Value of Stock & ABCClassificationLecture # 9Date:22nd March 2015IntroductionFrom a financial point of view, inventory is an asset and represents money that is tied up and cannot be used for other purposes.As we know, inventory has a carrying costthe costs of capital, storage, and risk.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.IntroductionTwo measures that do relate to sales aretheinventory turns ratioanddaysofsupply: Inventory turns Days of supplyInventory TurnsIdeally, a manufacturer carries no inventory.This is impractical, since inventory is needed to supportmanufacturing and often to supply customers.How much inventory is enough? There is no oneanswer.A convenient measure of how effectively inventoriesare being used is the inventory turns ratio:Inventory turns =annual cost of goods sold / average inventory in dollarsInventory TurnsFor example, if the annual cost of goods sold is $1 million and the average inventory is $500,000, then Inventory turns =$ 1,000,000 / $ 500,000=2What does this mean?At the very least, it means that with$500,000 ofinventory a company is able to generate $1 million in sales.If, through better materials management, the firm is able to increase its turns ratio to 10, the same sales are generated with only $100,000 of average inventory.Days of supplyDays of supply is a measure of the equivalent number of days of inventory on hand, based on usage.The equation to calculate the days of supplyis:Days of supply= inventory on hand / average daily usageCOGS & Gross ProfitThe cost of materials sold is the total price paid, or cost of acquiring, the units that were later sold. Then the gross profit comes from: Gross prot=net sales revenuecost of products sold Cost of products sold=opening stock + net purchasesclosing stockExample of an Entry in TradingAccountsAn example of stock value in product costingValue of StockOrganizations need accurate values for their assets including stock as this directly affects their reported performance.Any errors can bring serious consequences. At times of high inflation, for example, the valuation of stocks is often too low and a company appears to have fewer assets than it really has.This may give an artificially high return on assets, and in extreme cases allows the company to be bought at a fraction of its true value.Value of StockActual cost identifies each unit in stock with the price actually paid for it.First-In-First-Out (FIFO)This assumes that the first units arriving in stock are the first sold, so the value of remaining stock is set by the amount paid for the last units bought.Last-In-First-Out (LIFO)assumes that the latest units added to stock are used first, so the value of remaining stock is set by the amount paid for the earliest units bought.Weighted average cost finds the average unit cost over a typical periodFIFO (Example)A grocery store purchases milk at regular intervals to stock its shelves. As customers purchase milk, the stockers push the oldest product to the front of the fridge and replacenewer milk behind those cartons. The cartonsofmilk with the nearest expiration dates are thusthe ones first sold, whereas the later expiration dates are sold after the older product. This ensures that older products are sold before they perish or become obsolete, and then become profit lost.ExampleDuring her first job on a graduate trainee scheme, Madeleine Fraser was given the following record of transactions for an item and asked for her views on the profit. What answer could she give?SolutionAt the end of June the closing stock is:closing stock=opening stock + purchases sales=80+(60+80)(20+40+50+20)=90 unitsThe value of these units depends on theassumption used. She does not have enoughinformation to use actual costs, but she can usethe other three methods.SolutionFIFO: assumes the 90 units remaining in stock are the last 90 bought, and this values stock at: (8040)+(1030)=3,500 or 38.89 a unitSolutionLIFO:assumes the 90 units remaining in stock are thefirst units bought after allowing for sales. Only20 units of the opening stock can remain, as theremaining 60 units were sold in January andFebruary. Ten units of the stock bought in Marchcan remain, and the remaining 60 units werebought in May.(6040)+(1030) +(2020)=3,100 or 34.4 a unitSolutionWeighted Average Cost:Weighted average cost findspurchases as:Total cost/units purchasedtheaverage costofall[(80x20)+(60x30)+(80x40)]/(80 + 60 + 80)30 a unitThis values stock at 9030=2,700Solutiongross prot=sales revenuecost of units soldsales revenue=2030+4040+5050+2060=5,900cost of units sold=total cost of buyingvalue of stockallunitspresenttotal cost of buying allunits=8020+6030+8040=6,600Gross prot=5,900[6,600present value of stock]Solutionfirst-in-first-out: gross prot=5,900[6,6003,500]=2,800last-in-first-out: grossprofit=5,900[6,6003,100]=2,400weighted average cost: grossprot=5,900[6,6002,700]=2,000ABC Analysis of StocksAnother useful set of accounting information comes from an ABC analysis.Inventory control can take a lot of effort and so for some items, especially cheap ones, this effort is not worthwhile.Very few organizations, for example, include routine stationery or coffee in their formal stock systems.At the other end of the scale are very expensive items need special care above the routine calculations.thatIt would be useful to find the amount of effort worth putting into the control of any item.An ABC analysis gives some guidelines for this.ABC Analysis of StocksThe origin of the ABC analysis sometimes calledPareto analysis, or the rule of 8020In inventory control terms it means that 20 per cent of the inventory items need 80 per cent of the attention, while the remaining 80 per cent of items need 20 per cent of the attention.Inparticular, ABC analyses define the following:A items are the few most expensive ones that need special care.B items are ordinary ones that need standard care. C items are the large number of cheap items that need little careABC Analysis of StocksTypically an organization might use an automated system to deal with all B items.A items are more important, and althoughautomated system might make somesuggestions, managers make the finaldecisions after a thorough review ofcircumstances.theC items are very cheap and are usuallyleftoutof the automatic system, to be dealt with byad-hoc procedures.ABC Analysis of StocksAn ABC analysis starts by taking each item and multiplying the number of units used in a year by the unit cost.This gives the total annual use of items in terms of value.Usually, a few expensive items account for a lot of use, while many cheap ones account for little use.If we list the items in order of decreasing annual use by value, A items are at the top of the list and C items are at the bottom.ABC Analysis of StocksABC Analysis of StocksExampleA small store with 10 categories of item hasthefollowingcostsandannualdemands:Do an ABC analysisof these items. How mightstocks of each category be controlled?SolutionStep # 1 Calculate weekly usage (Unit CostStep # 2x WeeklyDemand) Sort theusagedata from largest tosmallest valueofweeklyStep # 3 Calculate % of weekly usage (weekly usage of item/sum of weekly usage for all items)x100SolutionStep # 4 Calculate Cumulative % of weekly usage % weekly usage of item + % weekly usage itemStep # 5 Calculate % of itemsof preceding (Quantity of items/sumofquantityofallitems)x100Step # 6 Calculate Cumulative %ofitemsStep # 7 Plot Cumulative % of items on x-axis and weekly usage on y-axisCumulative%ofQuestionBelgrave Furnishing Retail Ltd has 20categories of furniturewiththefollowingcostsandannualdemands:Do an ABC analysis forBelgrave. If resourcesare limited, which items should they give mostattention to?QuestionItem Name Annual Usage in Units Unit Cost ($)1 5,000 1.502 1,500 8.003 10,000 10.504 6,000 2.005 7,500 0.506 6,000 13.607 5,000 0.758 4,500 1.259 7,000 2.5010 3,000 2.00