Inventory Management

Inventory Costs

Inventory costs depend on the methods used, which include Specific Identification, Weighted Average Cost, Moving Average Cost, FIFO, and LIFO. Inventory management is primarily about specifying the shape and percentage of stocked goods. It is required at different locations within a facility or within many locations of a supply network to precede the regular and planned course of production and stocking materials.

Inventory management involves retailers who acquire and maintain a proper merchandise assortment while ordering, shipping, handling, and keeping related costs in check. It also involves systems and processes that identify inventory requirements, set targets, provide replenishment techniques, report actual and projected inventory status, and handle all functions related to the tracking and management of material. 

This would include monitoring material moved into and out of stockroom locations and reconciling inventory balances. It may include ABC analysis, lot tracking, cycle counting support, etc. Managing inventories involves determining/controlling stock levels within the physical distribution system and balancing the need for product availability against the need to minimize stock holding and handling costs.

Inventory: The inventory costs depend on which method is used.

So many variables can be hidden under this appearance of simplicity that various "adjusting" assumptions may be used.

These include:

Specific Identification

Specific identification is a method of determining the ending inventory cost. It requires a detailed physical count so the company knows exactly how many of each good brought on specific dates remained in the yearend inventory. When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date to get a number for the ending inventory cost.

This method is also very hard to use on interchangeable goods. For example, it is hard to relate shipping and storage costs to a specific inventory item. These numbers must be estimated, reducing the specific identification's benefit of being extremely specific.

Weighted Average Cost

Weighted Average Cost is a method of calculating Ending Inventory cost. It is also known as AVCO. It takes the Cost of Goods Available for Sale and divides it by the total amount of goods from Beginning Inventory and Purchases. This gives a Weighted Average Cost per Unit. A physical count is then performed on the ending inventory to determine the amount of goods left. Finally, this amount is multiplied by the Weighted Average Cost per Unit to estimate the ending inventory cost.

Moving-Average Cost

Moving Average (Unit) Cost is a method of calculating Ending Inventory cost. Assume that both Beginning Inventory and beginning inventory cost are known. From them, the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made.

Each time, purchase costs are added to the beginning inventory cost to get the Cost of the Current Inventory. Similarly, the number of units bought is added to the beginning inventory to get Current Goods Available for Sale. After each purchase, the Cost of the Current Inventory is divided by the Current Goods Available for Sale to get the Current Cost per Unit of Goods.

Also, during the year, multiple sales happen. The Current Goods Available for Sale are deducted from the goods sold. The current inventory cost is deducted by the number of goods sold at the latest (before this sale) current cost per unit of goods. This deducted amount is added to the Cost of Goods Sold.

At the end of the year, the last Cost per Unit of Goods, along with a physical count, is used to determine the ending inventory cost.

FIFO and LIFO

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first, but do not necessarily mean that the exact oldest physical object has been tracked and sold.

LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first. Since the 1970s, some U.S. companies have shifted toward using LIFO, which reduces their income taxes during inflation. However, with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is only used in Japan and the U.S.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is called the LIFO reserve. This reserve is essentially the amount by which an entity's taxable income has been deferred by using the LIFO method.