High level inventory management

High level inventory management

It seems that around about 1880 there was a change in manufacturing practise from companies with relatively homogeneous lines of products to vertically integrated companies with unprecedented diversity in processes and products. Those companies (especially in metalworking) attempted to achieve success through economies of scale - the gains of jointly producing two or more products in one facility. The managers now needed information on the effect of product mix decisions on overall profits and therefore needed accurate product cost information. A variety of attempts to achieve this were unsuccessful due to the huge overhead of the information processing of the time. However, the burgeoning need for financial reporting after 1900 created unavoidable pressure for financial accounting of stock and the management need to cost manage products became overshadowed. In particular it was the need for audited accounts that sealed the fate of managerial cost accounting. The dominance of financial reporting accounting over management accounting remains to this day with few exceptions and the financial reporting definitions of 'cost' have distorted effective management 'cost' accounting since that time. This is particularly true of inventory.
Hence high level financial inventory has these two basic formulas which relate to the accounting period:
Cost of beginning inventory at the start of the period + inventory purchases within the period + cost of production within the period = cost of goods sold
Cost of goods - cost of ending inventory at the end of the period = cost of goods sold
The benefit of these formulae is that the first absorbs all overheads of production and raw material costs in to a value of inventory for reporting. The second formula then creates the new start point for the next period and gives a figure to be subtracted from sales price to determine some form of sales margin figure.
Manufacturing management is more interested in inventory turnover ratio or average days to sell inventory since it tells them something about relative inventory levels.
Inventory turn over ratio (also known as inventory turns) = cost of goods sold/Average Inventory=Cost of Goods Sold/((Beginning Inventory+Ending Inventory)/2)
and its inverse
Average Days to Sell Inventory=Number of Days a Year/Inventory Turn Over Ratio=365 days a year/Inventory Turn Over Ratio
This ratio estimates how many times the inventory turns over a year. This number tells us how much cash/goods are tied up waiting for the process and is a critical measure of process reliability and effectiveness. So a factory with two inventory turns has six months stock on hand which generally not a good figure (depending upon industry) whereas a factory that moves from six turns to twelve turns has probably improved effectiveness by 100%. This improvement will have some negative results in the financial reporting since the 'value' now stored in the factory as inventory is reduced.
Whilst the simplicity of these accounting measures of inventory are very useful they are in the end fraught with the danger of their own assumptions. There are in fact so many things which can vary hidden under this appearance of simplicity that a variety of 'adjusting' assumptions may be used. These include:
Specific Identification
Weighted Average Cost
Moving-Average Cost
FIFO, and LIFO.