INVENTORY CONTROL

& DEPRECIATION

o Subhashni Jaiswalo Dhani Venkata Phanindra Reddyo Hriday Pratim Borao Syed Junaid Alio Ayushi Guptao Chiranjeevi R.

GROUP-10

INVENTORY CONTROL

INTRODUCTIONINVENTORYThe term inventory means the value or amount of materials or resources on hand. It includes raw material, work in progress, finished goods & stores & spares.

INVENTORY CONTROLIt is the process by which inventory is measured & regulated according to predetermined norms such as economic lot size for order or production, safety stock, minimum level, maximum level, order level etc.

TYPES OF INVENTORY REASONS FOR HOLDING THE INVENTORY

Raw Materials To reap the price available on seasonal raw materials.

Work in progress To balance the production flow.

Ready made components When the components are brought rather than made.

Scraps They are disposal of ink bulk.

Finished Goods Lying in stock rooms & waiting dispatches.

INVENTORY CALCULATION

It is used to calculate how much inventory a company has on hand

INVENTORY=BEGINNING INVENTORY +NEW INVENTORY PURCHASES –

COST OF INVENTORY SOLD

SYSTEM OF ACCOUNTING FOR INVENTORY SYSTEMS PERIODIC INVENTORY SYSYTEM

1. Involves physical count of materials on hand at periodical intervals to arrive at the ending inventory

2. This system is typically used by small businesses that can't afford or don't need an electronic tracking system (i.e. the bar code system)

PERPETUAL INVENTORY SYSTEM

1. Updates inventory and cost of goods sold after every purchase and sales transaction.

2. It shows both the cost of materials issued and ending materials inventory directly.

OBJECTIVES OF INVENTORY CONTROL

To meet the unforeseen future demand due to variation

in forecast figures and actual figures.

To meet the customer requirement timely, effectively ,

efficiently, smoothly and satisfactorily.

To balance various costs of inventory such as order cost or

setup cost and inventory carrying cost.

To smoothen the production process.

To gain economy production or purchase in lots.

BENEFITS OF INVENTORY CONTROL Ensures an adequate supply of materials

Minimizes inventory costs

Facilitates purchasing economies

Better utilization of available stocks

Provides a check against the loss of materials

Enables management in cost comparison

Consistant & reliable basis for financial statements

INVENTORY CONTROL TECHNIQUES ABC analysis

Economic order quantity (EOQ)

Reorder-point

Safety stock

ABC ANALYSIS (ALWAYS BETTER CONTROL)

This technique divides inventory into three categories A,B &

C based on their annual consumption value.

It is also known as Selective Inventory Control Method.

This method is a means of categorizing inventory items

according to the potential amount to be controlled.

ABC analysis has universal application for fields requiring

selective control.

PROCEDURE FOR ABC ANALYSIS

Make the list of all items of inventory. Determine the annual volume of usage & money value of each

item. Multiply each item’s annual volume by its rupee value. Compute each item’s percentage of the total inventory in terms

of annual usage in rupees. Select the top 10% of all items which have the highest rupee

percentages & classify them as “A” items. Select the next 20% of all items with the next highest rupee

percentages & designate them “B” items. The next 70% of all items with the lowest rupee percentages

are “C” items.

RE-ORDER LEVELIt is the inventory level at which a company would place a new order or start a new manufacturing run.

Example :

ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand daily. Its supplier takes a week to deliver the order.

The inventory manager should place an order before the inventories drop below 3,500 units (500 units of daily usage multiplied with 7 days of lead time) in order to avoid a stock-out.

REORDER LEVEL = LEAD TIME IN DAYS × DAILY AVERAGE USAGE

ECONOMIC ORDER QUANTITY (EOQ) Economic order quality deals when the cost of

procurement and handling of inventory are at optimum

level and total cost is minimum.

In this technique, the order quantity is larger than a single

period’s ne requirement so that ordering costs & holding

costs balance out.

EOQ or Fixed Order Quantity system is the technique of

ordering materials whenever stock reaches the reorder

point.

ASSUMPTIONS OF EOQ Demand for the product is constant

Lead time is constant

Price per unit is constant

Inventory carrying cost is based on average inventory

Ordering costs are constant per order

All demands for the product will be satisfied (no back

orders)

EOQ=√2AB/CA=Usage unit for inventory Planning Period (total inventory requirements)

B=Ordering cost per buying order

C=Carrying Cost per unit

EXAMPLEAnnual requirement quantity (A)=10,000 units

Cost per order (B)= $2

Cost per unit = $8

Carrying cost percentage = 0.02

EOQ=√2*10,000*2/8*0.02

= 500 units

SAFETY STOCK Safety stock is the stock held by a company in excess of its

requirement for the lead time. Companies hold safety

stock to guard against stock-out.

Safety stock is calculated using the following formula:

Lead time is the time which supplier takes in ordering the

items

Safety Stock = (Maximum Daily Usage − Average Daily Usage) × Lead Time

FIRST-IN-FIRST-OUT (FIFO)FIFO Method assumes that the inventory is consumed in

chronological order that is those received first are issued /

consumed first and value fixed accordingly.

WHERE FIFO CAN BE USED FIFO is just like a queue . Where first come will be first

served. Distributors use this method in moving first product

they acquired.

LAST IN FIRST OUT(LIFO)LIFO stands for last-in, first-out, meaning that the most

recently produced items are recorded as sold first.

Since the 1970s, some U.S. companies shifted towards the

use of LIFO, which reduces their income taxes in times

of inflation , but with International Financial Reporting

Standards banning the use of LIFO

WHERE LIFO CAN BE USEDLIFO is like stack. Where the last product

received will be first send out.

SIMPLE AVERAGE METHOD Under this method, simple average rate at cost is obtained by

adding the rate of purchases represented by stock at the time of

issue & then dividing the same by the number of such rates.

The rate needs to be revised at the time of any new purchase or

exhaustion of any existing stock. For the purpose of ascertaining

the average rate, the quantity by which each purchase is made

has to be ignored.

To dampen the severity of the effect of rises & falls in the

purchase price, use of any kind of average rate is made. Thus, in

case of fluctuating rates of purchase, average cost is used.

QUESTION:From the details prepare stores ledger under simple average

method.

2010 Dec 1 Opening Balance 400 kg @ $ 1.25

5 Received 200 kg @ $ 1.30

8 Issued 480 kg

10 Issued 40 kg

15 Received 320 kg @ $ 1.35

18 Issued 200 kg

20 Received 400 kg @ $ 1.40

25 Issued 160 kg

28 Issued 240 kg

Shortage of 40 kg on 16.12.2010 & another shortage of 40 kg on 26.12.2010 is found by the stock verifier.

Workings: Calculation of simple average price:For Issue on 8th Dec = (1.25+1.30)/2 = $ 1.275

For Issue on 10th Dec = $ 1.30

For Shortage on 16th Dec = (1.30+1.35)/2 = $ 1.325

For Issue on 18th Dec = $ 1.325

For Issue on 25th Dec = (1.35+1.40)/2 = $ 1.375

For Shortage on 26th Dec = $ 1.40

For Issue on 28th Dec =$ 1.40

WEIGHTED AVERAGE METHOD The weighted average cost under this method is obtained

by dividing the total value (at cost) of materials in stock at the time of issue by the total quantity of materials in stock.

Only the rates are taken into consideration in case of simple average, on the other hand, the rates & corresponding quantities are considered in case of weighted average because by multiplying the quantity by the rate, the value at cost is obtained.

If q, q1, q2, & q3 are the quantities in stocks on a day with p, p1, p2 & p3 as the corresponding purchases, the weighted average rate will be worked out as below:

Weighted average rate = pq + p1q1+p2q2+p3q3

q + q1 + q2 + q3

DEPRECIATION

DEPRECIATION ACCOUNTING STANDARD (AS-6)DEFINITIONDepreciation is a measure of the wearing out,

consumption or other loss of value of a depreciable asset

arising from use, effluxion of time or obsolescence

through technology and market changes.

DEPRECIABLE ASSET Are assets expected to be used during more than one

accounting period.

Have a limited useful life.

Are held by an enterprise for use in the production or supply

of good and services, for rentals to others, or for

administrative purposes & NOT for sale in the ordinary course

of business.

e.g. buildings , machines ,plants, trucks, vans land

improvements such as tunnels, underpasses, parking lots etc.

DEPRECIATION NOT APPLICABLE TO Forests, Plantations and similar regenerative natural

resources Wasting Assets including- Mineral rights,

Expenditure on the Exploration for and Extraction of

Minerals, Oil, Natural Gas and similar non-regenerative

resources.

Expenditure on Research & Development;

Goodwill Livestock

Land- unless it has limited life

FEATURES Depreciation is decline in the book value of fixed assets. Depreciation includes loss of value of assets due to

passage of time, usage etc. Depreciation is continuing process till the end of the

useful life of assets. Depreciation is an expired cost and hence must be

deducted before calculating taxable profits. Depreciation is a non cash expense. It doesnot involve

any cash flow. Depreciation is the process of writing off the capital

expenditure already incurred.

CAUSES OF DEPRECIATION Physical wear & tear

Physical Deterioration

Expiry of legal rights

By obsolescence

By depletion

Permanent fall in price

CALCULATION OF DEPRECIATION Historical cost of the asset

Estimated useful life of depreciable asset

Estimated residual/scrap value of depreciable assets

HISTORICAL COST OF THE ASSET Historical cost of a depreciable asset represents its

money outlay or its equivalent in connection with its

acquisition, installation and commissioning as well as

for additions to or improvement thereof.

The historical cost of a depreciable asset may undergo

subsequent changes arising as a result of increase or

decrease in long term liability on account of exchange

fluctuations, price adjustments, changes in duties or

similar factors.

ESTIMATED USEFUL LIFE OF DEPRECIABLE ASSETDetermination of the useful life of a depreciable asset is a

matter of estimation and is normally based on various

factors including experience with similar types of assets.

Such estimation is more difficult for an asset using new

technology or used in the production of a new product or in

the provision of a new service but is nevertheless required

on some reasonable basis.

ESTIMATED RESIDUAL/SCRAP VALUE OF DEPRECIABLE ASSETS Determination of residual value of an asset is normally a

difficult matter. If such value is considered as insignificant, it is normally regarded as nil.

On the contrary, if the residual value is likely to be significant, it is estimated at the time of acquisition/installation, or at the time of subsequent revaluation of the asset.

One of the bases for determining the residual value would be the realisable value of similar assets which have reached the end of their useful lives and have operated under conditions similar to those in which the asset will be used.

AMORTIZATION Spreading an INTANGIBLE ASSET cost over that asset’s

useful life.

For example, a patent.

The cost involved with creating the patent is spread out

over the life of the patent, with each portion being

recorded as an expense on the company’s income

statement.

DEPLETION It refers to the allocation of the cost of natural resources

over time. For example, an oil well A finite life before all of the oil is pumped out. Therefore

the oil well’s setup costs are spread-out over the predicted life of the oil well.

Depletion is the actual physical reduction of natural resources by companies.

For example, coal mines, oil fields and other natural resources are depleted on company accounting statements. This reduction in the quantity of resources is meant to assist in accurately identifying the value of the asset on the balance sheet.

METHODS OF DEPRECIATIONThere are two methods of depreciation.

STRAIGHT LINE METHOD (SLM) - Amount of

depreciation is fixed. Useful to assets whose service

remain uniform throughout the year. For eg: Furniture &

fixtures.

WRITTEN DOWN VALUE METHOD (WDV) -Depreciation is

charged at fixed rate on the reducing balance every year.

STRAIGHT LINE METHODAdvantages : Simple, easy to understand and to apply It provides uniform charge every year It’s calculated on original cost over the life time

Disadvantages: Depreciation is not related to the usage factor It ignores the fact that in the later years of the life of the

asset, efficiency of the asset declines. Loss of interest on investment in the asset is not

accounted

WRITTEN DOWN VALUE METHOD Advantages: it’s a simple method of providing depreciation as a fixed rate

is applied on book-value or written down value of assets. This method is quite popular It provides uniform charge for charge for services of the asset

through out the life INCOMETAX accepts this method for tax purpose Disadvantages: The method is slightly complicated If the asset has no residual value, it is very difficult to

calculate the rate.  

EXAMPLE ON SLM AND WDV

1.Cost of fixed asset $100,000

2.Residual Value Nil

3.Useful Life 4 Years

4.Rate of depreciation40% (for calculating

depreciation using reducing balance method)

Graphical representation