Inventory Management

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.

Advantages of holding stock

• Consumer demand can be met when stock is available. This may prevent the consumer from seeking to buy from an alternative business. This is a risk reduction strategy.

• If a particular product line runs out, an alternative can be offered, thereby generating income for the business instead of a lost sale.

• It reduces lead times between order and delivery.

• Stock can be distributed to distribution centres, which then rapidly transport the products to places as indicated by demand.

• A store of stock allows the business to promote use of products in non- traditional or even new markets. e.g. start selling online rather than just in-store

• Older stock can be sold at reduced prices and thereby encourage cash flow and also attract sales of other products.

• Stocks are an asset and are of value to the business, reflecting well on the balance sheet.

• Making products in bulk may reduce costs as there are economies of scale in purchasing inputs. This could be cheaper than the cost of holding the stock once it is made.

Disadvantages of holding stock

• The costs associated with holding stock , including storage charges, spoilage, insurance, theft and handling expenses (The costs associated with holding stock in warehouses can be as high as 30% of the value of the stock.)

.• The invested capital, labour and energy cannot be used elsewhere as it has been used to create the stock

• The cost of obsolescence, which can occur if stock remains unsold.

Inventory valuation methods/strategies

Overview of FIFO and LIFO Inventory Management Systems

FIFO (First-In, First-Out)

How It Works: The oldest inventory (first purchased) is sold first, meaning that the cost of goods sold (COGS) reflects older, often lower, costs in times of inflation.
Where It’s Used: Common in industries with perishable goods (e.g., food, pharmaceuticals) to prevent spoilage. Also used in businesses where inventory turnover is high, such as supermarkets and retail stores.
Advantages:
- Matches actual physical inventory movement.
- Ensures fresher stock for customers.
- Reports higher profits in times of rising prices (lower COGS).

LIFO (Last-In, First-Out)

How It Works: The newest inventory (last purchased) is sold first, meaning that the COGS reflects recent, often higher, costs in times of inflation.
Where It’s Used: More common in industries with non-perishable goods, such as oil, mining, and heavy manufacturing, where companies want to match recent costs with revenue.
Advantages:
- Reduces taxable income during inflation (higher COGS).
- Better matches current costs with revenue.

Is LIFO Illegal in Australia?

Yes, LIFO is not allowed under Australian accounting standards (AASB) and the International Financial Reporting Standards (IFRS). The FIFO method or weighted average cost (WAC) must be used for inventory valuation in Australia. LIFO is mainly used in the United States, where it is permitted under U.S. Generally Accepted Accounting Principles (GAAP).

Last in First out (LIFO)

The LIFO (last-in-first-out) method of pricing inventory assumes that the last goods purchased are also the first goods sold and therefore the cost of each unit sold is the last cost recorded.

LIFO is used, to overstate cost and understate gross profit (especially when the cost of purchased goods rises over time). Moreover, it may undervalue stocks on hand at the end of the period.

When would you use this accounting method?

If a U.S. corporation's costs of inventory items are continuously increasing, a profitable U.S. corporation will have lower income tax payments with LIFO. This results from matching the most recent higher costs of its items to the most recent sales. (The higher cost of goods sold means lower net income and lower taxable income than FIFO.)

Another reason for a company to use the LIFO cost flow assumption is to improve the matching of costs with sales. If the company had matched the old low costs using FIFO, the company would show a greater profit that was partly caused by merely holding some old inventory items.

First in First out (FIFO)

The FIFO (first-in-first-out) method of pricing inventory assumes that the first goods purchased are also the first goods sold and therefore the cost of each unit sold is the first cost recorded.

Alternatively, under a FIFO approach, stock costs may be understated and profits overstated. Moreover, stocks at the end of the period may be overvalued.

When would you use this accounting method?

If a U.S. corporation's cost of inventory items are continuously increasing and the corporation has been experiencing operating losses and negative taxable income, the use of FIFO means matching its oldest/lower costs with its current sales. The result is a larger gross profit and a positive operating income.

Good to use if you need to:

- Sell the business
- Look better for an audit
- Make it more valuable to shareholders
- If a profit is a requirement of your terms of finance

Example

Because the inventory valuation method has such a powerful impact on gross profit, a business must state in the footnotes to its financial accounts which method is used

Batch A Purchase 1000 phones @ $100. Total cost is $100 000.

Batch B Purchase 1000 phones @ $110. Total cost is $110 000.

Batch C Purchase 500 phones @ $120. Total cost is $60 000.

Total sales = (500 × $150) + (900 × $160) + (800 × $180)= $75 000 + $144 000 + 144 000 = $363 000

LIFO calculation

A total of 2200 items were sold out 2500. In businesses applying a LIFO approach, the business would apply cost on a last-in-first-out basis, meaning the stock bought last would assume to have been sold 1st.

This would give the following cost:

The last group (batch C) of 500 phones would be assumed to have sold 1st. Therefore, 500 of the phones would attract a cost of $120 each for a total cost of $60 000.
The second last purchased (batch B) cost would apply to the next 1000 phones sold. This gives the cost of that 1000 at $110 each, totalling $110 000.
The 1st stock sold is assumed to have sold last (batch A), meaning the remaining 700 phones that sold would be given the 1st cost of $100 each for a total of $70 000.

Under this analysis, the total cost of goods sold (COGS) is $60 000 + $110 000 + $70 000 = $240 000

Unsold stock has a value of (500+1000+700 = 2200) = 300 units × $100 = $30 000.

FIFO calculation

A total of 2200 items were sold out 2500. In businesses that apply a FIFO approach, the business would apply cost on a first-in-first-out basis, meaning the stock bought 1st would assume to have been sold 1st.

This would give the following cost:

The first group (batch A) of 1000 phones would be assumed to have sold 1st. Therefore, 1000 of the phones would attract a cost of $100 each for a total cost of $100 000.
The second purchased (batch B) cost would apply to the next 1000 phones sold. This gives the cost of that 1000 at $110 each, totalling $110 000.
The last stock sold (batch C) is assumed to have sold last, meaning the remaining 200 phones that sold would be given the first cost of $120 each for a total of $24 000.

Under this analysis, the total cost of goods sold is $100 000 + 110 000 + $24 000 = $234 000

Value of unsold stock (1000+1000+200 = 2200) 300 × $120 = $36 000

Just in Time

One means of managing stock is to apply a just-in-time (JIT) approach, which aims to overcome the problem of end-of-period stock valuation: a lean production method. This is because a JIT approach aims to have the business make only enough products to meet demand. A JIT approach also allows as they and can order in response to consumer demand.

Benefits

Retailers to display a wider range of products
Need to store less
Saves money as there are no expensive holding and insurance costs.
Shrinkage costs (`theft/wastage) and losses due to obsolescence (old technology) are also minimised.

HSC Questions

2013

Q18 A business is experiencing increasing costs for its stock over time. It is seeking to maximise its profit for the current financial period. Which strategy should it adopt to value its inventory?

(A) First in first out

(B) Just in case

(D) Last in first out

2014

Q7 A car assembly plant had to shut down operations for a day because tyres had not been delivered. What inventory management strategy at the car assembly plant may have caused this situation?

(A) Just-in-case

(B) Just-in-time

(D) Last-in-first-out

2015

Q8 Which of the following is the best method for managing the stock of fresh milk in a supermarket?

(A) Just‑in‑time

(B) First‑in‑last‑out

(D) First‑in‑first‑out

2016

Q24

A fruit shop has experienced strong growth in its sales of fresh organic fruit since it started to sell online.

(a) Discuss ONE possible method of inventory management for this business. 4 marks

2022

21 b)

Michael would like to open a new burger restaurant

Recommend an appropriate inventory management strategy for this business. 3 marks

2024

21 b) A department store is considering the quantity of products they will need to order and store for the following year. 3 marks

How can each of these TWO products below affect inventory management?

Google Sites

Report abuse