INVENTORY MANAGEMENT

Thetask of inventoryplanningcanbehighly complexinmanufacturingenvironments. At

thesametime, it restsonfundamental principles. Thesystemusedfor inventorymust tie
intotheoperationsof thefirm. Inventoryplanningandmanagement must beresponsive
totheneedsof thefirm. Thefirmshoulddesignsystems, includingreportsthat allowit to
makeproper businessdecisions.
What is"InventoryManagement"
Inventorymanagement istheactivecontrol programwhichallowsthemanagement of
sales, purchasesandpayments.
INVENTORY MANAGEMENT
Thetask of inventoryplanningcanbehighly complexinmanufacturingenvironments. At
thesametime, it restsonfundamental principles. Thesystemusedfor inventorymust tie
intotheoperationsof thefirm. Inventoryplanningandmanagement must beresponsive
totheneedsof thefirm. Thefirmshoulddesignsystems, includingreportsthat allowit to
makeproper businessdecisions.
What is"InventoryManagement"
Inventorymanagement istheactivecontrol programwhichallowsthemanagement of
sales, purchasesandpayments.
Thefivecostsof holdinginventoriesare:
1. Material Costsof Inventory:
Thesearethecostsof purchasingthegoodsincludingtransportationandhandlingcosts.
2. OrderingCosts:
Anymanufacturingorganizationhastopurchasematerials. Inthat event, theordering
costsrefer tothecostsassociatedwiththepreparationof purchaserequisitionby theuser
department, preparationof purchaseorder andfollow-upmeasurestakenby thepurchase
department, transportationof materials orderedfor, inspectionandhandlingat the
warehousefor storing. At timesevendemurragechargesfor not liftingthegoodsintime
areincludedaspart of orderingcosts.
3. CarryingCosts:
Thesearetheexpensesof storinggoods. Oncethegoodshavebeenaccepted, they
becomepart of thefirm'sinventories. Thesecostsincludeinsurance, rent/depreciationof
warehouse, salariesof storekeeper, hisassistantsandsecuritypersonnel, financingcost of
moneylocked-upininventories, obsolescence, spoilageandtaxes.
4. Cost of fundstiedupwithInventory:
Whenever afirmcommitsitsresourcestoinventory, it isusingfundsthat otherwise
might beavailablefor other purposes. Thefirmhaslost theuseof fundsfor other profit
makingpurposes. Thisisitsopportunitycost. Whatever thesourceof fundsinventoryhas
acost intermsof financial resources. Excessinventoryrepresentsanunnecessarycost.
OrderingCostsof inventory:
Anymanufacturingorganizationhastopurchasematerials. Inthat event, theordering
costsrefer tothecostsassociatedwiththepreparationof purchaserequisitionby theuser
department, preparationof purchaseorder andfollow-upmeasurestakenby thepurchase
department, transportationof materials orderedfor, inspectionandhandlingat the
warehousefor storing. At timesevendemurragechargesfor not liftingthegoodsintime
areincludedaspart of orderingcosts. Sometimes, someof thecomponentsand/or
material requiredfor productionmayhavefacilitiesfor manufactureinternally. If it is
foundtobemoreeconomical tomanufacturesuchitemsinternally, thenorderingcosts
refer tothecostsassociatedwiththepreparationof requisitionformsby theuser
department, set-upcoststobeincurredby themanufacturingdepartment andtransport,
inspectionandhandlingat thewarehouseof theuser department. Byandlarge, ordering
costsremainmoreor lessconstant irrespectiveof thesizeof theorder although
transportationandinspectioncostsmayvarytoacertainextent dependinguponorder
size. But this isnot goingtosignificantly affect thebehavior of orderingcosts. As
orderingcostsareconsideredinvariant totheorder size, thetotal orderingcostscanbe
reducedbyincreasingthesizeof theorders.
Suppose, thecost per order is$100andthecompanyuses1200unitsof amaterial during
theyear. Thesizeof theorder andthetotal orderingcoststobeincurredbythecompany
aregivenbelow.
Sizeof order (units) 100150200Number of ordersinayear 128 Total orderingcosts
@$100/ order $1200$800$600 Fromtheaboveexample, it canbeeasily seenthat a
companycanreduceitstotal orderingcostsbyincreasingtheorder sizewhichinturnwill
reducethenumber of orders. However, reductioninorderingcostsisusually followedby
anincreaseincarryingcoststobediscussednow.
CarryingInventoryCosts:
Thesearetheexpensesof storinggoods. Oncethegoodshavebeenaccepted, they
becomepart of thefirm'sinventories. Thesecostsincludeinsurance, rent/depreciationof
warehouse, salariesof storekeeper, hisassistantsandsecuritypersonnel, financingcost of
moneylocked-upininventories, obsolescence, spoilageandtaxes. Byandlarge, carrying
costsareconsideredtobeagivenpercentageof thevalueof inventoryheldinthe
warehouse, despitesomeof thefixedelementsof costswhichcompriseonly asmall
portionof total carryingcosts. Approximately, carryingcostsareconsideredtobearound
25percent of thevalueof inventoryheldinstorage. Thegreater theinvestment in
inventory, thegreater thecarryingcosts. Intheexampleconsideredinthecaseof
orderingcosts, let usassumethat thepriceper unit of material is$40andthat onan
averageabouthalf-of theinventorywill beheldinstorage. Then, theaveragevaluesof
inventoryfor sizesof order 100, 150and200alongwithcarryingcost @25percent of
theinventoryheldinstoragearegivenbelow.
Sizeof orders(units): 100500200Averagevalueof inventory: $2000$3000$4000
Carryingcost @25percent of above: $500$750$1000
Fromtheabovecalculations, it canbeeasily seenthat astheorder sizeincreases, the
carryingcost alsoisincreasinginadirectlyproportionatemanner.
Cost of Runningout of Goods:
Thesearecostsassociatedwiththeinabilitytoprovidematerials totheproduction
department and/ or inability toprovidefinishedgoodstothemarketingdepartment asthe
requisiteinventoriesarenot available. Inother words, therequisiteitemshaverunout of
stockfor want of timely replenishment. Thesecostshavebothquantitativeandqualitative
dimensions. Theseare, inthecaseof rawmaterials, thelossof productiondueto
stoppageof work, theuneconomical pricesassociatedwith`cash' purchasesandtheset-
upcosts, whichcanbequantifiedinmonetarytermswithareasonabledegreeof
precision.
Asaconsequenceof this, theproductiondepartment maynot beabletoreachitstarget in
providingfinishedgoodsfor sale. Itscost hasqualitativedimensionsasdiscussedbelow:
Whenmarketingpersonnel areunabletohonor their commitment tothecustomersin
makingfinishedgoodsavailablefor sale, thesalemaybelost. Thiscanbequantifiedtoa
certainextent. However, theerosionof thegoodcustomer relationsandtheconsequent
damagedonetotheimageandgoodwill of thecompanyfall intothequalitative
dimensionandeludequantification.
Evenif thestock-out cost cannot befully quantified, areasonablemeasurebasedonthe
lossof salesfor want of finishedgoodsinventorycanbeusedwiththeunderstandingthat
theamount someasuredcannot capturethequalitativeaspects.
INVENTORY MANAGEMENT TECHNIQUES
Whilethetotal orderingcostscanbedecreasedby increasingthesizeof order, the
carryingcostsincreasewiththeincreaseinorder sizeindicatingtheneedfor aproper
balancingof thesetwotypesof costsbehavinginoppositedirectionswithchangesin
order size.
Again, if acompanywantstoavert stock-out costsit mayhavetomaintainlarger
inventoriesof materialsandfinishedgoods, whichwill result inhigher carryingcosts.
Herealsoproper balancingof thecostsbecomesimportant.
Thus, theimportanceof effectiveinventorymanagement isdirectlyrelatedtothesizeof
theinvestment ininventory. Tomanageitsinventorieseffectively, afirmshouldusea
systemsapproachtoinventorymanagement. A systemsapproachconsidersinasingle
model all thefactorsthat affect theinventory.
economic order quantity
Inflationpoint information
reorder point
Learnabout safetystock
TheReorder Point Formula
ECONOMIC ORDER QUANTITY
Theeconomic order quantity(EOQ) referstotheoptimal order sizethat will result inthe
lowest total of order andcarryingcostsfor anitemof inventorygivenitsexpectedusage,
carryingcostsandorderingcost. Bycalculatinganeconomic order quantity, thefirm
attemptstodeterminetheorder sizethat will minimizethetotal inventorycosts.
Total inventorycost =Orderingcost +Carryingcost Total orderingcosts=Number of
ordersxCost per order =$U / QX F
WhereU =Annual usage
Q=QuantityorderedF =Fixedcost per order Thetotal carryingcosts=Averagelevel of
inventoryxPriceper unit xCarryingcost (percentage) Total carryingcosts=$Q/ 2xP
xC =$QPC over 2 WhereQ=QuantityorderedP =Purchasepriceper unit C =
Carryingcost as%
Asthelead-time(i.e., timerequiredfor procurement of material) isassumedtobezeroan
order for replenishment ismadewhentheinventorylevel reducestozero. Thelevel of
inventorywill beequal totheorder quantity(Qunits) tostart with. It progressively
declines(thoughinadiscretemanner) tolevel Oby theendof period1. At that point an
order for replenishment will bemadefor Qunits. Inviewof zerolead-time, theinventory
level jumpstoQandasimilar procedureoccursinthesubsequent periods. Asaresult of
this theaveragelevel of inventorywill remainat (Q/2) units, thesimpleaverageof the
twoendpointsQandZero.
Fromtheabovediscussiontheaveragelevel of inventoryisknowntobe(Q/2) units.
Fromthepreviousdiscussion, weknowthat asorder quantity(Q) increasesthetotal
orderingcostswill decreasewhilethetotal carryingcostswill increase. Theeconomic
order quantity, denotedby Q*, isthat valueat whichthetotal cost of bothorderingand
carryingwill beminimized. It shouldbenotedthat total costsassociatedwithinventory
T=$UF / Q+$QPC/ 2
Wherethefirst expressionof theequationrepresentsthetotal orderingcostsandthe
secondexpressionthetotal carryingcosts.
Thetotal cost curvereachesitsminimumat thepoint of intersectionbetweentheordering
costscurveandthecarryingcostsline. Thevalueof Qcorrespondingtoit will bethe
economic order quantityQ*. WecancalculatetheEOQformula.
Behavior of costsassociatedwithinventoryfor changesinorder quantity. For order
quantityQtobecomeEOQthetotal orderingcostsat Qshouldbeequal tothetotal
carryingcosts.
Usingthenotation, it amountstostating: UF/Q+QPC / 2(i.e.) 2UF =QPCor Q =2UF
/ PC units
TodisguishEOQfromother order quantities, wecansay: 2UF* EOQ=Q* PC
Intheaboveformula, when`U' isconsideredastheannual usageof material, thevalueof
Q* indicatesthesizeof theorder tobeplacedfor thematerial, whichminimizesthetotal
inventory-relatedcosts. When`U' isconsideredastheannual demandQ* denotesthesize
of productionrun.
Supposeafirmexpectsatotal demandfor itsproduct over theplanningperiodtobe
10,000units, whiletheorderingcost per order is$100andthecarryingcost per unit is$2.
Substitutingthesevalues, EOQ=2x10, 000x100=1000units. 2
Thus, if thefirmordersin1000-unit lot size, it will minimizeitstotal inventorycosts.
InflationaffectstheEOQ:
model intwomajor ways. First, whiletheEOQmodel canbemodifiedtoassume
constant priceincreases, manytimesmajor priceincreasesoccur only onceor twicea
year andareannouncedaheadof time.
REORDER POINT SUBSYSTEM
IntheEOQmodel discussedwehavemadetheassumptionthat thelead-timefor
procuringmaterial iszero. Consequently, thereorder point for replenishment of stock
occurswhenthelevel of inventorydropsdowntozero. Inviewof instantaneous
replenishment of stockthelevel of inventoryjumpstotheoriginal level fromzerolevel.
Inreal lifesituationsonenever encountersazerolead-time. Thereisalwaysatimelag
fromthedateof placinganorder for material andthedateonwhichmaterials are
received. Asaresult thereorder level isalways at alevel higher thanzero, andif thefirm
placestheorder whentheinventoryreachesthereorder point, thenewgoods
will arrivebeforethefirmrunsout of goodstosell. Thedecisiononhowmuchstock to
holdisgenerally referredtoastheorder point problem, that is, howlowshouldthe
inventorybedepletedbeforeit isreordered.
Thetwofactorsthat determinetheappropriateorder point aretheprocurement or
deliverytimestock whichistheInventoryneededduringtheleadtime(i.e., the
differencebetweentheorder dateandthereceipt of theinventoryordered) andthesafety
stockwhichistheminimumlevel of inventorythat isheldasaprotectionagainst
shortages.
ThereforeReorder Point =Normal consumptionduringlead-time+SafetyStock.
Several factorsdeterminehowmuchdelivery timestockandsafetystockshouldbeheld.
Insummary, theefficiencyof areplenishment systemaffectshowmuchdeliverytimeis
needed. Sincethedeliverytimestockistheexpectedinventoryusagebetweenordering
andreceivinginventory, efficient replenishment of inventorywouldreducetheneedfor
deliverytimestock. Andthedeterminationof level of safetystockinvolvesabasic trade-
off betweentherisk of stock-out, resultinginpossiblecustomer dissatisfactionandlost
sales, andtheincreasedcostsassociatedwithcarryingadditional inventory.
Another methodof calculatingreorder level involvesthecalculationof usagerateper day,
leadtimewhichistheamount of timebetweenplacinganorder andreceivingthegoods
andthesafetystocklevel expressedintermsof several days' sales.
Reorder level =Averagedaily usageratexlead-timeindays.
Fromtheaboveformulait canbeeasily deducedthat anorder for replenishment of
materials bemadewhenthelevel of inventoryisjust adequatetomeet theneedsof
productionduringlead-time.
If theaveragedaily usagerateof amaterial is50unitsandthelead-timeissevendays,
thenReorder level =Averagedaily usageratexLeadtimeindays=50unitsx7days=
350units
Whentheinventorylevel reaches350unitsanorder shouldbeplacedfor material. Bythe
timetheinventorylevel reacheszerotowardstheendof theseventhdayfromplacingthe
order materials will reachandthereisnocausefor concern.
SAFETY STOCK
Onceagaininreal lifesituationsonerarely comesacrossleadtimesandusageratesthat
areknownwithcertainty. Whenusagerateand/or leadtimevary, thenthereorder level
shouldnaturally beat alevel highenoughtocater totheproductionneedsduringthe
procurement periodandalsotoprovidesomemeasureof safetyfor at least partially
neutralizingthedegreeof uncertainty.
Thequestionwill naturally ariseastothemagnitudeof safetystock. Thereisnospecific
answer tothis question.
However, it depends, inter alia, uponthedegreeof uncertaintysurroundingtheusagerate
andlead-time. It ispossibletoacertainextent toquantify thevaluesthat usagerateand
lead-timecantakealongwiththecorrespondingchancesof occurrence, knownas
probabilities. Theseprobabilitiescanbeascertainedbasedonpreviousexperiencesand/or
thejudgmental abilityof astuteexecutives. Basedontheabovevaluesandestimatesof
stock-out costsandcarrying
costsof inventoryit ispossibletoworkout thetotal cost associatedwithdifferent levels
of safetystock.
Oncewerealizethat thehigher thequantityof safetystock, thelower will bethestock-
out cost andthehigher will betheincidenceof carryingcosts, theformulafor estimating
thereorder level will call for atrade-off betweenstock-outcostsandcarryingcosts. The
reorder level will thenbecomeoneat whichthetotal stock-out costs(tobemoreprecise,
theexpectedstock-out costs) andthecarryingcostswill beat itsminimum.
TheReorder Point Formula
.
Eveninarelatively simplesituationconsideredintheexampleabove, theamount of
calculationsinvolvedfor arrivingat thereorder level islarge. Inreal lifesituationsthe
assumptionof independenceintheprobabilitydistributionsmadeintheexampleabove
maynot bevalidandthenumber of timeperiodsmayalsobelarge. Insuchcasesthe
approachadoptedearlier canbecomemuchmorecomplex.
That isthereasonwhyonecanadopt amuchsimpler formulawhichgivesreasonably
reliableresultsincalculatingat what point inthelevel of inventoryareorder hastobe
placedfor replenishment of stock. Theformulaalongwithitsapplicationisgivenbelow,
usingthenotationdevelopedearlier. Reorder point =SxL +F ( SxRxL) WhereS=
UsageinunitsL =LeadtimeindaysR =Averagenumber of unitsper order F =Stock
out acceptancefactor
Thestock-out acceptancefactor, `F', dependsonthestock-outpercentageratespecified
andtheprobabilitydistributionof usage(whichisassumedtofollowaPoisson
distribution). For anyspecifiedacceptablestockout percentagethevalueof `F' canbe
obtainedfromthefigurepresentedbelow.
Thetotal systemfor inventorymanagement
TOTAL SYSTEM
Thethreesubsystemsaretiedtogether inasingleinventory-management system. The
inventorymanagement systemcanalsobeillustratedintermsof thethreesubsystems
that compriseit. Thefigurebelowtieseachsubsystemtogether andshowsthethreeitems
of informationneededfor thedecisiontoorder additional inventory.
Inventoryplanning
Theproductionside
Themarketingside
Inventorydatabase
INVENTORY PLANNING
Animportant task of working-capital management istoensurethat inventoriesare
incorporatedintothefirm'splanningandbudgetingprocess. Sometimes, thelevel of
inventoryreflectstheordersreceivedby thegeneral manager of theplant without serious
analysis astotheneedfor thematerials or parts. Thislack of planningcanbecostlyfor
thefirm, either becauseof thecarryingandfinancingcostsof excessinventoryor thelost
salesfrominadequateinventory. Theinventoryrequirementstosupport productionand
marketingshouldbeincorporatedintothefirm's planningprocessinanorderlyfashion.
THE PRODUCTIONSIDE
Thefirst stepininventoryplanningdealswiththemanufacturingmix of inventoryitems
andendproducts. Everyproduct ismadeupof aspecifiedlist of components. The
analyst must recognizethedifferent mix of componentsineachfinishedproduct. Each
itemmaintainedininventorywill haveacost. Thiscost mayvarybasedonvolume
purchases, leadtimefor anorder, historical agreements, or other factors. For thepurpose
of preparingabudget, eachitemmust beassignedagreements, or other factors. For the
purposeof preparingabudget, eachitemmust beassignedaunit cost.Oncethemix of
componentsisknownandeachcomponent hasbeenassignedavalue, theanalyst can
calculatethematerialscost for eachproduct, whichistheweightedaverageof the
components, andtheindividual products.
THE MARKETINGSIDE
Thesecondstepininventoryplanninginvolvesaforecast of unit requirementsduringthe
futureperiod. Bothasalesforecast andanestimateof thesafetylevel tosupport
unexpectedsalesopportunitiesarerequired. TheMarketingDepartment shouldalso
providepricinginformationsothosehigher profit itemsreceivemoreattention.
INVENTORY DATA BASE
Animportant component of inventoryplanninginvolvesaccesstoaninventorydatabase.
A databaseisacollectionof dataitemsarrangedinfiles, fieldsandrecords. Essentially,
weareworkingwithastructuredframeworkthat containstheinformationneededto
effectively manageall itemsof inventory, fromrawmaterials tofinishedgoods. This
informationincludestheclassificationandamount of inventories, demandfor theitems,
cost tothefirmfor eachitem, orderingcosts, carryingcosts, andother data.
Thefirst component of aninventorydatabasedeals withthemovement of individual
itemsandthesecondcomponent of inventorymanagement datainvolvesinformation
neededtomakedecisionsonrenderingor replenishingtheitems.
TheABC Systemof InventoryManagement
Inthecaseof amanufacturingcompanyof reasonablesizethenumber of itemsof
inventoryrunsintohundreds, if not more. Fromthepoint of viewof monitoring
informationfor control it becomesextremely difficult toconsider eachoneof theseitems.
TheABC analysis comesinquitehandyandenablesthemanagement toconcentrate
attentionandkeepaclosewatchonarelatively lessnumber of itemswhichaccount for a
highpercentageof thevalueof annual usageof all itemsof inventory.
A firmusingtheABC systemsegregatesitsinventoryintothreegroups- A, B andC.
Theitemsarethoseinwhichit hasthelargest dollar investment. TheA groupconsistsof
the10percent of theinventoryitemsthat account for 70percent of thefirm'sdollar
investment. Thesearethemost costlyor theslowest turningitemsof inventory.
TheB groupconsistsof theitemsaccountingfor thenext largest investment. TheB
groupconsistsof the20percent of theitemsaccountingfor about 20percent of thefirm's
dollar investment.
TheC grouptypically consistsof alargenumber of itemsaccountingfor asmall rupee
investment. C groupconsistsof approximately 70percent of all theitemsof inventory
but accountsfor only about 10percent of thefirm'sdollar investment. Suchitemsas
screws, nails, andwasherswouldbeinthis group.
ClassifyingtheinventoryintoA, B, andC itemsallowsthefirmtodeterminethelevel
andtypesof inventorycontrol proceduresneeded. Control of theA itemsshouldbemost
intensiveduetothehighrupeeinvestmentsinvolved, whiletheB andC itemswouldbe
subject tocorrespondingly lesssophisticatedcontrol procedures.
Thegeneral procedurefor categorizationof itemsinto`A', `B' and`C'
Theadvantagesof this system
Therequiredplanof ABC selectivecontrol
Methodsthat canbeadoptedtovaluetherawmaterial
Thevaluationof work-in-processandfinishedgoodsinventory
Thegeneral procedurefor categorizationof itemsinto`A', `B' and`C' groupsisbriefly
outlinedbelow:
All theitemsof inventoryaretoberankedinthedescendingorder of their annual usage
value.
Thecumulativetotalsof annual usagevaluesof thesei
temsalongwiththeir percentagestothetotal annual usagevaluearetobenoted
alongside.
Thecumulativepercentageof itemstothetotal number of itemsisalsotoberecorded
in
another column.
Anapproximatecategorizationof itemsintoA, B, and
C groupscanbemadeby comparingthecumulativepercentageof itemswiththe
cumulativepercentageof thecorrespondingusagevalues.
Theadvantagesof theABC systemareasfollows:
1. It ensurescloser control oncostlyitemsinwhichalargeamount of capital hasbeen
invested.
2. It helpsindevelopingascientific methodof controllinginventories, Clerical costsare
reducedandstockismaintainedat optimumlevel.
3. It helpsinachievingthemainobjectiveof inventorycontrol at minimumcost. The
stockturnover ratecanbemaintainedat comparatively higher level throughscientific
control of inventories.
Thesystemof ABC analysis suffersfromaseriouslimitation. Thesystemanalysesthe
itemsaccordingtotheir valueandnot accordingtotheir importanceintheproduction
process. It may, therefore, sometimescreatedifficult problems. For example, anitemof
inventorymay not beverycostly andhenceit may havebeenput incategoryC. However,
theitemmaybeveryimportant totheproductionprocessbecauseof itsscarcity. Suchan
itemasamatter of fact requirestheutmost attentionof themanagement thoughit isnot
advisabletodosoasper thesystemof ABC analysis. Hence, thesystemof ABC analysis
shouldnot befollowedblindly.
Therequiredplanof ABC selectivecontrol cannowbedrawnasfollows:
ABC PLAN
ItemsinItem%of total Valuecum. % Order of number itemstotal categoryvalue.
ranking
MONITORINGOF STORESANDSPARES
Just likeABC Analysisfor classificationof inventories, thereisaninventory
management techniquecalledVED. Analysis for monitoringandcontrol of storesand
sparesinventoryby classifyingtheminto3categoriesviz., Vital, Essential andDesirable.
Themechanicsof VEDanalysis aresimilar tothoseof ABC Analysis.
PRICINGOF INVENTORIES
Therearedifferent waysof valuingtheinventoriesandknowledgeof thesemethodsof
valuingstocksisessential for anefficient inventorymanagement process. The
followingmethodscanbeadoptedtovaluetherawmaterial:
First
-In-First-Out (FIFO): WhenafirmadoptstheFIFOmethodtopriceitsrawmaterial, the
issueof material fromthestoreswill beintheorder whichit wasreceived. Thusthe
pricingwill bebasedonthecost of material that wasobtainedfirst.
Last
-In-First-Out (LIFO): IntheLIFOmethod, thematerial issuedwill bepricedbasedonthe
material that hasbeenpurchasedrecently.
WeightedAverageCost Method: Thepricingof materials will bealoneonweighted
average
basis(weightswill begivenbasedonthequantity).
StandardPriceMethod: Material ispricedbasedonastandardcost, whichis
predetermined.
Whenthematerial ispurchasedthestockaccount will bedebitedwiththestandardprice.
Thedifferencebetweenthepurchasepriceandthestandardpricewill becarriedintoa
varianceaccount.
Replacement / Current PriceMethod: Inthis methodmaterial ispricedat thevaluethat is
realizableat thetimeof theissue.
VALUATION OF WORK-IN-PROCESSANDFINISHEDSTOCK
Thevaluationof work-in-processandfinishedgoodsinventorydependstoacertain
extent onthemethodof pricingtherawmaterial andtoalargeextent onthemethodof
costingusedtoapportionthefixedmanufacturingoverheads. Direct Costingand
AbsorptionCostingarethetwotechniquesusedfor allocationof coststotheinventory.
Direct costingisbasedonthetraceability of cost tothecost objective. All indirect costs
(whichmayincludefixedmanufacturingoverheads) arechargedtotheincomestatement
andareknownasperiodcosts. If thefixedcostsaredirectlyidentifiable, thenit is
consideredfor inventoryvaluation.
Absorptioncostingisatechnique, whichtreatsthefixedmanufacturingoverheadsas
product costs. Thus, all costsi.e. bothfixedandvariablewill beassignedtotheinventory
value.
Thisdifferenceinapproachtocostingwill affect theinventoryvalueandalsotheprofits.
Thedirect costingmethodlowerstheinventoryvalue(bynot consideringtheindirect
costs) andincreasesprofitswithadecreaseininventorylevel (whentheinventorylevel
decreasesthedirect costscomedownwhilethefixedcostsremainthesame). Contraryto
this theinventoryvaluationwill behigher for stocksvaluedunder absorptioncosting
methodasit considersall thefixedmanufacturingoverheads.