BM2020

INVENTORY AS MONEY
Accounting for Inventory (Muller, 2011)
The three (3) basic types of inventory are:
1. Raw Materials — Raw materials inventory is made up of goods that will be used to produce finished
products (e.g., nuts, bolts, flour, sugar).
2. Work in Process — Work in process inventory or WIP, consists of materials entered into the production
process but not yet completed (e.g., subassemblies).
3. Finished Goods — Finished goods inventory includes completed products waiting to be sold (e.g., bar
stools, bread, cookies).
Most inventory fits into one of these general buckets, yet the amount of each category varies greatly depending
on your industry and business's specifics. For example, the types of inventory found in distribution environments
are fundamentally different from those found in manufacturing environments. Distribution businesses tend to
carry mostly finished goods for resale while manufacturing companies tend to have less finished goods and
more raw materials and work in progress. Given these differences, it is natural that the accounting choices vary
between distribution and manufacturing settings.
How inventory is valued
To assign a cost value to inventory, you must make some assumptions about the inventory on hand. Under
income tax laws, a company can only make these assumptions once per fiscal year. Tax treatment is often an
organization's chief concern regarding inventory valuation. The five (5) common inventory valuation methods
are as follows:
1. First-in, First-out (FIFO) inventory valuation assumes that the first goods purchased are the first to be
used or sold regardless of the actual timing of their use or sale. This method is most closely tied to the
actual physical flow of goods in inventory.
2. Last-in, First-out (LIFO) inventory valuation assumes that the most recently purchased/acquired goods
are the first to be used or sold regardless of the actual timing of their use or sale. Since items you have
just bought often cost more than those purchased in the past, this method best matches current costs
with current revenues.
3. Average Cost Method of inventory valuation identifies the value of inventory and cost of goods sold by
calculating an average unit cost for all goods available for sale during a specific period. This valuation
method assumes that ending inventory consists of all goods available for sale.
4. Specific Cost Method (also Actual Cost Method) of inventory valuation assumes that the organization can
track an item's actual cost into, through, and out of the facility. That ability allows you to charge the actual
cost of a given item to production or sales. Specific costing is generally used only by companies with
sophisticated computer systems or reserved for high-value items, such as artwork or custom-made items.
5. Standard Cost Method of inventory valuation is often used by manufacturing companies to give all of their
departments a uniform value for an item throughout a given year. This method is a "best guess" approach
based on known costs and expenses, such as historical costs and any anticipated changes coming up in
the foreseeable future. It is not used to calculate actual net profit or for income tax purposes. Rather, it is
a working tool more than a formal accounting approach.
Inventory on balance sheet
The balance sheet shows the financial position of a company on a specific date. It provides details for the basic
accounting equation: Assets = Liabilities + Equity. In other words, assets are a company's resources, while
liabilities and equity are how those resources are paid for.
• Assets represent a company's resources. Assets can be in the form of cash or other items that have
monetary value, including inventory. Assets are made up of (a) current assets (cash assets or assets
easily convertible to cash within one year, such as accounts receivable, securities, and inventory), (b)

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longer term assets such as investments and fixed assets (property/plant/equipment), or (c) intangible
assets (patents, copyrights, and goodwill).
• Liabilities represent amounts owed to creditors (debt, accounts payable, and lease-term obligations).
• Equity represents ownership or rights to the company's assets (common stock, additional paid-in capital,
and retained earnings).
Inventory is typically counted among a company's current assets because it can be sold within one (1) year.
This information is used to calculate financial ratios that help assess the financial health of the company.
However, note that the balance sheet is not the only place where inventory plays a role in a company's financial
analysis. In fact, inventory shows up on the income statement in the accounting entry "cost of goods sold".
Inventory on income statement
The income statement is a report that identifies a company's revenues (sales), expenses, and resulting profits.
While the balance sheet can be described as a snapshot of a company on a specific date (June 30, for example),
the income statement covers a given period (June 1 through June 30). The cost of goods sold is the item on the
income statement that reflects the inventory cost flowing out of a business.
The old saying, "it costs money to make money," explains the cost of goods sold. You make money by using or
selling inventory. That inventory costs you something. The cost of goods sold (on the income statement)
represents the value of goods (inventory) sold during the accounting period.
The value of goods that are not sold is represented by the ending inventory amount on the balance sheet
calculated as:
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 = 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡𝑜𝑜𝑜𝑜𝑜𝑜 + 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
This information is also useful because it can show how a company "officially" accounts for inventory. With it,
you can back into the cost of purchases without knowing the actual costs by turning around the equation as
follows:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 − 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 + 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Or, you can figure out the cost of goods sold if you know what your purchases are by making the following
calculation:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 + 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
Finally, as you sell/use inventory and take in revenue for it, you subtract the items' cost from the income. The
result is your gross profit.
Ratio analyses
Is something good, or is it bad? To answer this question, we often compare one thing to another. That is the
definition of a "ratio"; it is an expression of how many of one item is contained within another.
Ratios can be used in the business world by selecting parts of an organization's financial statements and
comparing one set of financial conditions. A company's financial statements contain key aspects of the business.
By reviewing these aspects, you can determine an organization's economic well-being. One way of reviewing
these financial conditions is to compare one to another, dividing one by the other. For example, if you had
P200,000 in cash and P100,000 worth of debts, you could divide the cash (assets) by the debt (liabilities), which
would result in a ratio of 2 to 1. In other words, you have twice as many assets as you do liabilities.
Ratios are useful tools to explain trends and summarize business results. Often third parties, such as banks,
use ratios to determine a company's creditworthiness. By itself, a ratio holds little meaning. However, when
compared to other industry and/or company-specific figures or standards, ratios can be powerful in helping to
analyze your company's current and historical results. Companies in the same industry often have similar
liquidity ratios or benchmarks, as they often have similar cost structures. Your company's ratios can be
compared to:

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• Prior period(s)
• Company goals or budget projections
• Companies in your industry
• Companies in other industries
• Companies in different geographic regions
In particular, the following three (3) ratios are useful when assessing inventory.
a. Current ratio
The current ratio assesses the organization's overall liquidity and indicates a company's ability to meet its
short-term obligations. In other words, it measures whether or not a company will be able to pay its bills.
Technically speaking, the current ratio indicates the amount of assets we have for each peso of liabilities
that we owe. The current ratio is calculated as follows:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
Current assets refer to assets in the form of cash or that are easily convertible to cash within one (1) year,
such as accounts receivable, securities, and inventory. Current liabilities refer to due and payable liabilities
within 12 months, such as accounts payable, notes payable, and a short-term portion of long-term debt.
Standards for the current ratio vary from industry to industry. Companies in the service industry that carry
little or no inventory typically have current ratios ranging from 1.1 to 1.3. Companies that carry inventory
have higher current ratios. Manufacturing companies are included in this latter group and often have current
ratios ranging from 1.6 to 2.0; not only do they have inventory in the form of finished goods ready for sale,
but they also carry an inventory of goods that are not yet ready for sale. Generally speaking, the longer it
takes a company to manufacture the inventory and the more inventory it must keep on hand, the higher the
current ratio.
A low current ratio may signal that a company has liquidity problems or has trouble meeting its short- and
long-term obligations. In other words, the organization might be suffering from a lack of cash flow to cover
operating and other expenses. As a result, accounts payable may be building at a faster rate than
receivables. Note, however, that this is only an indicator and must be used in conjunction with other factors
to determine an organization's overall financial health. In fact, some companies can sustain lower-than-
average current ratios because they move their inventory quickly and/or are quick to collect from their
customers. Therefore, these companies have good cash flow.
A high current ratio is not necessarily desirable. It might indicate that the company is holding high-risk
inventory or doing a bad job managing its assets. For example, fashion retailers may have costly inventory,
but they might also have significant trouble getting rid of the inventory, for example, if the wrong clothing
line was selected. This makes it a high-risk company, forcing creditors to require a bigger financial cushion.
Further, if a high current ratio results from a very large cash account, it may indicate that the company is
not reinvesting its cash appropriately. Even if the current ratio looks fine, other factors must be considered,
as liquidity problems might still exist. Since ratios look at quantity, not quality, it is important to look at the
current assets to determine if they are made up of slow-moving inventory. Another test of liquidity should
be considered to assess inventory's impact on liquidity, such as the Quick Ratio (or Acid Test).
b. Quick ratio or acid test
The quick ratio compares the organization's most liquid current assets to its current liabilities. The quick
ratio is calculated as follows:
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
Assume that an industry that sells on credit has a quick ratio of at least 0.8. In other words, the company
has at least 0.8 centavos in liquid assets (likely in the form of accounts receivable) for every Php1 of
liabilities. Industries that have significant cash sales (such as grocery stores) tend to be even lower. As with

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the current ratio, a low quick ratio is an indicator of cash flow problems, while a high ratio may indicate poor
asset management, as cash may be properly reinvested or accounts receivable levels are out of control.
An organization's ability to promptly collect its accounts receivable has a significant impact on this ratio. The
quicker the collection, the more liquidity it has.
c. Inventory turnover ratio
The inventory turnover ratio measures, on average, how many times inventory is replaced over a period. In
its simplest sense, an inventory turn occurs every time an item is received, used or sold, and replaced. If
an SKU came in twice during the year, was used/sold, and then replenished, that would be two (2) turns
per year. If this happened once per month, it would be twelve turns per year, and so forth.
Inventory turnover is an important measure since moving inventory quickly directly impacts the company's
liquidity. Inventory turnover is calculated as follows:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
When a product is sold, it is subtracted from inventory and transferred to the cost of goods sold. Therefore,
this ratio indicates how quickly inventory is moving for accounting purposes. It does not necessarily reflect
how many times actual physical items were handled within the facility. This is true because the cost of goods
sold may include items you sold but never physically handled. For example, we purchase items and then
have drop shipped directly at our customer's site are never handled within our facility. A more accurate
measure of how many times actual physical inventory turned within site would be:
𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑝𝑝ℎ𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 =
𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
Note that if the inventory has increased or decreased significantly during the year, the average inventory
for the year may be skewed and not accurately reflect your turnover ratio going forward. In addition, if the
company uses the LIFO method of accounting, the ratio may be inflated because LIFO may undervalue the
inventory.
Unlike the current ratio and quick ratio, the inventory turnover ratio does not adhere to a standard range.
Organizations with highly perishable products can have inventory turns 30 times a year or more. Companies
that retain large amounts of inventory or require a long time to build their inventory might have turned only
two (2) or three (3) times a year. In general, today's overall trend is to reduce carrying costs by limiting the
amount of inventory in stock at any given time. As a result, both individual inventory turnovers and industry
averages in this area have increased in recent years.
It is important to understand, however, that many factors can cause a low inventory turnover ratio. The
company may be holding the wrong type of inventory, its quality may be lacking, or it may have
sales/marketing issues.
d. Profit margins
Another set of ratios a stock keeper must understand, especially one in a for-profit environment, relates to
profit margins.
Profit margins are ratios of profitability that measure how much of every peso of sales a company keeps in
earnings. If a company's expenses increase more quickly than sales, then, even though sales might be
higher than sales during the same period last year, its profit margins will go down. Basically, business
owners use gross profit margins to:

• Set prices at levels that ensure a strong profit,

• Measure and reduce costs for better profitability or
• Determine what to charge for a new item to make it profitable.

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Merchandising metrics
Stock keepers, especially those in for-profit enterprises, often must be concerned with setting the right price for
an item or a grouping of items. Or, they must determine the cost of an item.
a. Pricing generally
Price setting begins with determining the breakeven point.

• The breakeven point is reached when the cost of producing/purchasing and/or selling a product or
service is covered.
• The contributing margin is the gross profit derived from the sale of the product, that is, the selling price
less the cost of the goods or materials.
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 – 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
Breakeven formula
At the breakeven point, the revenue and the total cost are equal
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 ÷ 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
b. Selling price
Selling price determination for many consumer products is often a function of the cost of production and a
desired level of markup.
c. Margins, Markups, and Markdowns
A profit margin is different from a markup. The margin is the percentage of the final selling price that is
profitable. Markup is what percentage of the cost price you add to the cost price to get the selling price. A
markdown is the difference between the original selling price and the price at which an item is actually sold.
A selling price with a margin of 25% results in more profit than a selling price with a markup of 25%. For
example, if you buy an item for P100 and mark it up 25%, it would sell for P25. However, if you want to
make a 25% (profit) margin, it would sell for P133.33.
d. Determining the Selling price
To calculate the selling price at a percent margin when the cost is known, divide the cost by 100% minus
the desired margin percent
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 ÷ (100% − 𝑚𝑚𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
A quicker way to work it out is to divide the cost by the profit margin you want to make. For example:
For a 5% margin, divide the cost price by 0.95.
For a 10% margin, divide the cost price by 0.9.
For a 15% margin, divide the cost price by 0.85.
For a 20% margin, divide the cost price by 0.8.
For a 25% margin, divide the cost price by 0.75.
For a 30% margin, divide the cost price by 0.7.
e. Determining the cost
To calculate the cost when the selling price and the markup percent are known, multiply the selling price by
the markup percent and subtract the selling price's answer.
(𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 × 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝) − 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐

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f. Determining the margin percent

To determine the margin percent when the cost and the selling price are known, subtract the selling price
cost. Divide the difference by the selling price.
(𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 − 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐) ÷ 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
g. Determining markdowns
Sometimes an item does not sell at the desired price. You must then sell it at a markdown. In other words,
you're going to put the item "on sale."
To determine the marked-down (on-sale) price where the original price and the markdown percent are
known, multiply the original price by the markdown percent. Subtract the answer from the original price.
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 − (𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 × 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚) = 𝑜𝑜𝑜𝑜 − 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
h. Determining net operating profit before taxes
A measure of a company's profitability is its net operating profit. Net operating profit is the company's
profitability after accounting for the cost of goods sold and operating expenses. Operating profit does not
include expenses such as interest and taxes. See Figure 1. It also doesn't depend on a capital structure or
one-time expenses. So, it really does measure how well an enterprise is doing.

Sales price P50.00

Cost of product (25.00)
Freight cost (10.00)
Gross profit P15.00
Operating expenses (10.00)
Net operating profit before taxes P5.00
Figure 1. Calculating Net Operating Profit before Taxes

Obsolete stock
Any stock keeper who has had to repeatedly move really slow-moving or outright dead stock out of the way or
finds herself hurting for space because obsolete product eats up square foot after square foot knows that these
items "just gotta go."
Why is the dead stock still here? The three (3) reasons most often given as to why the product can't be disposed
of are:
1. It's already paid for.
2. It can be used someday.
3. It can be sold someday.
These explanations seem logical, and the idea of throwing away dead stock may be counterintuitive. However,
there are some very real practical problems with simply hauling it off to the dumpster.
Decision-makers often have difficulty disposing of dead inventory because it will adversely impact the balance
sheet and deplete resources considered valuable for lending purposes.
Anything that appears as an asset on the balance sheet has an accounting value. This value, consisting of an
item's original cost minus depreciation, is called the "book value." It is irrelevant that the item may actually be
worthless to either a customer or as part of a manufacturing process.
If we sell dead inventory that has a monetary value at a deep discount, throw it away, or give it away to a charity,
we will have to immediately write off the book value of those items, which will, of course, have a negative impact
on the financial statements.

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If your organization is sensitive to making extraordinary adjustments to the balance sheet and never or seldom
writes off dead inventory, you may have a difficult time ever convincing any decision-maker to dispose of these
items. The decision-maker will simply not be willing to "take the hit on the books."
Advantages of disposing dead stock
1. Recapture of space
In terms of space utilization, there are some simple mathematical facts to keep in mind:
• Multiplying an item's length by its width tells you the amount of square feet the item occupies.
• Multiplying an item's length by its width by its height tells you the amount of cubic space it is occupying.
If you were to actually figure out the cubic space taken up by dead product, you would gain a powerful
argument in favor of disposing of this inventory. To bolster the argument, you may want to ask your
organization's financial officer how much the company pays per square foot for rent. Multiplying the square
footage being consumed by dead product by the rent per square foot often results in a truly eye-opening
amount. Providing actual numbers to a decision-maker is far more effective than speaking in generalities,
such as "dead stock is taking up a lot of space." Pointing out that obsolete stock is "taking up 4,000 square
feet" or "represents Php100,000 per month in per square foot costs" should help you convince your decision-
maker that "it's gotta go."
2. Efficient utilization of labor and machine resources
Not only does obsolete inventory take up a lot of space, but it can also get in the way of workers. Repeatedly
moving obsolete products out of the way hurts efficient use of both labor and machine time.
Too often, in trying to argue against keeping obsolete stock, stock keepers will state generalities, such as
"it takes us a lot of time to move that stuff around." How long is "a lot of time"? Is it an hour a day, four (4)
hours per week? Without specific numbers, your arguments will sound hollow.
As many business writers have noted, "You cannot control what you do not measure." There are two (2)
things you need to do to get specific time and amounts:
• During each week for one (1) month, every time you or your staff move dead products out of the way,
measure the amount of direct labor that goes into that effort. Remember, if two (2) workers work together
to move the items and work for 15 minutes, that represents 15 minutes times two (2), or 30 minutes of
direct labor.
• At the end of the month, divide the total amount of labor hours by four (4) to determine a weekly average.
To determine the amount of yearly labor involved in moving dead stock, multiply the weekly average
times the number of weeks in a year your company operates.
Once again, obtain base information from your financial officer and multiply the average hourly wage you
pay your workers, including benefits, by the annual labor number. The result will make a rather impressive
argument about how the organization can save thousands of pesos per year by disposing of its dead stock.
3. Reduction of carrying costs
The K Factor represents the number of pennies per inventory peso per year a company spends to house
its inventory. It is generally expressed as a percentage. In other words, a K Factor of 25 percent means that
you are spending 25¢ per inventory peso per year to house your inventory. A P1 dead item that sits on your
shelf for a year would cost you 25¢ that year, 50¢ for the second year, 75¢ for the third year, and so on.
There are two (2) ways of computing the K Factor — a traditional method to add together various expenses
directly related to carrying inventory and a rough rule-of-thumb method.
Since it always costs something to carry inventory, it is obvious that the longer dead stock remains in your
facility, the more it will cost. Two approaches can be used to argue this point effectively:
• Demonstrate the impact of carrying costs on your existing dead stock. This addresses the "We've
already paid for it" argument in favor of retaining dead stock.

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• Demonstrate that if the product remains long enough, even selling it at a profit will not recapture your
original cost. This addresses the "We might need it someday" and "We might sell it someday" arguments
in favor of retaining dead stock.
Methods of disposal
Various approaches to disposing of dead stock exist:

• Sell at net price

• Temporarily raise commissions for salespeople
• Discount the price
• Return to vendor
• Donate it
• Write it off
• Auction
It is important to remember something about convincing decision-makers of anything. Ordinarily, when reports
or other information flow up a chain of command, the level of detail at each level decreases. Generally, each
higher level of management wants to see less and less information to make decisions. You should resist
providing only minimal data in making arguments regarding dead stock. This is a time to let the details do the
talking.
Costs and other important factors (Silver, Pyke, & Thomas, 2016)
1. Cost factors
a. The unit value or unit variable cost, 𝑣𝑣
The unit value (denoted by the symbol v) of an item is expressed in peso per unit. It is simply the price
(including freight) paid to the supplier, plus any cost incurred to make it ready for sale for a merchant.
It can depend, via quantity discounts, on the size of the replenishment. For producers, the unit value of
an item is usually more difficult to determine. However, one thing is certain: seldom the conventional
accounting or "book value" is assigned in most organizations. Ideally, the value of an item should
measure the actual amount of money (variable cost) spent on the SKU to make it available for usage
(either for fulfilling customer demand or for internal usage as a component of some other items).
For example, a small retailer buys ski hats for P1,000 and then hires a high-school student to unpack
them and put them on the shelves. The cost per unit of the student's time is P50 so that the value of v
should be P1,050. A second example is a manufacturer whose cost-accounting system shows that an
item costs P215 per unit to manufacture. Upon further examination, however, it is clear that this item is
particularly difficult to manufacture and that a production supervisor devotes up to 30% of her time
overseeing the process. The true cost of the item should reflect the value of the supervisor's time. At
30% of a P2,000,000 salary, and 25,000 units produced per year, the cost of the item should be
increased by (P2,000,000)(0.30)/(25,000 units) = P24 per unit.
b. The ordering or setup cost, 𝐴𝐴
The symbol A denotes the fixed cost (independent of the replenishment size) associated with a
replenishment. It is called an ordering cost for a merchant, and it includes the cost of order forms,
postage, telephone calls, authorization, typing of orders, receiving, (possibly) inspection, following up
on unexpected situations, and handling of vendor invoices. The production setup cost includes many of
these components and other costs related to interrupted production. For example, we might include a
skilled mechanic's wages who have to adjust the production equipment for this part. Then, once a setup
is completed, there often follows a period when the facility is produced at lower quality or slower speed
while the equipment is fine-tuned and the operator adjusts to the new part. This is normally called the
"learning effect," and the resulting costs are considered part of the setup cost because they result from
a decision to place an order. Finally, notice that during the setup and learning period, opportunity costs
are, in effect, incurred because production time on the equipment is being lost during which some other

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item could be manufactured. Hence, the latter opportunity cost is only incurred if the production facility
in question is being operated at capacity.
c. The costs of insufficient capacity in the short run
These costs could also be called the costs of avoiding stockouts and the costs incurred when stockouts
occur. In the case of a producer, they include the expenses that result from changing over equipment
to run emergency orders and the attendant costs of expediting, rescheduling, split lots, and so forth.
For a merchant, they include emergency shipments or substitution of a less-profitable item. All these
costs can be estimated reasonably well. However, there are also costs, which are much more indefinite,
resulting from not servicing customer demand. Will the customer be willing to wait while the item is
back-ordered, or is the sale lost for good? How much goodwill is lost as a result of the poor service?
Will the customer ever return? Will the customer's colleagues be told of the disservice? Such questions
can, in principle, be answered empirically through an actual study for only a limited number of SKUs.
For most items, the risks and costs inherent in disservice have to remain a matter of educated,
considered opinion, not unlike determining the risks inherent in carrying inventories.
d. System control costs
System control costs are those associated with the operation of the particular decision system selected.
These include the costs of data acquisition, data storage and maintenance, and computation. In
addition, there are less-tangible costs of human interpretation of results, training, alienation of
employees, and so on. Although difficult to quantify, this category of "costs" may be crucial in choosing
one decision system over another.
2. Other key variables
a. Replenishment lead time, 𝐿𝐿
A stockout can only occur during periods when the inventory on hand is "low." When an order should
be placed, our decision will always be based on how low the inventory should be allowed to be depleted
before the order arrives. The idea is to place an order early enough so that the expected number of
units demanded during a replenishment lead time will not often result in a stockout. We define the
replenishment lead time as the time that elapses from the moment it is decided to place an order until
it is physically on the shelf, ready to satisfy customers' demands. The symbol L will be used to denote
the replenishment lead time. It is convenient to think of the lead time as being made up of five distinct
components:
i. Administrative time at the stocking point (order preparation time): the time that elapses from the
moment it is decided to place the order until it is actually transmitted from the stocking point.
ii. Transit time to the supplier: this may be negligible if the order is placed electronically or by
telephone, but the transit time can be several days if a mailing system is used.
iii. Time at the supplier: if L is variable, this time is responsible for most variability. Its duration is
materially influenced by the availability of stock at the supplier when the order arrives.
iv. Transit time back to the stocking point.
v. Time from order receipt until it is available on the shelf: this time is often wrongly neglected. Certain
activities, such as inspection and cataloging, can take a significant amount of time.
b. Production versus nonproduction
Decisions in a production context are inherently more complicated than those in nonproduction
situations. There are capacity constraints at work centers and interdependency of demand among
finished products and their components. The production and inventory planning and control procedures
for a firm should depend on (1) whether production is make-to-stock or make-to-order (which, in turn,
depends on the relationship between customer promise time and production lead time) and (2) whether
purchasing is for known production or anticipated production (a function of the purchasing lead time).
c. Demand pattern

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Different control procedures are appropriate for new, mature, and declining items. The nature of the
item can also influence the demand pattern; for example, the demand for spare parts is likely to be less
predictable than the requirements for components of an internally produced item.
Inventory carrying costs (Jones, 2020)
Inventory carrying costs fall into several categories. They include the following:
1. Storage costs are the costs associated with occupying space in a storeroom, warehouse, or distribution
center. Inventory costs such as insurance for fire, flood, and theft are included in the expense of storing
goods.
2. Theft or inventory shrinkage identifies when more items are recorded entering warehouses than leaving.
3. Obsolescence describes when items in an inventory eventually become out of date.
4. Depreciation or deterioration of inventory as a function of time, not usage.
5. Interest refers to the interest charges for the money invested in inventories. Oftentimes, this represents the
investment into company inventories instead of money that can be invested in other investments.
6. Taxes refer to when inventories are taxed. Traditionally the tax is derived based on the inventory on hand
on a certain date. Most companies make a concentrated effort to have inventory present on that day to be
as low as possible.
7. Carrying costs include inventory tax and costs associated with avoiding or evading the inventory taxes.
a. Consider products such as fresh produce, which may deteriorate in only a few days. The depreciation
portion of a produce company's carrying costs might be as high as 50% per day. Other products
depreciate completely given their expiration dates, including dairy products, drugs, bread, soft drinks,
and camera film. For these products, the depreciation rate can be calculated because expired products
that are unsold must be removed from the shelf.
b. Specialized inventory costs are related to pets and livestock, which have costs related to being watered
and fed. Security costs for high-value items such as computer chips may increase inventory carrying
costs.
c. Inventory carrying charges are expressed as a percentage of the inventory's value, and a widely cited
estimate is that carrying costs approximate 25% per year of a product's value.
Component Breakdown of the 25% Figure
Insurance 0.25
Storage facilities 0.25
Taxes 0.50
Transportation 0.50
Handling costs 2.50
Depreciation 5.00
Interest 6.00
Obsolescence 10.00
Total 25.00%

Opportunity costs are not traditionally included in most carrying costs. Most companies must consider the trade-
off of holding inventory against having inventory to meet the customer demand fluctuations

Stockout costs
Stockout refers to the event that occurs when an item is out of stock when a customer wants to buy the item.
Stockout costs are difficult to determine and oftentimes affect customer satisfaction. The difficulty of determining
the cost lost due to stockouts requires a good understanding of a company's customer behavior. Customer can
have many varied reactions to stockouts. We suggest that the responses can be placed into three (3) categories:
• Future sale
• Lost sale
• Loss of customer.

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Consider a set of 500 customers who experienced stockouts for a given product. The three (3) types of customer
response may suggest of the 500 customers, 50 will return as a future sale, 325 customers may go to another
store, which represents a lost sell, and 125 customers may never return to the company. The percentages
represented by the future and lost sales and customer loss are 10%, 65%, and 25%, respectively. These
percentages can be considered probabilities of the events taking place and can determine the average cost of
a stockout.
Table 1 illustrates the procedure. Each cost is multiplied by the likelihood that it will occur, and the results are
added. A delayed sale has no cost because the customer is brand loyal and purchases the product when it is
again available. The lost sale alternative results in a loss of the profit that would have been made on the
customer's purchase. The lost customer situation is the worst. The customer tries the competitor's product and
prefers it to the product originally requested. The customer is lost, and the cost involved is that of developing a
new, brand-loyal customer. A firm's marketing department usually determines these costs, but we use the
suggested numbers for demonstration purposes.
Alternative Loss Probability Average Cost
1. Brand-loyal customer $0.00 0.10 $0.00
2. Switches and comes back $37.00 0.65 $24.05
3. Lost customer $1,200.00 0.25 $300.00
Average cost of a stockout 1.00 $324.05
Table 1. Determination of the Average Cost of a Stock Out

Safety stocks
Firms usually maintain safety stocks or excess inventory in order to prevent an excessive number of stockouts.
An analysis is required to minimize the amount of safety stock and determine the optimum level of safety stock.
We consider this example to demonstrate the safety-stock analysis. Consider that goods must be ordered from
a wholesaler in multiples of 10. The carrying cost of an additional or marginal 10 units is P60,000. However, by
stocking an additional 10 units of safety stock and maintaining it throughout the year, the firm can prevent 20
stockouts. The average cost of a stockout has already been determined to be P16,000. We derive that saving
20 stockouts saves the firm P320,000 (P16,000× 20). In this case, the savings justify the investment costs.
Next, we consider an alternative that maintains a safety stock throughout the year of 20 units. This adds P60,000
to the costs but prevents 16 additional stockouts from occurring, thereby saving P260,000.
The optimum quantity of safety stock is 60 units. With this quantity, the carrying cost of 10 additional units is
P60,000, but P64,810 is saved. If the safety stocks are increased from 60 to 70 units, the additional carrying
cost is again P60,000, while the savings are only P48,607.50. We conclude that the firm would be more
profitable by permitting three stockouts to occur each year. Note that these concerns determine the level of
customer service.
Safety stocks indicate that a firm will attempt to meet customer demand for out-of-stock items. Many firms
choose not to maintain safety stock due to the high carrying cost for inventory. Some mass merchandisers do
not replace many items, given their profit margins and the fact that customers are not loyal to that firm. In these
situations, customer behavior is to buy a complete set of items and/or fixtures needed to complete a project.
They understand that the merchandiser may not have that product in the future. This is evidenced in popular
"closeout" stores such as Big Lots and Hobby Lobby, in which the firm buys large quantities of a product and
sells it at a discount. When the product is sold out, there is no expectation of that product appearing at the store
in the future.
Economic Order Quantity
Safety stock level is the minimum inventory a firm tries to keep on hand. Commonly, determining the inventory
level, how they should be reordered, and how much should be ordered each time are determined by the
economic order quantity (EOQ). We will provide a brief overview of EOQ. Further reading is available in
academic texts that discuss operation and production planning.

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The typical inventory order size problem can be dealt with by calculating the proper order size based on
minimizing the total of two costs: (1) the costs of carrying the inventory, which is in direct proportion to the size
of the order that will arrive; and (2) the costs of ordering, which mainly involve the paperwork associated with
handling each order, irrespective of its size. Consider if there were no inventory carrying costs, customers would
hold inventory and avoid reordering. If there were no costs associated with ordering, one would place orders
continually and maintain no inventory at all, aside from safety stocks.
Mathematically, the EOQ is determined using this formula:

2𝐴𝐴𝐴𝐴
𝐸𝐸𝐸𝐸𝐸𝐸 = �
𝐼𝐼

Where:
EOQ is the most economic order size
𝐴𝐴 is the annual usage
𝐵𝐵 are the company costs per order of placing the order
is the carrying costs of the inventory (expressed as
𝐼𝐼
an annual percentage)
Example:
If P50,000 of an item is used each year if the order costs are P1,250 per the order submitted, and if carrying
costs are 20%, what is the EOQ?

2 × 50,000 × 1250
𝐸𝐸𝐸𝐸𝐸𝐸 = � = �6,250,000 = 𝑃𝑃25,000 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
0.20

Because of the assumption of even outward flow of goods, inventory carrying costs are applied to one half the
order size that would be the average inventory on hand.
EOQs, once calculated, may not be the same as the lot sizes that the product is bought and sold at a company.
EOQs can also be calculated in terms of the number of units that should be ordered. The formula is

2(𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑢𝑢𝑢𝑢𝑢𝑢 𝑖𝑖𝑖𝑖 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢)(𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜)
𝐸𝐸𝐸𝐸𝐸𝐸 = �
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦

References
Jones, E. C. (2020). Supply Chain Engineering and Logistics Handbook: Inventory and Production Control.
Boca Raton: CRC Press.
Muller, M. (2011). Essentials of Inventory Management (2nd ed.). New York: AMACOM.
Silver, E. A., Pyke, D. F., & Thomas, D. J. (2016). Inventory and Production Management in Supply Chains (4th
ed.). Boca Raton: CRC Press.

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