Inventory Management

inventory management – advantages and disadvantages of holding stock, LIFO (last-in-first-out), FIFO (first-in-first-out), JIT (just-in-time)

Definition

Inventory or stock refers to the amount of raw materials, work in progress and finished goods that a business has on hand at any particular point in time.

Stock is the product either in partial or full transformation, which has yet to be sold.

Problems that inventory management address include:

not having enough inventory when needed (both inputs to production and also to meet customer needs)
having too much inventory which can perish (perishable goods) or become out of date and obsolete (outdated technologies)
increased costs to store inventory and keep it secure and insured, and capital of the business is tied up in inventory in warehouses

Description of strategy

For many businesses, the warehousing and care of physical inventory can be very expensive. Inventory may account for 30-50% of the total assets of the business and thus inventory control and management is very significant.

Controlling the level of inventory in a business is very important because the business must hold enough to meet demand but not too much. Too much inventory will increase storage costs, while not having enough stock on hand will result in lost sales and potentially damage the business' reputation as a reliable supplier.

Ultimately, a business will need to balance its inventory expenses with the need to meet changing demand. Technology has made inventory management more efficient and accurate. The use of barcodes keep track of what they have, what has been sold and the exact location of stock.

Advantages and Disadvantages of Holding Stock

This is also known as just-in-case (JIC) or buffer stock.

Here the business holds a certain level of stock as a reserve to cover interruptions to supply or an unexpected increase in demand.

Advantages

Able to better meet consumer demand, increasing revenue and market share
Alternative products can be offered if a particular item runs out of stock
Reduces lead times between order and delivery
Cheaper prices may be obtained through purchasing inputs in bulk (economies of scale) reducing production costs
Stock is an asset on the balance sheet and adds value to the business
Stock of inputs means production is less exposed to disruption in the supply chain (pandemic or natural disaster for example)

Disadvantages

High costs associated with holding stock such as storage and handling, insurance expenses
Increased cash tied up in stock impairing cash flow
Invested capital, labour could be used elsewhere
More exposed to a change in market tastes and preferences- cost of obsolescence

Just-In-Time (JIT)

Definition

An inventory management approach which ensures that the exact amount of material inputs arrive only as they are needed in the operations process.

Description

The aim of the JIT inventory management is to hold as minimal stock as possible and only bring in stock from suppliers as required.
This will reduce the amount of working capital tied up in stock but also improve the efficiency of the operations process.
This system requires suppliers to have excellent inventory management and delivery systems to send out stock as soon as it is ordered.
The business will need to have an excellent relationship with their supplier and have suppliers who are reliable

Advantages

•Reduces costs of storage and securing stock.

•Increases the liquidity of working capital as less cash is tied up in stock.

•Reduces the chance of stock becoming obsolete

•Reduces the chance of perishable stock spoiling

In Summary

At the end of an accounting period, it is important to put a value on unsold stock.

There are TWO main inventory valuation techniques

LIFO (last-in-first-out)

FIFO (first-in-first-out)

*It is important to note that JIT is NOT an inventory valuation technique it can therefore be used in conjunction with LIFO/FIFO*

Just in Time by Toyota: The Smartest Production System in The World - YouTube

Last-In-First-Out (LIFO)

Definition

A method of pricing inventory that assumes the last goods purchased are also the first goods sold and therefore, the cost of each unit is the last recorded cost.

This method can be used for goods that have no use-by date such as machinery parts or some canned food.

On the revenue statement, the newer, more expensive stock is sold, making a higher cost of goods sold and lower profit. This will reduce the tax a business has to pay.

LIFO is rarely used in Australia. The ATO in most cases says it is not acceptable.

LIFO Example

First-In-First-Out (FIFO)

Definition

A method of pricing inventory that assumes the first goods purchased are also the first goods sold and therefore, the cost of each unit is the first recorded cost (usually used for perishable items)

Using FIFO, the business assumes that the first goods sold are the oldest and the most recently purchased items remain in inventory on the balance sheet.

Therefore closing stock on the balance sheet will be higher, increasing the value of current assets.

Cost of goods sold will be lower and gross profit higher than if the LIFO method was used.

This acts as a strategy to make the business look more profitable to attract investors and loans.

FIFO Example

In summary

By using LIFO, businesses have a tendency to present a higher value for COGS and a lower rate of Gross Profit. This is a result of businesses assuming the COGS are based on the most recent stock purchased.

When using FIFO businesses have a tendency to do the opposite. Costs my be understated and profits overstated

Practice Question

On 1 May, Zegna Shoes orders 200 pairs of joggers at $30 apiece and sells 150 pairs for $50. Eight weeks later, Zegna Shoes orders 100 more pairs at a new price of $35 and sells 60 of these at $55. By the end of the accounting period 210 of the 300 pairs are sold. Calculate the total cost of sales (cost of stock), total sales and gross profit using the (i) LIFO and (ii) FIFO simplified cost analysis methods.

•While LIFO and FIFO are essentially INVENTORY VALUATION methods, they can also be seen as INVENTORY MANAGEMENT strategies

•FIFO (first-in-first-out) can be used in the management of PERISHABLE GOODS. For example, a supermarket that sells dairy products would want to sell these products in the order that it received them so that customers have the freshest produce. So it must use STOCK ROTATION to ensure the oldest dairy products are at the front of the shelf.

•LIFO (last-in-first-out) can be used in the management of LARGE BULKY items. For example, Bunnings does not need to bring the oldest shovels to the front of the shelf it can just stake the most recently arrived shovel stock at the front. Less cost in managing inventory.

Metrics to determine if the strategy is effective

Reduction in inventory costs (inventory, storage, security, insurance)
Reduction in inventory outages (where there is no stock to fill customer orders)
Reduction in inventory obsolescence costs
Reduction in production time lost as a result of inputs not being available when required.

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