Accounting Business Reporting for Decision Making

540 Accounting: Business Reporting for Decision Making

wholesale prices change, the value of inventory changes. A drop in wholesale prices represents a cost, if

selling prices must be immediately dropped due to competitive pressure. Theft or shoplifting occurs in

practically all retail situations and, indeed, in almost all entities. Anecdotally, employees are responsible

for a significant proportion of inventory thefts.

Finally, there are the financing costs. Funds tied up in inventory could be invested elsewhere. If the best

alternative investment yields 5 per cent per annum, then the financing cost of holding inventory is 5 per cent

per annum or $50 per $1000 of inventory. In practice, the best alternative investment is probably an invest-

ment elsewhere in the entity, but it may be an investment externally on the short-term money market.

In making decisions about the levels of inventory to be held, the manager must trade off all these costs

against the benefits. Normally, holding inventory is an incremental thing. As entities become established,

turnover improves, cash flow improves and inventory tends to build up as managers see the need to hold

more of a particular product or another.

Inventory management techniques

Two techniques are commonly used to manage inventory levels:

• maintaining a minimum level of inventory


• managing the average turnover period.

Many managers maintain either an explicit or implicit minimum level of inventory. The level is

explicit when documented in inventory-management records, or implicit when the requisite level is an

idea or ‘feeling’ on the part of the manager.

The second technique involves managing the average inventory turnover period (ITP):

Inventory turnover =

Average inventory

× 365 = x days

Cost of sales

The value calculated with this equation is in units of days. Hence, from their experience managers can

decide on a number of days for inventory to be held as optimum for the business. For example, the data

in figure 13.2 relates to JB Hi-Fi Ltd for the period 2012 to 2015.

Item 2012 2013 2014 2015

Inventory 428 426 458 478

Average inventory N/A 427 442 468

Cost of sales N/A 2 596 2 727 2 853

Number of times (per year) N/A 6.07 6.17 6.10

Inventory turnover (days) N/A 60 59 59

FIGURE 13.2 JB Hi-Fi Ltd inventory and cost data ($ million)

DECISION-MAKING EXAMPLE

Controlling inventory turnover levels

SITUATION Using the data from the figure above, discuss JB Hi-Fi Ltd’s inventory management.

If JB Hi-Fi Ltd wanted to reduce the turnover to an average of 55 days, what strategies could be

employed?

DECISION It is clear from the figure above that the management of JB Hi-Fi Ltd has instituted a

policy to keep strict control of inventory levels. The average period it takes to sell the whole of the

inventory purchased by the entity varied from 59 days to 60 days during the period 2012 to 2015.

Reducing the turnover in days is conducive to increasing profits as funds are not tied up in inventory