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Financial inventory performance measures

By Anonymous - Posted on 11 February 2012

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.

(a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income.

(b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income.

(c) Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO.

Firms often adopt the LIFO approach for the tax benefits during periods of high inflation, and studies indicate that firms with the following characteristics are more likely to adopt LIFO - rising prices for raw materials and labor, more variable inventory growth, an absence of other tax loss carry forwards, and large size. When firms switch from FIFO to LIFO in valuing inventory, there is likely to be a drop in net income and a concurrent increase in cash flows (because of the tax savings). The reverse will apply when firms switch from LIFO to FIFO.

Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose to use the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. This can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based upon FIFO valuation.

(d)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.


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