Page 202 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 12: Inventory Management

The evaluation of inventory is significant from the standpoint both the balance sheet and the Notes
income statement. In the former, the inventory valuation influences the current assets, the total
assets, the ratio between current assets and current liabilities and the retained earnings. In the
later the inventory evaluation may influence the cost of goods sold and the net profits.
Under the normal circumstances, financial statements reflecting the results of the operation of a
business enterprise during a particular period are preferred on a going concern basis. Consistent
with this concept of continuing operations, their will always be goods on hand available for
sale. The goods owned at the end of an accounting period will seldom be exactly comparable to
the goods in which the opening inventory, but the purpose of inventory will be the same; to
make possible uninterrupted realization of income through sales.

Average Cost Method

The exact amount of the computed cost for an individual item is generally of little significance.
In fact, in the determination of cost for inventory purpose no one prescribed procedure can be
used. For determining the valuation of inventories consistency from year is of prime importance
and for this using average costs rather than specifically identified costs seems to be more
appropriate. The averaging process is in one sense a concept of a flow of costs, but it can also be
viewed as merely a compilation of the actual cost for a group of similar items under circumstances
where the amount paid for each item has no significance. The entire group of items is considered
as single entity; and when particular items are separated, they are treated as merely a
proportionate part of the whole.
In this method normally weighted average prices are taken, purchase of each type of material in
stock are taken together and an average price completed. If the price fluctuates considerably,
many calculations will be involved. It is usual to calculate a new average after each delivery. The
pricing book, if issued, and the stores ledger will require frequent amendment.
Since average prices are charged and, therefore whether the charges to production represent
current replacement costs depends on the turnover of the stocks. In a period of rising prices slow
turnover will tend to mean that costs which are lower than present day costs will be charged. In
these statements there is an over statement of profit. In appropriate circumstances the use of the
average cost will have a stabilizing effect of price used for issues and therefore profits.
Computations of income which attempt to reflect the actual flow of goods are not necessarily
the most meaningful to business management, investors or creditors. Each of these group is
normally more concerned with what the future earning of the business enterprise will be than
with the amount which could be realized from the inventory if it were liquidated completely
and the activity discontinued.

Example: A new company purchases four identical units in one month.

1 unit purchased on the 10th of the month at a cost of `100
1 unit purchased on the 16th of the month at a cost `120
1 unit purchased on the 20th of the month at a cost of `130
1 unit purchased on the 30th of the month at a cost of `140
Using the average cost method, if one item were sold for ` 250, the cost of goods sold would be
` 120.25 (` 100 + `120 + `130 + `140/4), profit would be `120.75, and ending inventory balance
would be `360.75 (average cost per unit `120.25 × 3 remaining units).

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