Accounting For Inventory

Foundation level
CHAPTER
Management Information
4
Accounting for inventory
Contents
1 Materials: procedures and documentation
2 Valuation of inventory
3 Material purchase quantities: Economic order quantity
4 Just-in-Time (JIT) and other inventory management methods
5 Chapter review
© Emile Woolf International 84 The Institute of Chartered Accountants of Nigeria

INTRODUCTION
Aim
Accountants play a vital role in management and management decision-making. Business
information deals with the production of accurate and useful information to support management
and decision-making including, costing, management accounting and the application of quantitative
methods in financial management.
Detailed syllabus
The detailed syllabus includes the following:
A Cost accounting (continued)
3 Accounting for cost elements
a Accounting for inventory
i Describe the different procedures and documents necessary for material
management:
• Ordering;
• Purchasing;
• Receiving;
• Storage; and
• Issuing.
ii Explain inventory management and control procedures.
iii Identify, explain and calculate relevant inventory costs.
iv Compute optimal re-order quantities (involving quantity discounts).
v Explain and calculate the value of closing inventory and material issues
to production using LIFO, FIFO and average methods.
vi Explain Just-In-Time (JIT).
Exam context
This chapter explains the measurement of inventories of items and various approaches to
inventory management.
By the end of this chapter you should be able to:

◼ Measure inventory at the lower of cost and net realisable value;
◼ Explain and apply FIFO, AVCO and LIFO;
◼ Describe the economic order quantity (EOQ) and apply the concept in given scenarios;
◼ Calculate the EOQ from data provided; and
◼ Explain JIT.

1 MATERIALS:PURCHASING PROCEDURES AND DOCUMENTATION
Section overview
The need for procedures and documentation of materials
The procedures and documents
Monitoring physical inventory: comparison with the inventory records
Entries and balances in a materials inventory account
1.1 The need for procedures and documentation of materials

When an entity purchases materials from a supplier, the purchasing process should be
properly documented. There are several reasons for this.
◼ Any purchase of materials from a supplier should be properly authorised and
approved at the appropriate management level. Documentation of the purchasing
process provides evidence that approval has been obtained;
◼ The receipt of materials from a supplier should also be documented, to make sure
that the goods that were ordered have actually been delivered;
◼ There should be an invoice from the supplier for the goods that have been
delivered. (In rare cases when goods are bought for cash, there should be a
receipt from the supplier). The amount payable for the materials provides
documentary evidence about their cost; and
◼ When materials are received from a supplier, they might be held in a store or
warehouse until needed. When they are issued from the store, there should be a
documentary record of who has taken the materials and how many were taken.
This is needed to provide a record of the cost of materials used by different
departments or cost centres.
Documentation of materials is therefore needed:
to ensure that the procedures for ordering, receiving and paying for materials has
been conducted properly, and there is no error or fraud;
to provide a record of materials purchases for the financial accounts; and
to provide a record of materials costs for the cost and management accounts.
1.2 The procedures and documents

The detailed procedures for purchasing materials and the documents used might differ
according to the size and nature of the business. However the basic requirements
should be the same for all types of business where material purchases are made.
Purchasing procedures and documents
In a large company with a purchasing department (a buying department) and a stores
department, the procedures for purchasing materials might be as follows:
The stores department identifies the need to re-order an item of raw materials for
inventory. It produces a request to the purchasing department to buy a quantity of the
materials. This request is called a purchase requisition. It should be properly
authorised by a manager with the authority to approve any such requisition;

A buyer in the purchasing department selects a supplier and provides the supplier with
a purchase order, stating the identity of the item to be purchased, the quantity
required and possibly also the price that the supplier has agreed;
When the supplier delivers the goods, the goods are accompanied by a delivery note
from the supplier. The delivery note is a statement of the identity and quantity of the
items delivered, and it provides confirmation that the items have been delivered. One
copy is kept with the stores department, and another copy is retained by the supplier
(the driver of the delivery vehicle), as evidence of the delivery;
The stores department prepares a goods received note, recording the details of the
materials received. This should include the inventory identity code for the item, as well
as the quantity received;
Copies of the delivery note and goods received note are sent to the accounts
department, where they are matched with a copy of the purchase order;
A purchase invoice is received from the supplier, asking for payment. The accounts
department checks the invoice details with the details on the purchase order and goods
received note, to confirm that the correct items have been delivered in the correct
quantities;
The purchase invoice is used to record the purchase in the accounting records; and
In the cost accounting system, there should be inventory records to record the
quantities and costs of materials received. Data for recording costs of purchases for
each item of inventory is obtained from the goods received note (quantity and inventory
code) and purchase invoice (cost).
Illustration: The purchase process

Inventory records
An entity should keep an up-to-date record of the materials that it is holding in
inventory.
In the stores department, the materials should be kept secure, and there should be
systems, processes and controls to prevent loss, theft or damage. The stores
department should keep a record of the quantity of each item of material currently held
in inventory. For each item of material, there might therefore be an inventory record
card, or ‘bin card’. This card is used to keep an up-to-date record of the number of units
of the material currently in the stores department, with records of each receipt and
issue of the inventory item. This process of continuous record-keeping is known as
perpetual inventory. The inventory record should be updated every time materials are
delivered into store from a supplier, and every time that materials are issued to an
operating department. Instead of having a ‘physical’ card for each stores item, there
may be a computerised record containing similar information.
In the cost accounting department, another separate record of inventory might be
kept, with an inventory ledger record for each item of material. The inventory ledger
record is a record of the quantity of the materials currently held in inventory, the
quantities received into store from suppliers and the quantities issued to operational
departments. In addition, the inventory ledger record also records the cost of the
materials currently held in inventory, the cost of new materials purchased and the cost
of the materials issued to each operating department (cost centre).
In a computerised inventory control system, the stores department and the cost
accounting department should use the same computerised records for inventory.
Issues and returns of materials
A cost accounting system also needs to record the quantities and cost of items of
materials that are issued to the user departments and the quantities and cost of any
items that are subsequently returned to store unused.
The documentation for the issue and returns of materials are:

A materials requisition note: this is a formal request from a user department to the
stores department for a quantity of an item of materials; and
A material return note: when items are returned to store unused, the stores department
should record the return on a material returns note.
A materials requisition note is used to record:
the details of the quantity of materials issued;
the department (cost centre) that receives them; and
(in a cost accounting system) their cost.
The inventory records are updated from the requisitions notes and returns notes to
record all issues and returns of materials.
Examples of this are shown in the next section.

1.3 Monitoring physical inventory: comparison with the inventory records
For various reasons, the inventory records in the cost accounts might not agree with
the physical quantities of materials actually held in store. There are several reasons for
this.
Errors in recording receipts, issues and returns. Mistakes might be made in

recording transactions for materials received from the supplier, materials issued from
store and returns to store. For example, an issue of material item 1234 from inventory
might be recorded as an issue of item 1243. This would result in inaccurate inventory
records for both item 1234 and item 1243.

Omissions. Similarly, some purchases, issues and returns to store might not be
recorded, due to mistakes.
Theft or physical loss. Some inventory might be stolen or might get lost, and the theft
or loss might not be noticed or recorded.
Damage to stores items or deterioration of items. Stores items might deteriorate in

quality when they are stored, particularly if they are stored in poor conditions. Damaged
items might be thrown away, but the write-off might not be recorded.
Management should try to minimise these discrepancies between inventory records (in
a perpetual inventory system) and physical inventory in the store.
It is the responsibility of the stores manager to minimise losses due to theft, loss or
deterioration and damage.
Documentation and record keeping should be accurate and mistakes should be

minimised. All movements of materials should be properly recorded in a document, and
the data from the document should be transferred accurately into the inventory records.
Even so, good record keeping and goods stores management will not prevent some
discrepancies between inventory records and physical inventory in store. This
discrepancy should be checked from time to time. The stores department staff can do
this by carrying out a physical count of the quantity of each material item currently
held, and comparing this ‘physical count’ with the figures in the stores records. The
records should then be adjusted to the correct quantities. (Quantities of materials that
are ‘missing’ will be recorded as a write-off of materials in the accounts).
Minimising discrepancies and losses

When physical inventory is checked against the inventory records, there will often be
some differences. When the differences are large, there could be a serious problem
with either:
Poor control over inventory: Some losses through theft, deterioration and breakages
should be expected, but the losses should not be large; and
Poor inventory records: If the inventory records are inaccurate, the information
prepared for management from inventory records will be unreliable.

Whichever is the reason for large discrepancies between physical inventory and
inventory records, management should take measures to deal with the problem.
Theft can be reduced by keeping inventory locked in a safe place. Close Circuit
Television (CCTV) can be used to monitor activities in the warehouse.
Deterioration of inventory can be reduced by keeping the inventory in better storage

condition.
Poor procedures for recording inventory movements in and out of the store can be
improved through better procedures and suitable controls, such as better supervision of
the recording process and better staff training.
1.4 Entries and balances in a materials inventory account

In a system of cost accounting, a separate record is kept for each inventory item. This
record – an inventory account – is used to maintain a record of all movements in the
materials, in terms of both quantities and cost.
The main contents of an inventory record are shown in the previous example. An
inventory record in the cost accounts provides a continual record of the following:
Purchases/deliveries from suppliers: quantity and cost;
Returns to suppliers: quantity and cost;
Issues of the item to user departments: quantity, cost and department identity;
Returns from user departments to the stores: quantity, cost and department identity;
and
The balance held in inventory (quantity and cost or value).
The inventory records are combined into a total record for all inventory, which is used
for reporting purposes, such as the preparation of a cost statement or an income
statement of the profit or loss made in a period. The system for recording inventory and
materials costs might also be a part of a bigger cost accounting system.
A cost accounting system is a system for recording all costs and in large organisations,
it is maintained in the form of a double entry accounting system of cost records in a
‘cost ledger’.

2 VALUATION OF INVENTORY
Section overview
Basic rule: Lower of cost and net realisable value (NRV)

Cost formulas
First-in, first-out method of valuation (FIFO)
Weighted average cost (WAVCO) method
Last-in, first-out (LIFO) method
Comparison of methods
2.1 Basic rule: Lower of cost and NRV

The valuation of inventory can be extremely important for financial reporting, because
the valuations affect both the cost of sales (and profit) and also total asset values in the
statement of financial position.
Inventory must be measured in the financial statements at the lower of:
Cost; or
net realisable value (NRV).
Net realisable value is the amount that can be obtained from disposing of the inventory
in the normal course of business, less any further costs that will be incurred in getting it
ready for sale or disposal.
Net realisable value is usually higher than cost. Inventory is therefore usually valued at
cost.
However, when inventory loses value, perhaps because it has been damaged or is now
obsolete, net realisable value will be lower than cost.
The cost and net realisable value should be compared for each separately-identifiable
item of inventory, or group of similar inventories, rather than for inventory in total.

Example: Lower of cost and NRV
A business has four items of inventory. A count of the inventory has established
that the amounts of inventory currently held, at cost, are as follows:
₦ ₦ ₦
Cost Sales price Selling costs
Inventory item A1 8,000 7,800 500
Inventory item A2 14,000 18,000 200
Inventory item B1 16,000 17,000 200
Inventory item C1 6,000 7,500 150
The value of closing inventory in the financial statements:
Lower of: ₦
A1 8,000 or (7,800 – 500) 7,300
A2 14,000 or (18,000 – 200) 14,000
B1 16,000 or (17,000 – 200) 16,000
C1 6,000 or (7,500 – 150) 6,000
Inventory valuation 43,300
2.2 Cost formulas

With some inventory items, particularly large and expensive items, it might be possible
to recognise the actual cost of each item.
In practice, however, this is unusual because the task of identifying the actual cost for
all inventory items is impossible because of the large numbers of such items.
A system is therefore needed for measuring the cost of inventory.
The historical cost of inventory is usually measured by one of the following methods:
First in, first out (FIFO).
Weighted average cost (WAVCO)
Illustration
On 1 January a company had an opening inventory of 100 units which cost ₦50
each.
During the year it made the following purchases:
5 April: 300 units at ₦60 each
14 July: 500 units at ₦70 each
22 October: 200 units at ₦80 each.
During the period it sold 800 units as follows:
9May: 200 units
25 July: 200 units
23 November: 200 units
12 December: 200 units

This means that it has 300 units left (100 + 300 + 500 + 200) – (200 + 200 + 200
+ 200)) but what did they cost?
There are various techniques that have been developed to answer this question.
The easiest of these is called FIFO (first in first out). This approach assumes
that the first inventory sold is always the inventory that was bought on the
earliest date. This means closing inventory is always assumed to be the most
recent purchased.
In the above example a FIFO valuation would assume that the 300 items left
were made up of the 200 bought on 22 October and 100 of those bought on 14
July giving a cost of ₦23,000 {i.e. (200 @ 80) + (100 @ 70)}.
2.3 First-in, first-out method of valuation (FIFO)

The FIFO and weighted average cost (WAVCO) methods of inventory valuation are
used within perpetual inventory systems. They can also be used to establish a cost for
closing inventory with the period-end inventory system.
With the first-in, first-out method of inventory valuation, it is assumed that inventory is
consumed in the strict order in which it was purchased or manufactured. The first items
that are received into inventory are the first items that go out.
To establish the cost of inventory using FIFO, it is necessary to keep a record of:
the date that units of inventory are received into inventory, the number of units received
and their purchase price (or manufacturing cost); and
the date that units are issued from inventory and the number of units issued.
With this information, it is possible to put a cost to the inventory that is issued (sold or
used) and to identify the cost of the items still remaining in inventory.
Since it is assumed that the first items received into inventory are the first units that are
used, it follows that the value of inventory at any time should be the cost of the most
recently-acquired units of inventory.
Example (as before): FIFO

each.
9 May: 200 units
25 July: 200 units

Inventory movement can be shown on a cost ledger card as follows.
Example: Inventory ledger card (FIFO)
Receipts Issues Balance

Date Qty @ ₦ Qty @ ₦ Qty @ ₦
1 Jan
b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 50/60 23,000
9 May 100 50 5,000 100 50 5,000
100 60 6,000 100 60 6,000
200 50/60 11,000 (200) 50/60 (11,000)
200 60 12,000
14 Jul 500 70 35,000 500 70 35,000
700 60/70 47,000
25 Jul 200 60 12,000 (200) 60 (12,000)
500 70 35,000
22 Oct 200 80 16,000 200 80 16,000
700 70/80 51,000
23 Nov 200 70 14,000 (200) 70 (14,000)
500 70/80 37,000
12 Dec 200 70 14,000 (200) 70 (14,000)
1,100 74,000 800 51,000 300 70/80 23,000
Note 1,100 minus 800 equals 300

:
74,000 minus 51,000 equals 23,000
2.4 Weighted average cost (WAVCO) method

With the weighted average cost (WAVCO) method of inventory valuation it is assumed
that all units are issued at the current weighted average cost per unit.
The normal method of measuring average cost is the perpetual basis method. With
the perpetual basis WAVCO method, a new average cost is calculated whenever more
items are purchased and received into store. The weighted average cost is calculated
as follows:

Formula: Weighted average cost
Cost of inventory currently in store + Cost of new items received
Number of units currently in store + Number of new units received
Example (as before): WAVCO

each.
5April: 300 units at ₦60 each
9May: 200 units
25 July: 200 units
Inventory movement can be shown on a cost ledger card as follows:
Example: Inventory ledger card (weighted average cost method)

1 Jan
b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 57.5 23,000
9 May 200 57.5 11,500 (200) 57.5 (11,500)
200 57.5 11,500
14 Jul 500 70 35,000 500 70 35,000
700 66.43 46,500
25 Jul 200 66.43 13,286 (200) 66.43 (13,286)
500 66.43 33,214
22 Oct 200 80 16,000 200 80 16,000
700 70.31 49,214
23 Nov 200 70.31 14,062 (200) 70.31 (14,062)
500 70.31 35,152
12 Dec 200 70.31 14,062 (200) 70.31 (14,062)
1,100 74,000 800 52,910 300 70/80 21,090

:
74,000 minus 52,910 equals 21,090

2.5 Last-in, first-out (LIFO) method
With the last-in, first-out (LIFO) method of inventory valuation it is assumed that:
the most recent units received into store are the first materials issued, and are priced
accordingly; and
at any time, the remaining units in store are likely to have been purchased some time
ago.
Example (as before): LIFO

each.
9 May: 200 units, 25 July: 200 units, 23 November: 200 units, 12 December:
200 units
Inventory movement can be shown on a cost ledger card as follows:
Example: Inventory ledger card (LIFO method)

1 Jan
b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 50/60 23,000
9 May 200 60.0 12,000 (200) 60.0 (12,000)
200 50/60 11,000
14 Jul 500 70 35,000 500 70 35,000
700 50/60/70 46,000
25 Jul 200 70.00 14,000 (200) 70.00 (14,000)
500 50/60/70 32,000
22 Oct 200 80 16,000 200 80 16,000
700 50/60/70/80 48,000
23 Nov 200 80.00 16,000 (200) 80.00 (16,000)
500 50/60/70 32,000
12 Dec 200 70.00 14,000 (200) 70.00 (14,000)
1,100 74,000 800 56,000 300 50/60/70 18,000

:
74,000 minus 56,000 equals 18,000

2.6 Comparison of methods
Choice of inventory valuation method

The value of inventory and the cost of materials issued and used in the period are
determined by the selected inventory valuation method, such as FIFO, LIFO, weighted
average cost or standard cost.
The choice of valuation method – FIFO, weighted average cost, LIFO – therefore
affects the reported profit for each period.
LIFO is not allowed as a valuation method in financial reporting, but it may be used in
cost accounting systems, which are not governed by the rules of accounting standards
and external financial reporting.
Costing of issues from inventory and inflation

As a general rule, the different methods of inventory valuation will give different
valuations for the cost of sales and the value of closing inventory during a period of
inflation and this becomes more pronounced as inflation increases.
When prices are rising, the cost of sales under FIFO will be lower than the current
replacement cost of materials used. The closing inventory value should be close to
current value since they will be the units bought most recently (‘last’).
When prices are rising, the cost of sales under WAVCO will be higher and the value of
closing inventory lower than with FIFO valuation.
When prices are rising, the cost of sales under LIFO will be higher and the value of
closing inventory lower than with FIFO valuation.
With WAVCO during a period of high inflation, the cost of sales will be higher and the
value of closing inventory lower than with FIFO valuation.
In the example used above to illustrate the different methods when prices were rising,
the valuations of the cost of goods issued and closing inventory were as follows:
Example: FIFO vs WAVCO vs LIFO when prices are rising

Valuation method Cost of goods issued Closing inventory
₦ ₦
FIFO 51,100 23,000
WAVCO 52,900 21090
LIFO 56,000 18,000
The valuation of closing inventory is higher and the cost of goods issued is lower using
FIFO. This is typical during a period when prices are rising steadily.
The opposite is true when prices are falling. The valuation of closing inventory is lower
and the cost of goods issued is higher using FIFO.

Advantages and disadvantages of FIFO
Advantages
Logical (probably represents physical reality).
Easy to understand and explain to managers.
Gives a value near to replacement cost.
Disadvantages
Can be cumbersome to operate.
Managers may find it difficult to compare costs and make decisions when they are
charged with varying prices for the same materials.
In a period of high inflation, inventory issue prices will lag behind current market value.
Advantages and disadvantages of AVCO

Advantages
Smoothes out price fluctuations.
Easier to administer than FIFO and LIFO.
Disadvantages
Issue price is rarely what has been paid.
Prices tend to lag a little behind current market values when there is gradual inflation.
Advantages and disadvantages of LIFO

Advantages
Issue price is up to date therefore enhances profit reporting.
Easy to apply.
Disadvantages
In reality, managers will try to sell older inventory first and LIFO does not reflect this
reality.
Inventory can be stated at well below replacement cost thus giving lower quality
information about inventory.
Not allowed under IFRS.

3 MATERIAL PURCHASE QUANTITIES: ECONOMIC ORDER QUANTITY
Section overview
Costs associated with inventory

Economic order quantity (EOQ)
Optimum order quantity with price discounts for large orders
3.1 Costs associated with inventory

Many companies, particularly manufacturing and retailing companies, might hold large
amounts of inventory. They usually hold inventory so that they can meet customer
demand as soon as it arises. If there is no inventory when the customer asks for it (if
there is a ‘stock-out’ or ‘inventory-out’), the customer might buy the product from a
competitor instead. However holding inventory creates costs.
The costs associated with inventory are:

Purchase price of the inventory;
Re-order costs are the costs of making orders to purchase a quantity of a material item
from a supplier. They include costs such as:
the cost of delivery of the purchased items, if these are paid for by the buyer;
the costs associated with placing an order, such as the costs of telephone calls;
costs associated with checking the inventory after delivery from the supplier; and
batch set up costs if the inventory is produced internally.
Inventory holding costs

cost of capital tied up;
insurance costs;
cost of warehousing; and
obsolescence, deterioration and theft.
Shortage costs
lost profit on sale;
future loss of profit due to loss of customer goodwill; and
costs due to production stoppage due to shortage of raw materials.
Investment in inventory has a cost. Capital is tied up in inventory and the capital
investment has a cost. Inventory has to be paid for, and when an organisation holds a
quantity of inventory it must therefore obtain finance to pay for it.

Example: Cost of holding inventory
A company holds between 0 units and 10,000 units of an item of material that
costs ₦1,000 per unit to purchase.
The cost of the materials held in store therefore varies between ₦0 and
₦10,000,000.
If demand for the inventory is constant throughout the year, the average cost of
inventory held is ₦5,000,000 (half the maximum).
This inventory must be financed, and it is usual to assume (for simplicity) that it
is financed by borrowing that has an interest cost.
If the interest cost of holding inventory is 5% per year, the cost per year of
holding the inventory would be ₦250,000 (₦5,000,000  5%).
There are also running expenses incurred in holding inventory, such as the
warehousing costs (warehouse rental, wages or salaries of warehouse staff).
A distinction can be made between variable inventory holding costs (cost of capital,
cost of losses through deterioration and loss) and fixed inventory costs (wages and
salaries, warehouse rental). Changing inventory levels will affect variable inventory
holding costs but not fixed costs.
Trade off
Note that there is a trade-off between holding costs and ordering costs.
Example: Trade-off between holding costs and ordering costs

A company requires 12,000 of a certain component every year.
Demand for the component is constant. (This condition means that the average
inventory is half of the maximum as long as there is no safety stock).
The company can decide on the number it orders and this affects the holding
cost and ordering costs.
Let: Q = Order size
D = Annual demand
Order size (Q)

12,000 6,000 3,000
Average inventory (Q/2) 6,000 3,000 1,500
D
Number of orders ( /Q) 1 2 3
The average inventory falls as the order size falls thus reducing holding cost. However,
smaller orders mean more of them. This increases the order cost.
A business will be concerned with minimising costs and will make decisions based on
this objective. Note that any decision making model must focus on those costs that are
relevant to the decision. The relevant costs are only those that change with a decision.
When choosing between two courses of action, say A and B, any cost that will be
incurred whether action A or action B is undertaken can be ignored. This is covered in
more detail in chapter 14.

3.2 Economic order quantity (EOQ)
The Economic Order Quantity model (EOQ) is a mathematical model used to calculate
the quantity of inventory to order from a supplier each time that an order is made. The
aim of the model is to identify the order quantity for any item of inventory that minimises
total annual inventory costs.
The model is based on simplifying assumptions.
Assumption Implication
There are no bulk purchase discounts Order size (Q) does not affect the total
for making orders in large sizes. All annual purchase cost of the items.
units purchased for each item of Purchase price can be ignored in the
material cost the same unit price. decision as it does not affect the
outcome.
The order lead time (the time between Delivery of a new order is always
placing an order and receiving timed to coincide with running out of
delivery from the supplier) is constant inventory so the maximum inventory is
and known. the order size (Q)
There is no risk of being out of stock.
Shortage costs can be ignored.
Annual demand for the inventory item Average inventory is the order size/2
is constant throughout the year. because the maximum inventory is Q
As a result of the simplifying assumptions, the relevant costs are the annual holding
cost per item per annum and the annual ordering costs.
If the price of materials is the same, no matter what the size of the purchase order, the
purchase order quantity that minimises total costs is the quantity at which ordering
costs plus the costs of holding inventory are minimised.
The EOQ model formula

The order quantity or purchase quantity that minimises the total annual cost of ordering
the item plus holding it in store is called the economic order quantity or EOQ.
Formula: Economic order quantity (Q)
Where:
Q = Quantity purchased in each order to minimise costs
CO = Fixed cost per order
CH = the cost of holding one item of inventory per annum
D = Annual demand
Notes:
There will be an immediate supply of new materials (Q units) as soon as existing
quantities in store run down to zero. The minimum quantity held in store is therefore
zero and this always occurs just before a new purchase order quantity is received.

The maximum quantity held is Q units. The average amount of inventory held is
therefore Q/2 and total holding costs each year are (Q/2) × CH.
The number of orders each year is D/Q. Total ordering costs each year are therefore
(D/Q) × CO.
The economic order quantity (EOQ) is the order size that minimises the sum of these
costs during a period (normally one year), given the assumptions stated above.
Example:
A company uses 120,000 units of Material X each year, which costs ₦300 for
each unit. The cost of placing an order is ₦6,500 for each order. The annual
cost of holding inventory each year is 10% of the purchase price of a unit.
The economic order quantity for Material X is as follows:
CO = Fixed cost per order = ₦ 6,500
CH = the cost of holding one item of inventory per annum = 10% 
300= ₦ 30
D = Annual demand = 120,000 units
The EOQ is the quantity that minimises the sum of the annual order costs and the
annual holding costs. The annual holding costs equal the annual order costs at this
level.
Example:
Using information from the previous example
Annual order costs: ₦
Number of orders  fixed cost per order
D
/Q CO = 120,000/7211.1 6,500 108,166
Annual holding costs:

Average inventory  cost of holding one item per
annum:
Q
/2 30 = 7,211.1/2 30 108,166
Total annual cost that is minimised by the EOQ 216,332
Annual purchase price (D  Price = 120,000  300) 36,000,000
Total annual cost 36,216,332
The costs that are minimised are often very small compared to the purchase price in
the model. The purchase price is irrelevant in deciding the order quantity because it is
not affected by the order size when the annual demand is constant.
Total annual ordering costs and annual holding costs are always the same whenever
the purchase quantity for materials is the EOQ and the assumptions on which the EOQ

is based (described earlier) apply. This would not be the case if safety inventory was
held (but the simplifying assumptions preclude this from happening).
Practice questions 1
1 A company uses the Economic Order Quantity (EOQ) model to
determine the purchase order quantities for materials.
The demand for material item M234 is 12,000 units every three
months.
The item costs ₦80 per unit, and the annual holding cost is 6% of the
purchase cost per year. The cost of placing an order for the item is
₦250.
What is the economic order quantity for material item M234 (to the
nearest unit)?
2 A company uses the Economic Order Quantity (EOQ) model to
determine the purchase order quantities for materials.
The demand for material item M456 is 135,000 units per year. The
item costs ₦100 per unit, and the annual holding cost is 5% of the
purchase cost per year.
The cost of placing an order for the item is ₦240.
What are the annual holding costs for material item M456?
3 A company uses a chemical compound, XYZ in its production
processes.
XYZ costs ₦1,120 per kg. Each month, the company uses 5,000 kg
of XYZ and holding costs per kg. per annum are ₦20.
Every time the company places an order for XYZ it incurs
administrative costs of ₦180.
What is the economic order quantity for material item XYZ (to the
nearest unit)?
3.3 Optimum order quantity with price discounts for large orders
When the EOQ formula is used to calculate the purchase quantity, it is assumed that
the purchase cost per unit of material is a constant amount, regardless of the order
quantity.
If a supplier offers a discount on the purchase price for orders above a certain quantity,
the purchase price becomes a relevant cost. When this situation arises, the order
quantity that minimises total costs will be either:
the economic order quantity; or
the minimum order quantity necessary to obtain the price discount.
The total costs each year including purchases, ordering costs and holding costs, must
be calculated for the EOQ and the minimum order quantity to obtain each discount on
offer.

Example:
A company uses 120,000 units of Material X each year, which costs ₦300 for
each unit.
The cost of placing an order is ₦6,500 for each order.
The annual cost of holding inventory each year is 10% of the purchase cost.
The EOQ based on the above information is 7,211 units.
The supplier offers a price discount of ₦ 5 per unit for orders of 10,000 or
more.
The order quantity that will minimise total costs is found as follows:
10,000
Order quantity: 7,211.1 units units
₦ ₦
Annual ordering costs (
D
/Q CO = 120,000/7211.1 6,500 108,166
D
/Q CO = 120,000
/10,000 6,500 78,000
Holding costs
Q
/2 30 = 7,211.1/2 30 108,166
Q
/2 30 = /2 30
10,000
150,000
216,332 228,000
Annual purchase costs
120,000 ₦ 300 36,000,000
120,000 ₦ (300 − 5) 35,400,000
Total costs 36,216,332 35,628,000
Conclusion: The order quantity that minimises total costs is 10,000 units.
(The sum of the annual ordering costs plus the annual holding costs is greater
for 10,000 units as would be expected from our knowledge of the EOQ model.
However, this increase is more than compensated for by the saving in
purchase price at this order level.)
Practice question 2
A company uses 120,000 units of Material X each year, which costs ₦3
for each unit before discount.
The costs of making an order are ₦605 for each order. The annual cost
of holding inventory is 10% of the purchase cost.
The supplier offers a price discount of ₦0.10 per unit for orders of
25,000 up to 40,000 units, and a discount of ₦0.20 per unit for orders of
40,000 units or more.
Find the quantity that will minimise total costs.

4 JUST-IN-TIME (JIT) AND OTHER INVENTORY MANAGEMENT
METHODS
Section overview
JIT production and JIT purchasing

Practical implications of JIT
Other inventory control systems
4.1 JIT production and JIT purchasing

Just-in-Time (JIT) management methods originated in Japan in the 1970s. JIT is a
radically different approach to inventory management compared with management
using the EOQ model and reorder levels.
The principle of JIT is that producing items for inventory is wasteful, because inventory
adds no value, and holding inventory is therefore an expense for which there is no
benefit.
If there is no immediate demand for output from any part of the system, a production
system should not produce finished goods output for holding as inventory. There is no
value in achieving higher volumes of output if the extra output goes into inventory as it
has no immediate use.
Similarly, if there is no immediate demand for raw materials, there should not be any of
the raw materials in inventory. Raw materials should be obtained only when they are
actually needed.
It follows that in an ideal production system:

there should be no inventory of finished goods: items should be produced just in time to
meet customer orders, and not before ( just in time production); and
there should be no inventories of purchased materials and components: purchases

should be delivered by external suppliers just in time for when they are needed in
production (just in time purchasing).
4.2 Practical implications of JIT
JIT production
It is important that items should be available when required. Finished goods must be
available when customers order them, and raw materials and components must be
supplied when they are needed for production.
In practice, this means that:
Production times must be very fast. If there is no inventory of finished goods,
production has to be fast in order to meet new customer orders quickly;
Production must be reliable, and there must be no hold-ups, stoppages or bottlenecks.

Poor quality production, leading to rejected items and scrap, is unacceptable; and

Deliveries from suppliers must be reliable: suppliers must deliver quickly and
purchased materials and components must be of a high quality (so that there will be no
scrapped items or rejected items in production).
JIT purchasing
JIT depends for its success not only on highly efficient and high-quality production, but
also on efficient and reliable supply arrangements with key suppliers. For successful
JIT purchasing, there must be an excellent relationship with key suppliers.
Collaborative long-term relationships should be established with major suppliers, and
purchasing should not be based on selecting the lowest price offered by competing
suppliers.
By implementing a JIT system, an entity will be working with its key (‘strategic’)
suppliers to implement a manufacturing system that will:
reduce or eliminate inventories and WIP;
reduce order sizes, since output is produced to meet specific demand and raw material
deliveries should be timed to coincide with production requirements; and
ensure deliveries arrive in the factory exactly at the time that they are needed.
The overall emphasis of a JIT purchasing policy is on consistency and quality, rather
than looking for the lowest purchase price available.
Problems with JIT

There might be several problems with using JIT in practice.
Zero inventories cannot be achieved in some industries, where customer demand

cannot be predicted with certainty and the production cycle is quite long. In these
situations, it is necessary to hold some inventories of finished goods.
It might be difficult to arrange a reliable supply system with key suppliers, whereby
suppliers are able to deliver materials exactly at the time required.
If the EOQ model succeeds in minimising total costs of holding costs and ordering
costs, this suggests that with a JIT purchasing system, ordering costs might be very
high.
4.3 Other inventory control systems

EOQ and JIT are two methods of managing and controlling inventory and purchasing
quantities. Other systems might be used.
Two-bin system
When a two-bin system is used in a warehouse or stores department, each item of
inventory is stored in two bins or large containers. Inventory is taken from Bin 1 until it
is empty, and a new order is placed sufficient to fill Bin 1 again.
However, the delivery of more units of the item will take time, and since Bin 1 is empty,
units are now taken from Bin 2. Bin 2 is large enough to continue supplying the item
until the new delivery arrives. On delivery, both bins are replenished and units are
once again supplied from Bin 1.

This cycle continues indefinitely.
Periodic review system

In a periodic review system, there is a reorder quantity and a reorder level for each
item of inventory.
Inventory levels are checked periodically, say every one, two, three or four weeks. If
the inventory level for any item has fallen below its reorder level, a new order for the
reorder quantity is placed immediately.
Example:
The demand for an inventory item each week is 400 units, and inventory
control is applied by means of a three-weekly periodic review. The lead-time
for a new order is two weeks.
The minimum inventory level should therefore be (3 weeks + 2 weeks) = 5
weeks × 400 units = 2,000 units.
If the inventory level is found to be lower than this level at any periodic review,
a new order for the item should be made.

5 CHAPTER REVIEW
Chapter review
Before moving on to the next chapter check that you now know how to:
Measure inventory at the lower of cost and net realisable value;
Explain and apply FIFO, WAVCO and LIFO;
Describe the economic order quantity (EOQ) and apply the concept in given
scenarios;
Calculate the EOQ from data provided; and
Explain JIT.
SOLUTIONS TO PRACTICE QUESTIONS

Solutions 1
1 Economic order quantity
Annual holding cost

Solutions 2
EOQ
2CoD
EOQ =
CH
Where:
CO = 605
D = 120,000
CH = 10% × 3 = 0.3
 2  120,000  605 
=   = 484,000,000 = 22,000 units
 0.3 
The economic order quantity is 22,000 units

The order quantity that will minimise total costs is found as follows:
Order quantity
22,000 25,000 40,000
units units units
₦ ₦ ₦
Annual purchase costs
120,000 × ₦3 360,000
120,000 × ₦(3 – 0.10) 348,000
120,000 × ₦(3 – 0.20) 336,000
Annual ordering costs (D/Q  CO)
(120,000/22,000) × ₦605 3,300
(120,000/25,000) × ₦605 2,904
(120,000/40,000) × ₦605 1,815
Holding costs (Q/2  CH)
(22,000/2) × ₦0.3 3,300
(25,000/2) × ₦0.29 3,625
(40,000/2) × ₦0.28 5,600
Total costs 366,600 354,529 343,415
Conclusion
The order quantity that minimises total costs is 40,000 units.

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Foundation level

© Emile Woolf International 84 The Institute of Chartered Accountants of Nigeria

By the end of this chapter you should be able to:

© Emile Woolf International 85 The Institute of Chartered Accountants of Nigeria

1.1 The need for procedures and documentation of materials

1.2 The procedures and documents

© Emile Woolf International 86 The Institute of Chartered Accountants of Nigeria

Illustration: The purchase process

© Emile Woolf International 87 The Institute of Chartered Accountants of Nigeria

The documentation for the issue and returns of materials are:

Examples of this are shown in the next section.

Errors in recording receipts, issues and returns. Mistakes might be made in

© Emile Woolf International 88 The Institute of Chartered Accountants of Nigeria

Damage to stores items or deterioration of items. Stores items might deteriorate in

Documentation and record keeping should be accurate and mistakes should be

Minimising discrepancies and losses

© Emile Woolf International 89 The Institute of Chartered Accountants of Nigeria

Deterioration of inventory can be reduced by keeping the inventory in better storage

1.4 Entries and balances in a materials inventory account

© Emile Woolf International 90 The Institute of Chartered Accountants of Nigeria

Basic rule: Lower of cost and net realisable value (NRV)

2.1 Basic rule: Lower of cost and NRV

© Emile Woolf International 91 The Institute of Chartered Accountants of Nigeria

2.2 Cost formulas

Weighted average cost (WAVCO)

© Emile Woolf International 92 The Institute of Chartered Accountants of Nigeria

2.3 First-in, first-out method of valuation (FIFO)

Example (as before): FIFO

© Emile Woolf International 93 The Institute of Chartered Accountants of Nigeria

Example: Inventory ledger card (FIFO)

Receipts Issues Balance

Note 1,100 minus 800 equals 300

74,000 minus 51,000 equals 23,000

2.4 Weighted average cost (WAVCO) method

© Emile Woolf International 94 The Institute of Chartered Accountants of Nigeria

Example (as before): WAVCO

Inventory movement can be shown on a cost ledger card as follows:

Example: Inventory ledger card (weighted average cost method)

Receipts Issues Balance

Note 1,100 minus 800 equals 300

74,000 minus 52,910 equals 21,090

© Emile Woolf International 95 The Institute of Chartered Accountants of Nigeria

Example (as before): LIFO

Inventory movement can be shown on a cost ledger card as follows:

Example: Inventory ledger card (LIFO method)

Receipts Issues Balance

Note 1,100 minus 800 equals 300

74,000 minus 56,000 equals 18,000

© Emile Woolf International 96 The Institute of Chartered Accountants of Nigeria

Choice of inventory valuation method

Costing of issues from inventory and inflation

Example: FIFO vs WAVCO vs LIFO when prices are rising

© Emile Woolf International 97 The Institute of Chartered Accountants of Nigeria

Advantages and disadvantages of AVCO

Advantages and disadvantages of LIFO

© Emile Woolf International 98 The Institute of Chartered Accountants of Nigeria

Costs associated with inventory

3.1 Costs associated with inventory