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Unit 12: Inventory Management

is depleted, the originally established cost is assigned to the replacement goods in the subsequent Notes
inventories when the base stock quantities are actually on hand.
The quantity of material included in the base stock is actually a somewhat flexible minimum
amount necessary to permit orderly operations within reasonable limits. The process must be
able to accept goods tendered by the suppliers with whom he has continuing relations, and
similarly his customer’s demands must be met, not only the anticipated demands for which the
customer gives order for future delivery but also the orders for immediate delivery resulting
from unforeseen circumstances.
If base stock quantity is properly established, this method should result in income being fairly
reflected. The cost of acquiring an equal volume of goods will be charged against revenues
derived from sales. Earnings will not be affected by increases or decreases in the cost or market
value of the base stock.
Income is not realized from merely replacing inventory quantities, and it can be argued that
these should be deducted from the revenue derived from selling the goods previously owned
whatever expenditure are necessary to restore the company to a position of being able to
continue operations.

Issues are priced at actual cost but base stock is carried forward at the end of each year at the
original price paid when the business commenced to operate, which may have been years ago.

Last-In First-Out (LIFO) Inventory Method

Under LIFO it is assumed that the stocks sold or consumed in any period are those most recently
acquired or made. As a consequence of this assumption the stocks to be carried forwards as the
inventories are considered as if they were those earliest acquired or made. The result at the LIFO
method is to change current revenues with amounts approximating current replacement costs.
To the goods owned at the end of any period are assigned costs applicable to items purchased or
made in earlier periods.
It is more obvious with respect to LIFO to FIFO although true under both inventory methods –
that the concepts are as to the flow of goods sold.

Reporting on profits by application LIFO under ideal conditions is simple. As here used, conditions
are ‘ideal’ when closing inventory equals opening inventory and the goods sold are equivalent to
the purchases for each accounting period. Since such conditions are rarely found in practice, an
accounting system must be sufficiently flexible to reflect the facts, whatever they may be.
If at the end of n interim accounting period, the inventory of any LIFO group is below the
opening inventory, an estimate should be charged with the cost of goods purchased plus an
estimated amount to cover the cost to be incurred in making good the temporary decrease in
inventory, and an account should be established for the differences between the estimated
replacement cost and the LIFO inventory cost of the quantities to the interim date.

An indication of the extent to which inventory is composed of raw materials, work in process,
and finished goods may be significant for balance sheet.
The artificiality of paper profits resulting from assigning a larger amount to a closing inventory
merely because market prices have increased – when from the standpoint of physical attributes
the opening and the closing inventories are comparable – has particular practical significance
when tax rates are high only the income remaining after paying taxes can be used to replace
inventories, expand the plant, pay dividends and so forth. The higher the taxes the lower is the
rate of earnings, and the greater is the proportion of the year’s earnings needed to maintain
inventories during a period of rising prices.

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