Accounting Business Reporting for Decision Making

CHAPTER 13 Financing the business 539

ensure that sales can be effected immediately. JB Hi-Fi Ltd keeps over 78 per cent of its current assets in

the form of inventories. Entities selling services, on the other hand, normally have insignificant values of

inventories, as inventories are limited to such items as office supplies and vehicle maintenance supplies. The

Qantas Group, for example, has about 6.3 per cent of its current assets in the form of inventories.

Types of inventories

The types of inventories include:

• raw materials


• work in progress


• finished goods.

The purpose of holding these inventory types is essentially the same. Raw materials are held by all

types of manufacturers to ensure that production can be carried out without delay, should there be inter-

ruption in normal supply. Work in progress (WIP) consists of goods (or services) where some of the

required work operations have been completed and some have not. Normally, the more complex the

transformation process, the more likely an entity will have WIP inventories. Finished goods are held as a

buffer between production and sales. Inventories are allowed to increase when sales fall, to avoid cutting

staff and production. Conversely, inventories fall when unexpected increases in sales are not immedi-

ately reflected in increased production, which may mean the payment of overtime costs.

Benefits and costs of holding inventories

Managing inventories is an art, although there are techniques managers can use to transform much of the

role into a science. Suppose you manage a convenience store on the Melbourne–Albury truck route and

you sell a wide variety of products, including fuel, oil, vehicle spare parts, fast food, ice-cream, sweets,

drinks and newspapers. How much of each type of these goods should you hold? What are the benefits

and what are the costs of holding the inventory?

The benefits of holding inventory are:

• sales are made and profits gained


• cross-sales are made and profits increased (truck drivers stop for fuel, but also buy meals, drinks, ice-

cream and newspapers)

• goodwill is built up (‘that place always has what you want’) and no-inventory costs are avoided (‘that

place never has what you want, let’s go elsewhere’).

However, there are costs that must be balanced against the benefits. The costs of holding inventory include:

• ordering costs


• holding costs.

Ordering costs include the time and cash costs involved in placing orders, freight and quantity dis-

counts forgone, if only small orders are made. In general, the larger the order, the smaller and less sig-

nificant will be the sum of these costs. However, making only large orders may not be possible because

of the nature of the goods. Large orders also increase holding costs.

Holding costs include:

• storage and display costs


• insurance costs


• deterioration and obsolescence


• wholesale price changes


• theft


• financing costs.

Storage costs can be high for some types of goods. The different sugars held by the listed company

Sugar Australia, for example, must all be held in specially built silos, which must be weatherproof,

vermin-proof and, possibly, climate controlled. Inventory should be insured unless the manager believes

the entity can afford to lose the lot or that the risk is so small that losing the lot is hardly possible. When