Methodology of Calculating
Inventory
Carrying
Costs
ASSOCIATES
MANAGEMENT CONSULTANTS
20 NASSAU STREET, SUITE 244
PRINCETON, NEW JERSEY 08542
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Contents
!
The Truth About Carrying Inventory
!
What Makes Up Inventory Carrying Costs?
!
Inventory Carrying Cost Summary
!
Inventory Carrying Costs Studies
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The Truth About Carrying Inventory
Studies of industries about inventory carrying costs reveal the
following . . . .
!
Over 65% of most companies do not compute inventory carrying costs,
they use rough estimates
!
Leading logistics experts place the cost of carrying inventory between
18% per year and 75% per year depending on the type of products and
business
!
The standard “rule of thumb” for inventory carrying cost is 25% of
inventory value on hand
!
The cost of capital is the leading factor in determining the percentage
of carrying cost
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What Makes Up Inventory Carrying Costs?
Inventory carrying costs are made up of the following . . . .
Inventory
Carrying
Costs
Capital
Costs
Inventory
Service Costs
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Storage
Space Costs
Inventory
Risk Costs
What Makes Up Inventory Carrying Costs?
Capital costs include the investment in inventory . . . .
Capital
Costs
Inventory
Investment
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5
What Makes Up Inventory Carrying Costs?
Inventory service costs include insurance, physical handling,
and taxes . . . .
Inventory
Service
Costs
Insurance
Physical
Handling
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Taxes
What Makes Up Inventory Carrying Costs?
Storage space costs include public, plant, rented, and
company owned warehouses . . . .
Storage
Space
Costs
Plant
Warehouses
Public
Warehouses
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Rented
Warehouses
Company
Owned
Warehouses
What Makes Up Inventory Carrying Costs?
Inventory risk costs are made up of obsolescence, damage,
shrinkage, and relocation costs. . . .
Inventory
Risk Costs
Obsolescence
Shrinkage
Damage
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Relocation
Costs
Inventory Carrying Costs In Summary
Total inventory carrying costs can be estimated at . . . .
!
Cost of Money
6% - 12%
!
Taxes
2% - 6%
!
Insurance
1% - 3%
!
Warehouse Expenses
2% - 5%
!
Physical Handling
2% - 5%
!
Clerical & Inventory Control
3% - 6%
!
Obsolescence
6% - 12%
!
Deterioration & Pilferage
3% - 6%
Total
25% - 55%
Richardson, Helen: Transportation & Distribution, “Control Your Costs then Cut Them” December, 1995
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Inventory Carrying Costs In Summary
Total inventory carrying costs can be broken down by . . . .
Warehouse
Expenses 2-5%
Insurance 1-3%
Taxes 2-6%
Physical Handling
2-5%
Clerical &
Inventory Control
3-6%
Obsolescence
6-12%
Cost of Money
6-12%
Deterioration &
Pilferage 3-6%
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Inventory Carrying Costs Studies
Inventory Management Perspective . . . .
! CLM Conference attendees identified the management of inventory as
the top priority in the next several years. The conference referred to
Logistics, as inventory in motion.
! Inventory is money and many companies assess an inventory carrying
cost of 2% per month.
Inventory Reduction Report, December 1994
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Inventory Carrying Costs Studies
Author
Publication
Textbook inventory carrying costs
are suspect. Inventory carrying
costs should not always be based
on industry averages. Inventory
carrying costs should be
calculated by business. That
being said the following estimates
of inventory carrying costs from
Strategic Logistics Management,
L.P. Alford & John R.
Bangs (eds.)
George W. Aljian
Dean S. Ammer
Donald J. Bowersox,
David J. Closs and
Omar K. Helferich
Joseph L. Cavinato
J.J. Coyle and E. J.
Bardi
Gordon T. Crook
Thomas W. Hall
2nd edition, 1987,James R. Stock
and Douglas M. Lambert, Irwin,
Homewood, Illinois, can be used
as rules of thumb only:
J. L. Heskett, N.A.
Glaskowsky, Jr., and
R. M. Ivie
James C. Johnson and
Donald F. Wood
Production Handbook, (New York: Ronald Press,
1955) p. 397.
Purchasing Handbook, (New, York: McGraw-Hill,
1958), pp. 9-29.
Materials Management, (Homewood, Ill.: Richard
D. Irwin, 1962), p. 137.
Logistics Management, 3rd ed., (New York:
Macmillan, 1986), pp. 189-97.
Purchasing and Materials Management, (St. Paul,
MN.: West Publishing, 1984), p. 284.
The Management of Business Logistics, 3rd ed.
(St. Paul, MN.: West Publishing, 1984), p. 144.
“Inventory Management Takes Teamwork,”
Purchasing, March 26 1962, p. 70.
“Inventory Carrying Costs: A Case Study,”
Management Accounting, January 1974, pp. 37-39
Business Logistics, 2nd ed. (New York: Ronald
Press, 1973), p. 20.
Contemporary Physical Distribution and
Logistics, 3rd ed. (Tulsa, OK.: PenWell
Publishing, 1986), p. 253.
John F. Magee
“The Logistics of Distribution,” Harvard Business
Review, July-August 1960, p. 99.
Benjamin Melnitsky
Management of Industrial Inventory (ConoverMast Publication, 1951), p. 11.
Thomson M. Whitlin
The Theory of Inventory Management, (Princeton,
NJ.: Princeton University Press, 1957), p. 220.
* Not specified, although 20 percent was used in examples.
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Estimate of
Carrying
Costs as a
% of
Inventory
Value
25%
12-34%
20-25%
20%*
25%
25-30%
25%
20.4%
28.7%
25%
20-35%
25%
25%
ASSOCIATES
MANAGEMENT CONSULTANTS
20 Nassau Street, Suite 244
PO Box 7345
Princeton, New Jersey 08543-7345
Phone: 609-275-4444
Fax: 609-275-5651
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www: http://www.remassoc.com
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CHAPTER 17
Understanding
Accounting
and
Financial
Information
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
LEARNING OBJECTIVES
1. Demonstrate the role that accounting and financial
information play for a business and its stakeholders.
2. Identify the different disciplines within the accounting
profession.
3. List the steps in the accounting cycle, distinguish
between accounting and bookkeeping, and explain
how computers are used in accounting.
4. Explain how the major financial statements differ.
5. Demonstrate the application of ratio analysis in
reporting financial information.
17-2
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WHAT’S ACCOUNTING?
LO 17-1
• Accounting -- Recording, classifying, summarizing
and interpreting of financial events and transactions
in an organization to provide interested parties
needed financial information.
The Accounting System
17-3
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MANAGERIAL ACCOUNTING
LO 17-2
• Managerial Accounting -- Provides information
and analysis to managers inside the organization to
assist them in decision making.
• Managerial accounting is involved with:
- Costs of production
- Costs of marketing
- Preparation and control of budgets
- Minimizing tax liabilities
17-4
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FINANCIAL ACCOUNTING
LO 17-2
• Financial Accounting -- Financial information and
analyses are generated for people primarily outside
the organization. Outside users are interested in
these questions:
- Is the organization profitable?
- Is it able to pay its bills?
- How much debt does it owe?
• Annual Report -- A yearly statement of the financial
condition, progress, and expectations of the firm.
17-5
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PUBLIC vs. PRIVATE
ACCOUNTANTS
LO 17-2
• Private Accountants -- Work in a single firm,
government agency, or nonprofit organization.
• Public Accountants -- Provide accounting services
to individuals or businesses.
• Certified Public Accountants (CPAs) -Accountants who have passed a series of
examinations established by the American Institute of
Certified Public Accountants (AICPA) and met a
state’s requirements for education and experience.
17-6
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AUDITING CHECKS ACCURACY
LO 17-2
• Auditing -- Reviewing and evaluating the information
used to prepare a company’s financial statements.
• Independent Audit -- An evaluation and unbiased
opinion about the accuracy of a company’s financial
statements.
• Certified Internal Auditors (CIAs) -- Accountants
who have a bachelor’s degree and two years of
experience in internal auditing and pass an exam
administered by the Institute of Internal Auditors.
17-7
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SPECIALIZED ACCOUNTANTS
LO 17-2
• Tax Accountants -- Accountants trained in tax law
and are responsible for preparing tax returns or
developing tax strategies.
• Government and Not-forProfit Accounting -Support for organizations
whose purpose is not
generating a profit, but
serving others according to a
duly approved budget.
17-8
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The ACCOUNTING CYCLE
LO 17-3
• Accounting Cycle -- A six-step procedure that
results in the preparation and analysis of the major
financial statements.
17-9
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BOOKKEEPER’S ROLE
and TOOLS
LO 17-3
• Bookkeeping -- The recording of business
transactions. Bookkeepers divide a firm’s transactions
into meaningful categories and post them into a record
book or computer program called a journal.
• Double-Entry Bookkeeping -- Bookkeepers record
all transactions in two places so they can check one
list of transactions against the other for accuracy.
• Ledger -- A specialized accounting book or program
where all information is in one place.
• Trial Balance -- A summary of all the information in
the account ledgers.
17-10
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FINANCIAL STATEMENTS
LO 17-3
• Financial Statement -- A summary of all the
financial transactions that have occurred over a
particular period.
• Key financial statements of business are:
- Balance Sheet -- The financial statement that reports
a firm’s financial condition at a specific time.
- Income statement
- Statement of cash flows
17-11
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The FUNDAMENTAL
ACCOUNTING EQUATION
LO 17-4
• Assets -- Economic resources owned by a firm.
Items can be tangible or intangible.
• Owners’ Equity -- The amount of the business
that belongs to the owners minus any liabilities of
the owners.
• Fundamental Accounting Equation -- The
basis for the balance sheet.
• The equation must always be balanced and includes
the formula:
Assets = Liabilities + Owners Equity
17-12
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CLASSIFYING ASSETS
and LIABILITIES
ASSETS
•
Current Assets -- Items that
can or will be converted to
cash within one year.
•
Fixed Assets -- Long-term
assets that are relatively
permanent such as land,
buildings, or equipment.
•
Intangible Assets -- Longterm assets that have no
physical form but do have
value such as patents,
trademarks, and goodwill.
LO 17-4
LIABILITIES
• Liabilities -- What the business
owes to others (debts).
• Accounts Payable -- Current
liabilities a firm owes for
merchandise or services
purchased on credit.
• Notes Payable -- Short or longterm liabilities a business
promises to pay by a certain
date.
• Bonds Payable -- Long-term
liabilities that the firm must pay
back
17-13
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The INCOME STATEMENT
• Income Statement -The financial statement
that shows a firm’s
bottom line - that is, its
profit after costs,
expenses, and taxes.
LO 17-4
Formula for income statement
Revenue
-Cost of Goods Sold
= Gross Profit
-Operating Expenses
= Net Income before Taxes
• Net Income/Net Loss - The revenue left over
after costs and expenses.
-Taxes
= Net Income or Net Loss
17-14
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ACCOUNTS of the INCOME
STATEMENT
LO 17-4
• Revenue is the monetary value a firm received for
goods sold, services rendered or other payments.
• Cost of Goods Sold (or Manufactured) -Measures the cost of merchandise the firm sells or
the cost of raw materials and supplies it used in
producing items for resale.
• Gross Profit (or Gross Margin) -- How much a
firm earned by buying (or making) and selling
merchandise.
17-15
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ACCOUNTS of the INCOME
STATEMENT
LO 17-4
• Operating Expenses – Cost
involved in operating a business,
such as rent, salaries and
supplies.
• Depreciation -- The systematic
write-off of the cost of a tangible
asset over its estimated useful
life.
17-16
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The STATEMENT of CASH FLOWS
LO 17-4
• Statement of Cash Flows -- Reports cash
receipts and cash disbursements related to the
three major activities of a firm:
1. Operations
2. Investments
3. Financing
• Cash Flow -- The difference between cash
coming in and cash going out of a business.
• Managing cash flow is a key consideration of a
business and can be particularly challenging for small
and seasonal businesses.
17-17
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USING FINANCIAL RATIOS
LO 17-5
• Ratio Analysis -- The assessment of a firm’s
financial condition using calculations and financial
ratios developed from the firm’s financial statements.
• Key ratios include:
- Liquidity ratios
- Leverage ratios
- Performance ratios
- Activity ratios
17-18
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COMMONLY USED
LIQUIDITY RATIOS
LO 17-5
• Liquidity ratios measure a firm’s ability to turn
assets into cash to pay its short-term debts.
• Two key ratios are:
- Current ratio
- Acid-test ratio
• This information is found on the firm’s balance
sheet.
17-19
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LEVERAGE RATIOS
LO 17-5
• Leverage ratios measure the degree to which a
firm relies on borrowed funds in its operations.
• Key ratios include:
- Debt to Owner’s Equity Ratio
• This information is found on the firm’s balance
sheet.
17-20
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PROFITABILITY RATIOS
LO 17-5
• Profitability ratios measure how effectively a
firm’s managers are using the firm’s various
resources to achieve profits.
• Key ratios include:
- Basic earnings per share
- Return on sales
- Return on equity
• This information is found on the firm’s balance
sheet and income statement.
17-21
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ACTIVITY RATIOS
LO 17-5
• Activity ratios measure how effectively
management is turning over inventory.
• Key ratios include:
- Inventory turnover ratio
• This information is found
on the firm’s balance
sheet and income
statement.
17-22
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Ratios: What Do They
Mean
Butler Lumber
Acid Ratio Test
Measures the ability of a firm to pay
its short term debt. The calculation
does not include inventory.
Current Ratio
The ability of a firm to pay its short term
debt. It includes its inventory in the
formula.
Return on Sales/Operating Income
How efficiently a company runs its
business to generate profits. What % of
company revenues are converted into
company profits. (Before Taxes and
Interest)
Inventory Turnover Rate
The number of times a company’s
inventory is sold and replaced over
time.
The number of days it takes to sell its existing
inventory
NET Profit Margin
How much of a company’s revenue
are kept as profit.
Return on Equity
How much profit a company is
generating on with the money
shareholders has invested
.
Debt to Owners Equity
How much debt there is for every
dollar of equity there in the
company.
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