[MUSIC PLAYING] This is Dr. Bob Nolley, back to talk about inventory management. The management of an accounting for inventory is a critical financial function, particularly for businesses that sell physical goods.
Let's take a look at the challenges. The first challenge is that all inventory is not the same. Most companies divide them into three different types. Raw materials are those items that are used to make the products that are going to be sold. Work in process includes raw materials that have been started in the manufacturing process but not yet completed. And finally, finished goods are goods ready to be sold to the customers.
While these three types of inventory on the surface seem to be clear in their definition, measuring each of them in accounting can be a problem. One way of accounting for inventory is the FIFO method. FIFO stands for First In and First Out. This means that the older inventory items are recorded as being the ones sold first, even though the exact physical items may not have been the ones used during the manufacturing.
The second method of accounting for inventory is called LIFO, or Last In First Out. This means that the most recently purchased items are recorded as sold first. Now this is favorable to the company because in a time of rising prices, such as one with inflation, they realize a tax advantage by booking the expense of the more pricey inventory.
However, because of this advantage, the International and Finance Reporting Standards Board barred the use of LIFO. And most companies have gone back to using FIFO.
The third method is fairly straightforward. And this is the average cost. This method takes the weighted average of all the units in inventory during the accounting period and uses that average cost to determine the value of the cost of goods sold.
A final method is the ABC method. And this is used when a company has a need for very selective inventory control because it has items that vary greatly in value and inventory cost.
Let's take it as an example of an electronics firm. They have class A inventory that might be very expensive finished goods that they keep very tightly controlled down to the point of the individual item level. And they require a very accurate record keeping. Class B items require a bit less control and less detailed record keeping. And other items that are much less expensive and require minimal individual control would be class C items.
Companies that use the ABC method, also called selective inventory control, recognize that their inventory broadly does not have the same equal value. There are several reasons why a company carries any inventory quantity at all.
The first is time. No supply chain is perfect. And often enough, time lags can ruin potential business opportunities. Playing it safe and having certain items in stock ahead of time avoid lost opportunity cost.
The second reason is uncertainty. Supply and demand forecast are not perfectly predictable. And uncertainly means keeping enough on hand as necessary to fill fluctuations in demand.
There is also economies of scale. Many companies increase their profitability solely because they take the risk of buying a high volume of a given product at a lower price in the hope that they can mark up the price and sell each item individually to customers. This is sometimes called the economies of scale, and by nature requires some storage and inventory. Grocery stores function this way.
Some businesses keep inventory as an investment. Fine wines, fine foods, for example, will appreciate in value over time. The downside is that it will cost money to keep them. For example, these both require appropriate temperature conditions and storage.
There are some issues to consider in inventory management. And these include seasonality. Many industries are subject to dips and rises in the demand as a result of seasonality. So logically, sourcing the same amount of each given product every month for inventory is not practical for those industries.
Inventory management and seasonality impacted businesses can become quite complex. And the accuracy of forecasts can have a substantial impact on profitability. Another important aspect of seasonality management is the issue of perishable goods.
From food to fashion, some goods simply go bad or lose most of their value for no other reason than culture has passed us by. This is called a perishable good. Perishable goods have an even greater opportunity cost when it comes to mismanaging inventory.
If too much of a perishable good is ordered, not only will it cost the organization unnecessary inventory fee, but also adds the risk of never being sold at all. It would end up being a complete sunk cost. So understanding the shelf life or the trend life can add a great deal of profitability to a business.
Finally, a business needs to be able to determine its economic order quantity. This is the quantity that minimizes holding cost and ordering cost. Quantitative formulas to calculate the economic order quantity consider the annual demand for the product, the fixed costs per order, including shipping and handling. This is not the unit cost of the good, but also the handling cost including storage, warehouse, refrigeration, and insurance.
Now let's review the key concepts concerning inventory management. Remember, there are three different types of inventory-- raw materials that will be used to manufacture products, work and process that includes raw materials that have started but not yet ready for sale, and finished goods which are the final products that are ready for the customers.
With different types of inventory, there are different accounting methods used. There is the FIFO method, First In and First Out, where the cost of goods sold is calculated as if the first material used was the first material purchased.
The LIFO method uses another cost of goods sold from the last inventory purchased, creating a possible task advantage. This is no longer widely used.
Inventory can also be calculated on the basis of an average cost. The company with widely varying inventory items, the ABC method can be used. This is also called selective inventory control.
A company keeps inventory to make sure it has items on hand for sale when their supply chain does not deliver as planned. They also hold inventory in case their projections of supply and demand are inaccurate.
There are also economies of scale where they buy greater volumes at lower pricing, hoping to sell them individually at a higher price to individual customers. And finally, inventory is sometimes seen as an investment for products that may appreciate over time.
A company must also consider seasonality with planning for inventory to accommodate the cycles that they may expect. It also must consider the perishability of any product or inventory, whether due to spoilage or due to customer changes in taste.
Finally, a business must be able to model what the optimal order quantity is. This model would consider the fixed costs per order and holding costs.
This is Dr. Bob Nolley. And I'll see you in the next lesson.
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