LIRA UNIVERSITY
FACULTY OF MANAGEMENT SCIENCES
PGDFM LECTURE NOTES MARCH 2023
MANAGEMENT ACCOUNTING
ORDERING AND ACCOUNTING FOR INVENTORY
1. Introduction
In this topic, we will look at the documents used within a business in relation to the goods,
and at the various methods of valuing the closing inventories.
2. Documents used within a business for the ordering, purchasing, receiving, and issuing
of goods.
i. Ordering goods
When a department requires new material, they will send a purchase requisition form to
the purchasing department. The purchasing department will then send a purchase order
form to the relevant supplier (with copies to the accounts department and to the goods
receiving department).
ii. Receiving goods from the supplier
When the goods are received by the goods receiving departments, they will check the
goods against the purchase order and against the delivery note (which the supplier will
have prepared and sent with the goods and which will list what is in the delivery). The
goods receiving department will prepare a goods received note giving full details of the
goods that have been received and will send copies to the purchasing department and
to the accounting department. The inventory records will be updated.
iii. Receiving the invoice from the supplier
The purchasing department will match the invoice details with the purchase order and
the goods receive note and approve it for payment. The approved invoice will be sent
to the accounting department who will enter it into the ledgers and later pay it.
iv. Issuing of inventory
When the production department requests materials for production, they will send a
material requisition note to the stores. The stores will issue the material and update the
inventory records. Any unused material will be returned to the stores together with a
material returned note and inventory records will be updated.
If material is transferred from one production department to another, a material transfer
note is prepared. When finished goods are despatched to customers, a goods despatch
note, and a delivery note are created.
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3. The valuation of inventory
There are three methods used for the valuation of closing inventory in management
accounting that you need to be aware of for the exam - FIFO, LIFO, and Weighted
average.
FIFO - First In First Out
This method assumes that materials are issued out of inventory in the same order in which
they were delivered into inventory. As a result, the closing inventory will consist of the most
recent receipts.
Example 1
JM Ltd had the following material transactions during November.
Date Number of units Cost per unit
Opening balance 01 November 2020 20 4.00
Receipt 08 November 2020 140 4.40
Issues 12 November 2020 80
Receipt 18 November 2020 100 4.60
Issues 26 November 2020 140
Required:
Calculate the closing inventory value at the end of November using FIFO.
Suggested Solution
Units Receipts Total Issues Unit Units Balance Total
Unit cost Cost Units Cost Unit cost Cost
(Shs) (Shs) (Shs) (Shs) (Shs)
Opening 20 4.00 80.00
balance
8 140 4.40 616.00 140 4.40 616.00
November 160 696.00
12 20 4.00 80.00
November 60 4.40 264.00
80 344.00
80 4.40 352.00
18 100 4.60 460.00 100 4.60 460.00
November 180 812.00
26 80 4.40 352.00
November 60 4.60 276.00
140 628.00
40 4.60 184.00
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Example 1b.
The following information relates to Elite Enterprises the manufacturers of a local brew in
Lira City West in the first week of January 2022. The transactions in connection with the
materials are as follows:
Receipts Issues
Units Rate per unit Units
1st January 2022 balance b/f 05 10,000
1st January 2022 40 15,000
2nd January 2022 20 16,000
3rd January 2022 30
4th January 2022 50 17,000
5th January 2022 20
6th January 2022 40
Required:
i. Calculate the cost of materials issued under the FIFO method.
Suggested Solution
Units Receipts Total Issues Unit Units Balance Total
Unit cost Cost Units Cost Unit Cost
(Shs) (Shs) (Shs) cost (Shs)
(Shs)
1st January 05 10,000 50,000
2022
1st January 40 15,000 600,000 40 15,000 600,000
2022 45
2nd 20 16,000 320,000 20 16,000 320,000
January 65 970,000
2022
3rd January 30
2022 05 10,000 50,000
25 15,000 375,000
425,000
15 15,000 225,000
20 16,000 320,000
545,000
4th January 50 17,000 850,000 50 17,000 850,000
2022 85 1,395,000
5th January 20
2022 15 15,000 225,000
5 16,000 80,000
305,000
15 16,000 240,000
3
50 17,000 850,000
1,090,000
6th January 40
2022 15 16,000 240,000
25 17,000 425,000
665,000
25 17,000 425,000
LIFO - Last In First Out
This method assumes that materials are issued out of inventory in the reverse order to
which they were delivered into inventory.
LIFO is prohibited simply because it understates/under values closing inventory, hence
low tax liability.
Example 2
JM Ltd had the following material transactions during November.
Date Number of units Cost per unit
Opening balance 01 November 2020 20 4.00
Receipt 08 November 2020 140 4.40
Issues 12 November 2020 80
Receipt 18 November 2020 100 4.60
Issues 26 November 2020 140
Required:
Calculate the closing inventory value at the end of November using LIFO.
Suggested Solution
Units Receipts Total Issues Unit Units Balance Total
Unit cost Cost Units Cost Unit cost Cost
(Shs) (Shs) (Shs) (Shs) (Shs)
Opening 20 4.00 80.00
balance
8 140 4.40 616.00 140 4.40 616.00
November 160 696.00
12 80 4.40 20 4.00 80.00
November 60 4.40 264.00
80 344.00
18 100 4.60 460.00 100 4.60 460.00
November 180 804.00
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26 100 4.60 20 4.00 80.00
November 40 4.40 20 4.60 88.00
140 40 168.00
Cumulative Weighted Average Cost
This method calculates the average cost after each issue of materials.
Example 3
JM Ltd had the following material transactions during November.
Date Number of units Cost per unit
Opening balance 01 November 2020 20 4.00
Receipt 08 November 2020 140 4.40
Issues 12 November 2020 80
Receipt 18 November 2020 100 4.60
Issues 26 November 2020 140
Required:
Calculate the closing inventory value at the end of November using Cumulative
weighted average cost.
Suggested Solution
Units Receipts Total Issues Unit Units Balance Total
Unit cost Cost Units Cost Unit cost Cost
(Shs) (Shs) (Shs) (Shs) (Shs)
Opening 20 4.00 80.00
balance
8 140 4.40 616.00 140 4.40 616.00
November 160 4.35 696.00
12 80 4.35 80 4.35 348.00
November
18 100 4.60 460.00 100 4.60 460.00
November 180 4.49 808.00
26 140 4.49 40 4.49 179.64
November
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INVENTORY CONTROL
1. Introduction
There are many approaches in practice to ordering goods from suppliers. In this chapter
we will consider one particular approach – that of ordering fixed quantities each time.
For example, if a company needs a total of 12,000 units each year, then they could
decide to order 1,000 units to be delivered 12 times a year. Alternatively, they could order
6,000 units to be delivered 2 times a year. There are obviously many possible order
quantities. We will consider the costs involved and thus decide on the order quantity that
minimises these costs (the economic order quantity).
2. Costs involved
The costs involved in inventory ordering systems are as follows:
▪ the purchase cost
▪ the reorder cost
▪ the inventory-holding cost
Purchase cost
This is the cost of actually purchasing the goods. Over a year the total cost will remain
constant regardless of how we decide to have the items delivered and is therefore
irrelevant to our decision; unless we are able to receive discounts for placing large orders.
Re-order cost
This is the cost of actually placing orders. It includes such costs as the administrative time
in placing an order, and the delivery cost charged for each order.
If there is a fixed amount payable on each order then higher order quantities will result in
fewer orders needed over a year and therefore a lower total reorder cost over a year.
Inventory holding cost
This is the cost of holding items in inventory. It includes costs such as warehousing space
and insurance and also the interest cost of money tied up in inventory.
Higher order quantities will result in higher average inventory levels in the warehouse and
therefore higher inventory holding costs over a year.
3. Minimising costs
One obvious approach to finding the economic order quantity is to calculate the costs
p.a. for various order quantities and identify the order quantity that gives the minimum
total cost.
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Example 1
Janis has demand for 40,000 desks p.a. and the purchase price of each desk is Shs. 25.
There are ordering costs of Shs. 20 for each order placed. Inventory holding costs amount
to 10% p.a. of inventory value.
Required:
Calculate the inventory costs p.a. for the following order quantities, and plot them on a
graph:
a. 500 units
b. 750 units
c. 1,000 units
d. 1,250 units
Suggested Solution
Order Number of (Shs. 20 per Average (10%×Shs.25=Shs.2.50 Total
quantity orders order) inventory p.u.) Stockholding inventory
Reorder cost cost p.a. (a + b)
p.a. (a) (b)
500 80 1,600 250 625 2,225
(40,000/500) (80 x 20) (500/2) (250 x 2.50)
750 53.33 1,067 375 938 2,005*
(40,000/750) (53.33 x 20) (750/2) (375 x 2.50)
1,000 40 800 500 1,250 2,050
(40,000/1,000) (40 x 20) (1,000/2) (500 x 2.50)
1,250 32 640 625 1,563 2,203
(40,000/1,250) (32 x 20) (1,250/2) (625 x 2.50)
5. The EOQ formula
A more accurate and time-saving way to find the EOQ is to use the formula that is
provided for you in the exam.
The formula is: EOQ = √2CoD/CH
Where Co = fixed costs per order
D = annual demand
CH = the inventory holding cost per unit per annum
Example 2
For the information given in Example 1,
a. use the EOQ formula to calculate the Economic Order Quantity.
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b. calculate the total inventory costs for this order quantity.
Suggested Solution
EOQ = √2CoD/CH
EOQ = √2 x 20 x 40,000/2.5
EOQ = 800 Units
𝐷 40,000
Reorder cost = 𝐸𝑂𝑄 = = 50 x Shs. 20 = Shs. 1,000
800
𝐸𝑂𝑄 800
Inventory Holding cost = = = 400 x Shs. 2.50 = Shs. 1,000
2 2
Total Inventory Cost = Shs. 2,000 per annum
6. Quantity discounts
Often, discounts will be offered for ordering in large quantities. The problem may be
solved using the following steps:
i. Calculate EOQ ignoring discounts
ii. If it is below the quantity which must be ordered to obtain discounts, calculate
total annual inventory costs.
iii. Recalculate total annual inventory costs using the order size required to just obtain
the discount
iv. Compare the cost of step (i) and (iii) with the saving from the discount and select
the minimum cost alternative.
v. Repeat for all discount levels
Example 3
For the information given in Example 1 the supplier now offers us discounts on purchase
price as follows:
Order quantity discount
0 to < 5,000 0%
5,000 to < 10,000 1%
10,000 or over 1.5 %
Required:
Calculate the Economic Order Quantity
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Suggested Solution
Order quantity = EOQ = 800 units:
Shs.
Purchase cost: 40,000 × Shs. 25 1,000,000
Inventory costs 2,000
1,002,000 per annum
Order quantity = 5,000 units
Shs.
Purchase cost: 40,000 × 99% × Shs. 25 990,000
Inventory costs:
40,000
Reorder: = = 8 × Shs. 20 = 160
5,000
5,000
Inventory holding: = = 2,500 × 99% ×Shs. 2.50 = 6,188
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Shs. 996,348 p.a.
Order quantity = 10,000 units
Shs.
Purchase cost: 40,000 × 98.5% × Shs. 25 985,000
Inventory costs:
40,000
Reorder: = 10,000
= 4 × Shs. 20 = 80
10,000
Inventory holding: = = 5,000 × 98.5% ×Shs. 2.50 = 12,313
2
Shs. 997,393 p.a.
Order quantity of 5,000 units is the best option.
7. The Economic Batch Quantity
In the earlier examples, we assumed that we purchased goods from a supplier who
delivered the entire order immediately.
Suppose instead that we have our own factory. The factory can produce many different
products (using the same machines). Whenever we order a batch of one particular
product then the factory will set-up the machines for the product and start producing
and delivering to the warehouse immediately.
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However, it will take them a few days to produce the batch and during that time the
warehouse is delivering to customers. As a result, the maximum inventory level in the
warehouse never quite reaches the order quantity, and the formula needs changing
slightly.
𝐷
EBQ= √2CoD/CH (1− 𝑅 )
where: CO = fixed costs per batch (or set-up costs)
D = annual demand
CH = inventory holding cost per unit per annum
R = rate of production per annum
It is also worth learning that the average inventory level in this situation will be:
𝐸𝐵𝑄 𝐷
Average inventory = x (1− 𝑅 )
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Example 4
A company has demand for 50,000 units p.a. They produce their own units at a cost of
Shs. 30 per unit and are capable of producing at rate of 500,000 units p.a. Machine set-
up costs are Shs. 200 for each batch. Inventory holding costs are 10% p.a. of inventory
value.
Required:
Calculate the Economic Batch Quantity, and the costs involved p.a. for that quantity.
Suggested Solution
𝐷 50,000
EBQ= √2CoD/CH (1− 𝑅 ) = √2x200x50,000/3(1− 500,000) = 2,722 units
Shs.
Reorder costs: = 3,674
Inventory holding cost = 3,675
Total inventory costs Shs. 7,349p.a.
8. Re-order level and ‘safety’ inventories
In the previous paragraphs we have considered the re-order quantities for inventory -
that is the quantity that we should order each time.
However, in real life, it is unlikely that the supplier will deliver our order instantly - for
example, it might take a week for the delivery to arrive - and therefore we need to place
an order when we still have some units left. If we do not have sufficient units in inventory
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to last us until the delivery arrives, then we will run out of inventory and have to turn
customers away.
The time between the placing of an order and the delivery arriving is known as the lead
time.
The level of inventory at which time we should place a new order is known as the re-order
level.
Example 5
A company has a demand from customers of 100 units per week. The time between
placing an order and receiving the goods (the lead time) is 5 weeks.
Required:
What should the re-order level be? (i.e., how many units should we still have in inventory
when we place an order).
Suggested Solution
Re-order level = demand over the lead time = 5 × 100 = 500 units
In practice, the demand per day and the lead time are unlikely to be certain.
What therefore we might do is re-order when we have more than 500 units in inventory,
just to be ‘safe’ in case the demand over the lead time is more than 500 units. Any extra
held in inventory for this reason is known as safety inventory, or buffer inventory.
Example 6
A company has a demand from customers of 100 units per week. The time between
placing an order and receiving the goods (the lead time) is 5 weeks.
The company has a policy of holding safety inventory of 100 units.
Required:
What should the re-order level be?
Suggested Solution
Demand of the lead time = 500 units (see answer 5)
Safety inventory 100 units
Re-order level 600 units
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Alternatively, if we do know the maximum demand over the lead time and want to be
certain of not running out of inventory then the re-order level needs to be equal to the
maximum possible demand over the lead time.
Example 7
Demand from customers is uncertain and is between 70 and 120 units per week. The lead
time is also uncertain and is between 3 and 4 weeks.
Required:
What should the re-order level be if we are to never run out of inventory?
Suggested Solution
Re-order level = maximum lead time x maximum demand = 4 × 120 = 480 units
Although our answer to example 7 (a re-order level of 480 units) will mean that if the very
worst should happen then we will still have enough units to fulfil demand, much of the
time the demand will be lower than the maximum and/or the lead time will be shorter
than the maximum.
If the demand over the lead time is less than the re-order level, then it will mean we still
have some units in inventory when the new delivery arrives.
It therefore means that the maximum inventory level will be the maximum number left in
inventory, plus the number of units delivered.
The maximum number left in inventory is the re-order level less the minimum demand over
the lead time.
Example 8
Demand from customers is uncertain and is between 70 and 120 units per week. The lead
time is also uncertain and is between 3 and 4 weeks. We have a re-order quantity of 1,000
units each time.
Required:
What is the maximum inventory level?
Suggested Solution
Re-order level = 480 units (see answer 7)
Minimum demand over lead time = minimum lead time x minimum demand per week =
3 x 70 = 210 units
Therefore, maximum inventory left when the new order arrives = 480 - 210 = 270 units
The new delivery will be of 1,000 units, therefore the maximum inventory = 270 + 1,000 =
1,270 units.
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