Inventory Management
Introduction
Inventories refer to total amounts tied up in raw materials, work in progress and finished goods. Company usually record inventories once a year basically at the year –end. Inventories has to be recorded based on accounting principles i.e. GAAP. Inventories are recorded in the income statement on the cost-of-goods sold calculation and also shown in balance sheet as current assets (All business, 2010). The cost of inventories is initially recorded on the balance sheet. As the inventories sold, these costs are removed from the balance sheet and flow into the income statement as cost of goods sold (Wild J.J., Subramanyam, K.R., & Halsey, R.F., 2007).
Inventory Management system is the systematic plan, procedure and method deployed to maintain the optimal amount of inventories in the organization. The objective of inventory management system is to facilitate continuous productions and sales at the lowest cost and also to specify the proper volume of inventories needed. The inventory management concerns with activities such as “carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, available physical space for inventory, quality management, replenishment, returns and defective goods and demand forecasting” (Inventory management, 2007). Inventories should be ordered in proper amounts that assist to meet the proper customer demand and also to lower the holding cost of inventories. When inventory get shortage the company has to lose customers at the same time when inventories get excess company has to abide holding cost. Managing inventories is very complex and challenging task. Especially for the manufacturing company effective inventory management play crucial function for the success of the company. The reason is that firm has invested most of the funds in inventories and if inventories are not managed properly then their investment stuck on warehouse of the company instead of earning the returns (Donovan, 2010).
Methods of Inventory valuation
Inventory storage method refers to the valuation of inventories and recording them into company’s financial statements reflecting all the changes that occurs over the year in inventory. Changes in the inventory could occur as a result of “obsolescence, deterioration, increase/ decrease in demand and supply levels, and market trends” (Ehow, 2010). Inventories carry significant percentage of company’s operating assets and therefore needed to reveal accurately on balance sheet (Ehow, 2010). General Accepted Accounting Principle (GAAP) allows companies several options to determine inventories values which can be recognized as cost of goods sold in the income statement and removed portion of inventory from balance sheet (Donovan, 2010).
First-In, First-Out (FIFO)
This method assumes that the first units purchased are the first unit sold. FIFO inventory accounting corresponds most closely to the actual physical flows inventory since inventories are cost on first in first out basis (Droms G., 2003). However, during the period of frequent price rise this method does not reflect correct value of inventories in the income statement and also in balance sheet. Since the inventories are recorded on old price that overstate net income by lowering the cost of goods sold. FIFO inventory accounting record the cost of the recent inventory in the balance sheet based on the assumption that the first purchased are used on production or sales and last purchased are stored. Since the new price of the inventories are recorded on balance sheet that overstate the total assets (Bragg, 2007).
Last-In, First-Out (LIFO)
This method assumes that the last unit purchased is the first unit sold. LIFO inventory accounting record the cost of the old inventory in the balance sheet based on the assumption that the recent purchased are used on production or sales (Droms G., 2003). Since the old price of the inventories are recorded on balance sheet that understate the total assets. During the period of frequent price rise this method reflects correct value of inventories in the income statement as cost of goods sold. LIFO method is very useful from tax consequences. In the income statement the latest price of the inventories are recorded that understate net income and helps the company to obligate less tax liability (Bragg, 2007).
Average Cost
Average cost method is fairly straight forward that is often used to account for fungible goods such as wheat and other physically indistinguishable products. In this method, inventory is priced as weighted average of cost prices of inventories at the time of purchase (Bragg, 2007). In the income statement the cost of goods sold is calculated as a weighted average of the total cost of goods available for sale divided by the number of units available for sale. Ending units are recorded on the balance sheet (Wild, J. et al., 2007). This method is not as popular as LIFO and FIFO.
Effect of inventory valuation on financial statement
Effects on Profitability
The profitability of the company differs by the choice of the company’s inventory costing method. During the periods of continuous rising of inventory prices, FIFO produce higher gross profits than LIFO because lower cost of inventories are recorded on income statement. The figure of the gross profit overstated as the current market price of the inventory (Cost of goods sold) is higher than book value. Similarly, LIFO produce lower gross profit by recording inflationary cost of inventories and also by significantly impacting on tax liabilities. While at the period of decreasing inventory prices, FIFO produce lower gross profits than LIFO because higher cost of inventories are recorded on income statement (Wild et. al., 2007).
LIFO best matches the current value of cost of goods sold with current revenue by assigning most recent inventory costs. Therefore, LIFO produces the cost of goods sold figure that is closest to what it would cost company to replace the goods that were sold. In this sense, LIFO produces the best measure of net income. In contract, FIFO matches the oldest inventory costs against the revenue – a poor match of current expenses with current revenue (Horngren, 2010).
Effect on balance sheet
LIFO reports the oldest cost of inventory on balance sheet as the latest inventory is used first. During the period of continuous price rising, prices of inventory on balance sheet are significantly lower than replacement cost. Therefore, the balance sheet of LIFO companies does not correctly embody the current investment on inventories. While the FIFO reports the most current inventory cost on balance sheet. In the period of rising prices, prices of inventory on balance sheet are higher than market prices which overstate the balance sheet. As a result, the invested capital from the balance sheet is omitted (Wild et al., 2007).
Effect on Cash flow
As the FIFO report the higher gross profit company owes higher tax liability. During the period of price rising company might have problems on cash flow because of higher tax obligation. At the same time company must replace the inventory sold at the higher replacement cost than the original purchase price that ultimately lead the liquidity problems (Wild et al., 2007). LIFO reports the lower gross profit and consequently the lower tax liability. At the period of price rising, replacement cost of the inventory is almost the same as the original purchase price. However, as per the IRS requirement, if companies use LIFO inventory costing for tax purposes then they have to use LIFO methods for financial reporting also (Wild et al., 2007).
Concerns for the Financial Analyst
As per the nature of the business, company uses different inventory valuation techniques. At the same time outer environmental forces such as raise in prices, inflation, interest rate, economic recession, and regulatory forces also influence the value of the inventory on different methods. Even though, companies have to follow stated accounting rules i.e. GAAP while preparing their financial statement, management could use those rules for their own interest and benefits. Therefore, it is the responsibility of financial analyst to check accuracy of the value stated on every elements of financial statement i.e. income statement, balance sheet, and cash flow statement. Following are some of the concerns that the financial analyst may have while analyzing the accuracy of inventory value.
· To what extend portion of inventories are moving slow.
· Is the value of inventories on balance sheet reflecting the current inventories cost.
· The value of inventories increased on balance sheet is on the same proportion compared to investment side of cash flow statement or not? If not then what happen on the differences of inventories value. Are they obsolete or company sold them due to excess on warehouse?
· Changes on inventory costing method during the accounting year. For example from LIFO to FIFO. The chances in costing methods significantly impact on value of cost of goods sold, ending value of inventory, and money invested on inventory (replacement cost).
· The same company may use different methods of inventory costing for different types of inventory, for different business segments. It is the responsibility of analyst to distinguish among them and calculate the value of inventories accordingly (All business, 2005).
· To what extend company is able to self finance its working capital. Is the cash cycle of the company too big or appropriate?
Conclusion
Inventory is one of the important operating assets of the company. Specially manufacturing company has to invest momentous percentages of their investment on inventories. Therefore, inventories should be managed properly that assist to meet the proper customer demand and also to lower the carrying cost of inventories. Inventories are classified into three categories: Raw materials, work-in progress and finished goods. As per the nature of these inventories their movement differs from company to company. For example, inventory cycle for hotel and restaurant is very short and risky because of perishable nature of the inventory; similarly inventory cycle of departmental store is long and don’t have riskiness of perishable of inventory. All inventory costing methods: LIFO, FIFO and weighted average cost are very useful for the companies for valuation of the inventories. Based on the nature of business and requirement of federal government, some companies use LIFO, some other companies use FIFO and Weighted average cost. “LIFO and FIFO are widely used in USA” (All business, 2005) mostly in USA, companies use LIFO method. Companies which values are appreciating day by day use the LIFO inventory valuation techniques. For example, oil and gas refining company, drug retail, home furnishing, food retail, and others. As per the inventories costing method that company is using, the value of inventories differs. Those differences on value of inventories significantly impact on cost of goods sold, net income, inventory on balance sheet, tax liability and others. Therefore, it is the responsibility of financial analyst to check financial statement of companies to reflect the accuracy on financial statements and to make sure the management has not use any resources solely for their benefits.
