,000
2,000 $1.25 $2,500
3,000 $1.27 $3,810
10,000 $12,310
 The weighted average cost is

$12,310/10,000 = $1.231 per unit.
 The cost of goods sold is
6,000 @ $1.231 = $7,386
 The value of the ending inventory is
4,000 @ $1.231 = $4,924
 Total cost $7,386 + $4,924 $12,310
First-In, First-Out Method for
Merchandising Companies
Units Unit price Total cost Cost of Goods Sold
5,000 $1.20 $6,000 5000@$1.20 = $6,000
2,000 $1.25 $2,500 1000@$1.25 = $1,250
3,000 $1.27 $3,810 6000 $7,250
Units Unit price Total cost Ending Inventory Value

5,000 $1.20 $6,000
2,000 $1.25 $2,500 1000@$1.25 = $1,250
3,000 $1.27 $3,810 3000@$1.27 = $3,810
4,000 $5,060
Total cost $7,250 + $5,060 $12,310
Comparison of Methods
Weighted Average Method
If 6,000 units sold @ $2.00
Sales $12,000
Cost of goods sold (WAM) 7,386
Gross profit 4,614
FIFO Method
Sales $12,000
Cost of goods sold(FIFO) 7,250
Gross profit 4,750
Net Realizable Value (NRV)
 NRV is the potential proceeds of sale of
inventory, less any costs of disposal
 If the NRV is lower than the recorded cost,
the inventory item should be recorded at
NRV
Methods of Costing Inventory
in Manufacturing
 Custom
 Unique, single products
 Batch
A quantity of the same goods produced at the
same time ( a production run)
 Continuous (Process Costing)
 Continuous production process of the same,
indistinguishable goods
Job Order Costing
 Cost of raw materials as they are issued to each job
(either a custom product or a batch of products)
 Plus the cost of time spent by different categories of
labour
 To each of these costs, overhead is allocated to
cover the fixed and variable manufacturing
overheads that are not included in materials or
labour (overhead will be explained in Chapter 11)
 Accumulated cost of materials, labour, and
overhead is the cost of that custom product
Job Costing Example
Helo Ltd manufactures components for helicopters in batches of
100 components.
Each batch requires 500 Kg of rolled and formed steel, which takes
15 hours of labour.
July Transactions
 Purchase of steel 1,000 Kg @ $12/Kg
 Issue of steel to production 500 Kg
 Direct labour to roll and form 500 Kg steel 15 hours @ $125/hour
 Overhead is allocated $2,000 at completion of batch.
 60 of the components manufactured in the batch were sold for $130
each.
 At month end, but prior to the completion of the job, 500 Kg of steel
had been issued to production and 7 hours had been worked.
Calculate the value of work in process at month end
Work in Process
Materials: Steel 500 Kg @ $12/Kg = $6,000

Labour: 7 hours @ $125 875
Work in progress $6,875
At the completion of a batch of 100
components, calculate:
 Totaljob cost
 The unit cost per component
 The gross profit
 The value of
 raw materials inventory
 finished goods inventory
 work in process inventory
Materials: Steel 500 Kg @ $12/Kg $6,000
Labour: 15 hours @ $125 1,875
Overhead 2,000
Total job cost $9,875
Cost per component ($9,875/100) $98.75
Sales income (60 @ $130) = $7,800

Cost of sales (60 @ $98.75) = $5,925
Gross profit is $7800 - $5925 = $1,875
Finished goods inventory (40 @ $98.75) = $3,950

Raw materials inventory 500 Kg of steel @ $12/Kg = $6,000
(purchased 1000Kg less used 500Kg)
Total inventory $9,950
There is no Work in progress as the job is complete
Process Costing
 Costs are collected over a period of time
together with a measure of the volume of
production
 At the end of the accounting period, the total
costs are divided by the volume produced
(equivalent units) to give a cost per unit of
volume
 Equivalent units are the number of fully
completed units in production
Process Costing
 Equivalent units measure the fully completed
units by multiplying the number of units in the
work-in-process inventory by their percentage of
completion
 This amount is added to the finished units to
determine the equivalent units
Process Costing
 Either the weighted average method or the first-
in, first-out (FIFO) method can be used to
calculate inventory costs for process costing.
 Under both methods, it is necessary to complete
three steps:
1. Determine the number of units completed.
2. Calculate the equivalent units in work in
process and the cost per equivalent unit.
3. Assign the cost to finished goods and ending
WIP inventory
Note: In process costing examples, unless
you are advised otherwise, materials are
assumed to be added at the beginning of the
process, and conversion costs are added
uniformly throughout the process.
Material
added Conversion costs applied uniformly
Beginning End of
of process process
Process Costing with Partially
Completed Units – Weighted Average
Kazoo produces oils on a process basis during a month
 Opening work in progress 7,000 units:

 55% completed
 Materials $12,000 and conversion costs $30,000.
 12,000 units commenced production during the month.
 Closing work in progress 4,000 units, 75% complete.
 Cost of materials issued to production during the month
was $140,000.
 Conversion costs for production during the month were
$80,000.
 Calculate:
 The number of units completed
 The equivalent units in WIP and the cost per
equivalent unit, using the weighted average
method
 The cost of work in process and finished
goods at month end.
Calculation of Units Completed
Units
Opening WIP 7,000
Units commenced 12,000
19,000
Closing WIP 4,000
Completed 15,000
Calculation of Equivalent
Units and Cost per Unit
Opening Cost for Total $ Completed WIP Total Cost per
WIP $ month $ units Equivalent equivalent equivalent
units units unit $
Material 12,000 140,000 152,000 15,000 4,000 19,000 $8.000
Conversion 30,000 80,000 110,000 15,000 *3,000 18,000 $6.111
Total $42,000 $262,000 $14.111
* 4,000 units, 75% complete at end of month = 3,000 equivalent units
Assignment of Costs
Work in progress:
Materials 4,000 @ $8 $32,000
Conversion 3,000 @ $6.111 $18,333
$50,333
Finished goods:
15,000 units @ $14.111 $211,666
Total costs $262,000*
* Materials $12,000 + $140,000 + Conversion $30,000 + $80,000
Process Costing with Partially
Completed Units – First-in First-Out
(FIFO)
Kazoo produces oils on a process basis during a month
 Opening work in progress 7,000 units:

 55% completed
 Materials $12,000 and conversion costs $30,000.
 12,000 units commenced production during the month.
 Closing work in progress 4,000 units, 75% complete.
 Cost of materials issued to production during the month
was $140,000.
 Conversion costs for production during the month were
$80,000.
 Calculate:
 The number of units completed
 The equivalent units in WIP and the cost per
equivalent unit, using the FIFO method
 The cost of work in process and finished
goods at month end.
Calculation of Units Completed
Units
Opening WIP 7,000
Units commenced 12,000
19,000
Closing WIP 4,000
Completed 15,000
Calculation of Equivalent
Units and Cost per Unit
Opening Cost for Beginning Completed Ending Total Cost per
WIP $ month $ WIP units WIP equivalent equivalent
completed Equivalent units unit $
units
Material 0 140,000 0 8,000 4,000 12,000 $11.6667
Conversion 0 80,000 *3,150 8,000 **3,000 14,150 $5.6537
Total $42,000 220,000 $17.3207
* 7.000 units, 55% complete, 45% added in current month: 7,000 x 45% = 3,150
** 4,000 units, 75% complete at end of month = 3,000 equivalent units
Assignment of Costs
Work in process:
Materials 4,000 @ $11.6667 $46,667
Conversion 3,000 @ $5.6537 $16,961
$63,628
Finished goods:
Beginning WIP already completed $42,000
Beginning WIP finished (3,150 @ $5,6537) $17,809
Units started and completed
(8,000 units @ $17.3207) $138,564
$198,373
Total costs $262,000*
* Materials $12,000 + $140,000 + Conversion $30,000 + $80,000

Valuation of Inventory for
Service Companies
 Professional service firms also have
inventories.
 Accountants and lawyers are examples of
firms with large work-in-process
inventories, covering work carried out on
behalf of clients but not yet invoiced.
Just-In-Time Inventory
Management
 Maintain minimal inventories (as close to zero as
possible) to reduce inventory carrying costs, such as
storage and materials handling costs, and to reduce the
cost of obsolescence
 Advantages
 Cost savings
 Improved customer and employee satisfaction
 Improved quality
 Disadvantages
 Inability to predict demand
 Strong reliance on suppliers
© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7
41
Backflush Costing
 Transfers the cost of materials from suppliers, along
with conversion costs, to finished goods inventory
when production of finished goods is complete (the
trigger point)
The Flow of Costs in Backflush Costing
Long-Term Contract Costing
 Large units produced over longer periods
 Percentage of completion
 Revenues and gross profit are recognized in
the applicable periods of production, not when
production has been completed.
 The costs incurred in reaching the relevant
stage of completion are then matched with
income
Long-Term Contract Costing
 Architects certificate as to stage of
completion
 Progress payments by customer
 Retention value
Long-term Contract Costing
Example
Macro Builders has entered into a 2 year contract to construct a
building.
Contract price is $1.2 million,
Expected cost of construction of $1 million.
After 1 year, the following costs have been incurred:

Material delivered to site $500,000
Salaries and wages paid 130,000
Overhead costs 170,000
Certification of value of work completed is $600,000.
Macro estimates cost of $250,000 to complete over and above the costs
already incurred.
Calculate:
 The anticipated profit on the contract
 The amount of profit that can be considered to have been earned to
date.
Anticipated Profit
Costs of construction:
Material delivered to site $500,000
Salaries and wages paid 130,000
Overhead costs 170,000
$800,000
Less work not certified 200,000
Cost of work certified $600,000
Anticipated profit:
Cost of work certified $600,000
Work not certified 200,000
Estimated cost to complete 250,000
Currently estimated cost 1,050,000 (budget $1 million)
Contract price 1,200,000
Anticipated profit $150,000
Profit to Date
Expected cost of construction $1,050,000

Certified as complete $ 600,000
Percentage complete 57% ($600,000/$1,050,000)
Anticipated profit $ 150,000
Recognise profit of 57% of $150,000 = $85,500
Inventory Management
 Objective is to optimize the levels of inventory
 Reduce costs associated with ordering and carrying
inventories
 Ensuring there is enough inventory on hand to meet
consumer demand
 Costs associated with ordering and carrying inventory
1. Ordering costs
2. Carrying costs.
3. Stockout costs.
Economic Order Quantity and
Lead Times
 Economic order quantity (EOQ)
 Determine the levels of inventory that will
reduce costs while meeting demand
 Lead time
 Time between when an order is placed with a
supplier and when it is needed
 Safety stock
 an amount of extra stock that is kept on hand
to cover any unexpected increases in demand
Economic Order Quantity
Calculated using the following formula
Conclusion
 Several methods of calculating the value of
inventory and cost of goods sold
 How inventories are reported on the financial
statements for a company
 Looked at the two main methods of costing
inventories, job costing and process costing
 A method of long-term contract costing
 Benefits and challenges of using just-in-time (JIT)
inventory management practices
 Economic order quantity can be used to optimize
inventory costs.

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© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 1

Statement of Financial Position

The Flow of Costs in Purchasing

Statement of Financial Position

The Flow of Costs in Manufacturing

 The weighted average cost is

Units Unit price Total cost Ending Inventory Value

Total cost $7,250 + $5,060 $12,310

Calculate the value of work in process at month end

Materials: Steel 500 Kg @ $12/Kg = $6,000

 work in process inventory

Cost per component ($9,875/100) $98.75

Sales income (60 @ $130) = $7,800

Finished goods inventory (40 @ $98.75) = $3,950

There is no Work in progress as the job is complete

 Opening work in progress 7,000 units:

* 4,000 units, 75% complete at end of month = 3,000 equivalent units

* Materials $12,000 + $140,000 + Conversion $30,000 + $80,000

 Opening work in progress 7,000 units:

* Materials $12,000 + $140,000 + Conversion $30,000 + $80,000

The Flow of Costs in Backflush Costing

After 1 year, the following costs have been incurred:

Expected cost of construction $1,050,000

Percentage complete 57% ($600,000/$1,050,000)

Anticipated profit $ 150,000

Recognise profit of 57% of $150,000 = $85,500

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