Financial inventory performance measures

Finance wants as little inventory as possible and needs some measure of the level of inventory. Total inventory investment is one measure, but in itself does not relate to sales. 2 measures that do relate to sales are the inventory turns ratio and days of supply.

Inventory turns. A convenient measure of how effectively inventories are being used is the inventory turns ratio:

Inventory turns = Annual cost of goods / Average invseonltdo ry in dollars

The calculation of average inventory can be complicated and is a subject for cost accounting.

Days of supply. Days of supply is a measure of the equivalent number of days of inventory on hand, based on usage. The equation to calculate it is:

Days of supply = Inventory on hand / Averages odladi ly usage

Methods of evaluating inventory
There are 4 methods accounting uses to cost inventory: first in first out, last in first out, average cost and standard cost. There is no relationship with the actual  physical movement of actual items in any of the methods. Whatever method is used is only to account for usage.

First in first out (FIFO). In rising prices, replacement is at a higher than the assumed cost. This method does not reflect current prices and replacement will be understated. The reverse is true in a falling price market.

Last in first out (LIFO). In rising prices, replacement is at the current price. The reverse is true in a falling price market. However, the company is left with an inventory that may be grossly understated in value.

Average cost. This method assumes an average of all prices paid for the article. The problem with this method in changing price is that the cost used is not related to the actual cost.

Standard cost. This method uses cost determined before production begins. The cost includes direct material, direct labor and overhead. Any difference between the standard cost and the actual cost is stated as a variance.