Inventory Management & Costing Techniques: FIFO, LIFO, WAC, ABC, EOQ, JIT

TAKEAWAYS:

• Inventory valuation determines profit and tax liabilities: FIFO assumes first-in-first-out, LIFO last-in-first-out, and WAC averages all units.
• Costing techniques match costs to products: job costing for custom orders (e.g., wedding cakes), process costing for mass production (e.g., rice milling).
• ABC analysis prioritizes inventory by value: 20% of items often account for 80% of costs (critical for hotel linen or restaurant ingredients).
• EOQ balances ordering costs and holding costs to minimize total inventory expenses (used by Daraz or Pathao for stocking spare parts).
• JIT reduces waste by ordering only what’s needed when needed (seen in Kathmandu’s fresh produce markets or hotel kitchens).
• Perpetual vs. periodic inventory systems affect accuracy and decision-making: perpetual updates continuously, while periodic relies on physical counts.

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1. Inventory Management: Definitions and Objectives

Inventory is the stock of goods held by a business for production or resale. Effective inventory management ensures:

• Optimal stock levels (avoiding overstocking or stockouts).
• Cost control (reducing holding and ordering costs).
• Customer satisfaction (timely supply of products/services).
• Profitability (minimizing losses from obsolete or damaged stock).

Key Terms:

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2. Inventory Valuation Methods

Inventory valuation affects profit, tax, and financial statements. Three primary methods are used:

A. First-In-First-Out (FIFO)

Definition: Assumes the first units purchased are the first sold. Remaining inventory is valued at the most recent purchase prices.

How It Works:

1. When goods are sold, the oldest inventory is allocated to cost of goods sold (COGS).
2. Ending inventory reflects the most recent purchases (closer to current market prices).

Example (Nepali Context): A Kathmandu-based hotel buys rice in three batches:

• Batch 1: 100 kg @ Rs 150/kg (Jan 2024)
• Batch 2: 100 kg @ Rs 180/kg (Mar 2024)
• Batch 3: 100 kg @ Rs 200/kg (May 2024)

In June 2024, the hotel sells 150 kg of rice. Under FIFO:

• COGS: (100 kg × Rs 150) + (50 kg × Rs 180) = Rs 24,000
• Ending Inventory: 150 kg × Rs 200 = Rs 30,000

Visual: FIFO Flow

```mermaid
flowchart LR
    A["Batch 1\n100 kg @ Rs 150"] -->|Sold First| B["COGS\n100 kg"]
    C["Batch 2\n100 kg @ Rs 180"] -->|Sold Next| D["COGS\n50 kg"]
    E["Batch 3\n100 kg @ Rs 200"] -->|Remaining| F["Ending Inventory\n150 kg"]

Advantages:

• Matches physical flow of goods (e.g., perishables like hotel fresh produce).
• Ending inventory reflects current replacement costs (useful for financial reporting).

Disadvantages:

• Overstates COGS in inflationary periods (higher profit reported).
• Complex tracking required for multiple batches.

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B. Last-In-First-Out (LIFO)

Definition: Assumes the most recently purchased units are sold first. Ending inventory is valued at the oldest purchase prices.

How It Works:

1. When goods are sold, the newest inventory is allocated to COGS.
2. Ending inventory reflects the oldest purchases (may be obsolete or outdated).

Using the Same Example:

• COGS: (100 kg × Rs 200) + (50 kg × Rs 180) = Rs 29,000
• Ending Inventory: 150 kg × Rs 150 = Rs 22,500

Visual: LIFO Flow

```mermaid
flowchart LR
    A["Batch 3\n100 kg @ Rs 200"] -->|Sold First| B["COGS\n100 kg"]
    C["Batch 2\n100 kg @ Rs 180"] -->|Sold Next| D["COGS\n50 kg"]
    E["Batch 1\n100 kg @ Rs 150"] -->|Remaining| F["Ending Inventory\n150 kg"]

Advantages:

• Reduces taxable income in inflationary periods (lower profit reported).
• Matches tax regulations in some countries (e.g., USA).

Disadvantages:

• Does not reflect physical flow (risk of obsolete inventory).
• Understates COGS in deflationary periods (higher profit reported).

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C. Weighted Average Cost (WAC)

Definition: Allocates the average cost per unit to COGS and ending inventory. The average is recalculated periodically (e.g., monthly).

How It Works:

1. Calculate the total cost of inventory ÷ total units.
2. Apply the average to COGS and ending inventory.

Using the Same Example (Periodic Average):

• Total Cost: (100 × 150) + (100 × 180) + (100 × 200) = Rs 63,000
• Total Units: 300 kg
• Average Cost: Rs 63,000 ÷ 300 = Rs 210/kg
• COGS (150 kg): 150 × Rs 210 = Rs 31,500
• Ending Inventory (150 kg): 150 × Rs 210 = Rs 31,500

Visual: WAC Calculation

```mermaid
flowchart TD
    A["Total Cost: Rs 63,000"] --> B["Total Units: 300 kg"]
    B --> C["Average Cost: Rs 210/kg (63,000 ÷ 300)"]
    C --> D["COGS: 150 kg × Rs 210 = Rs 31,500"]
    C --> E["Ending Inventory: 150 kg × Rs 210 = Rs 31,500"]

Advantages:

• Simpler to implement than FIFO/LIFO.
• Smooths out price fluctuations in financial statements.

Disadvantages:

• Does not reflect actual physical flow.
• Less accurate for highly volatile prices.

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3. Comparison of Inventory Valuation Methods

Real-World Example:

• Nepal Food Corporation (NFC) uses FIFO for rice distribution to match the physical flow of grains.
• Daraz (Nepal’s Amazon) uses WAC for its vast inventory to simplify cost tracking.

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4. Costing Techniques

Costing techniques assign costs to products, services, or departments. Four key methods:

A. Job Costing

Definition: Used when custom or unique products are produced (e.g., wedding cakes, hotel event setups).

Steps:

1. Identify the job (e.g., a 50-person banquet at a Kathmandu hotel).
2. Allocate direct materials (e.g., Rs 20,000 for food).
3. Allocate direct labor (e.g., 10 chefs × Rs 1,000/day = Rs 10,000).
4. Allocate overheads (e.g., Rs 5,000 for rent, utilities).
5. Calculate total cost and mark up for profit.

Example: A Lumbini hotel hosts a wedding reception:

• Direct Materials: Rs 50,000 (food, decor)
• Direct Labor: Rs 20,000 (staff for 2 days)
• Overheads: Rs 10,000 (rent, cleaning)
• Total Cost: Rs 80,000
• Profit Markup (50%): Rs 40,000
• Selling Price: Rs 120,000

Visual: Job Costing Breakdown

```figure
{"type":"pie","labels":["Direct Materials","Direct Labor","Overheads","Profit"],"values":[50,20,10,20],"caption":"Job Costing Breakdown for Wedding Reception (Rs 100,000 Total)"}

When to Use:

• Hotels (event catering, room service).
• Restaurants (custom menus for corporate clients).
• Manufacturing (e.g., custom furniture orders).

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B. Batch Costing

Definition: Used when similar products are produced in batches (e.g., a bakery making 50 identical cakes for an order).

Steps:

1. Group identical items into a batch.
2. Allocate costs per batch (not per unit).
3. Divide total batch cost by number of units to get cost per unit.

Example: A Pokhara bakery receives an order for 100 identical pastries:

• Materials: Rs 5,000
• Labor: Rs 3,000
• Overheads: Rs 2,000
• Total Cost per Batch: Rs 10,000
• Cost per Pastry: Rs 10,000 ÷ 100 = Rs 100

Visual: Batch Costing Flow

```mermaid
flowchart LR
    A["Batch Order\n100 Pastries"] --> B["Materials\nRs 5,000"]
    A --> C["Labor\nRs 3,000"]
    A --> D["Overheads\nRs 2,000"]
    B --> E["Total Cost\nRs 10,000"]
    C --> E
    D --> E
    E --> F["Cost per Unit\nRs 100"]

When to Use:

• Bakeries (custom cake orders).
• Printing presses (bulk brochures for hotels).
• Pharmaceuticals (batch production of medicines).

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C. Process Costing

Definition: Used for mass production of identical units (e.g., rice milling, bottled drinks).

Steps:

1. Track costs per process (e.g., cleaning, milling, packaging).
2. Allocate costs to units produced in each process.
3. Sum costs across all processes to get total cost per unit.

Example: A rice mill in Chitwan processes 10,000 kg of rice:

Visual: Process Costing Table

| Process          | Cost (Rs) | Units (kg) | Cost per kg (Rs) |
|------------------|-----------|------------|------------------|
| Cleaning         | 50,000    | 10,000     | 5                |
| Milling          | 100,000   | 10,000     | 10               |
| Packaging        | 30,000    | 10,000     | 3                |
| **Total**        | **180,000** | **10,000** | **18**           |

When to Use:

• Food processing (rice, oil, sugar).
• Textile industries (yarn spinning, fabric weaving).
• Chemical manufacturing (soap, detergents).

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D. Operation Costing

Definition: A hybrid of job and process costing used when standardized products have minor customizations (e.g., hotel room service with optional add-ons).

Steps:

1. Identify standard costs for the base product.
2. Add costs for customizations (e.g., extra pillows, room service items).
3. Calculate total cost per unit.

Example: A Kathmandu hotel offers standard and premium room service:

• Base Cost (Standard Meal): Rs 800
• Customization (Extra Dessert): Rs 200
• Total Cost (Premium Meal): Rs 1,000

Visual: Operation Costing

```figure
{"type":"t-account","title":"Operation Costing for Premium Meal","dr":[["To Base Cost",800],["To Customization",200]],"cr":[],"balance":true}

When to Use:

• Hotels (room service with optional items).
• Fast food chains (base burger + toppings).
• Automobile manufacturing (base car + optional features).

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5. ABC Analysis (Always-Better-Customer)

Definition: A tool to prioritize inventory based on usage value (80% of value comes from 20% of items).

Steps:

1. Calculate annual usage value for each item (Quantity × Cost).
2. Rank items by value (highest to lowest).
3. Categorize into:
   • A (20% items, 80% value) – Critical items (e.g., hotel linen, restaurant spices).
   • B (30% items, 15% value) – Moderate importance (e.g., toiletries, basic utensils).
   • C (50% items, 5% value) – Low value (e.g., disposable cups, napkins).

Example (Hotel Inventory):

Visual: ABC Analysis Pie Chart

```figure
{"type":"pie","labels":["A Items (80%)","B Items (15%)","C Items (5%)"],"values":[80,15,5],"caption":"ABC Analysis for Hotel Inventory (Value-Based Classification)"}

Applications:

• Hotels: Focus on linen, food ingredients, and cleaning supplies.
• Restaurants: Prioritize spices, meat, and dairy.
• Retail Stores: Track high-value electronics or branded goods.

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6. Economic Order Quantity (EOQ)

Definition: Determines the optimal order quantity that minimizes total inventory costs (ordering + holding costs).

Formula: [ EOQ = \sqrt{\frac{2DS}{H}} ] Where:

• (D) = Annual demand (units)
• (S) = Ordering cost per order (Rs)
• (H) = Holding cost per unit per year (Rs)

Example (Hotel Supplies): A Pokhara hotel orders toilet soap:

• Annual Demand (D): 1,000 units
• Ordering Cost (S): Rs 500 per order
• Holding Cost (H): Rs 10 per unit per year

[ EOQ = \sqrt{\frac{2 \times 1,000 \times 500}{10}} = \sqrt{100,000} = 316 \text{ units} ]

Visual: EOQ Graph

```mermaid
graph LR
    A["Total Cost"] --> B["Ordering Cost\n(Decreases with larger orders)"]
    A --> C["Holding Cost\n(Increases with larger orders)"]
    D["Optimal Order Quantity (EOQ)"] --> E["Minimum Total Cost"]

Real-World Use:

• Daraz uses EOQ to optimize spare parts inventory.
• Pathao drivers (who restock food items) could use EOQ for snack supplies.

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7. Just-In-Time (JIT) Inventory

Definition: A system where inventory arrives exactly when needed for production or sale, eliminating holding costs.

Key Principles:

• Zero inventory waste.
• Suppliers deliver frequently in small batches.
• High reliance on supplier trust and quality.

Example (Hotel Kitchen): A Thamel restaurant orders:

• Vegetables: Daily deliveries (no storage needed).
• Meat: Twice-daily deliveries (refrigerated storage only).
• Bakery Items: Morning deliveries (same-day use).

Advantages:

• Reduces holding costs (no storage space needed).
• Minimizes obsolete stock (e.g., perishable items).
• Improves cash flow (less capital tied in inventory).

Disadvantages:

• High dependency on suppliers.
• Risk of stockouts (delays in delivery).
• Requires precise demand forecasting.

Visual: JIT vs. Traditional Inventory

```figure
{"type":"timeline","events":[{"date":"Traditional Inventory","label":"Bulk Orders\n• High Holding Costs\n• Stockouts Risk\n• Buffer Stock"},{"date":"JIT Inventory","label":"Small Frequent Orders\n• Low Holding Costs\n• Supplier Dependency\n• Just-in-Time Delivery"}],"caption":"Traditional vs. Just-In-Time Inventory Systems"}

Real-World Use:

• Toyota Production System (automotive industry).
• Kathmandu’s fresh produce markets (daily deliveries).
• Hotel kitchens (just-in-time food ordering).

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8. Perpetual vs. Periodic Inventory Systems

Example (Hotel Linen):

• Perpetual: Barcode system tracks every towel used/replaced (real-time).
• Periodic: Count towels once a month (inefficient for high turnover).

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In the Real World

1. eSewa & Khalti (Digital Payments)

   • Inventory Management: These apps track transaction volumes (like inventory levels) to ensure liquidity (cash reserves) matches demand. If too many users withdraw funds (like "selling inventory"), the system must replenish liquidity (like ordering more stock) to avoid failures.
   • Costing Technique: Uses process costing to allocate costs across millions of transactions (e.g., server costs, security, customer support).

2. Daraz (E-Commerce)

   • ABC Analysis: Daraz prioritizes high-value items (e.g., smartphones, laptops) with tight stock controls, while low-value items (e.g., stationery) have looser inventory rules.
   • EOQ: Daraz’s warehouse management uses EOQ to decide how many units of a product to order from suppliers (balancing ordering costs vs. storage costs).
   • JIT: For perishable items (e.g., fresh groceries), Daraz partners with suppliers for daily deliveries to avoid waste.

3. Nepal Tourism Board (Hotel Industry)

   • FIFO for Perishables: Hotels like Himalayan Java use FIFO for food inventory (e.g., fresh fruits, dairy) to ensure oldest stock is used first.
   • Job Costing for Events: Hotels charge custom event costs using job costing (e.g., a wedding banquet’s cost includes catering, decor, staff).
   • ABC Analysis for Housekeeping: High-value items like linen and towels are tracked closely, while low-cost items (e.g., soap) are ordered in bulk.

4. NTC (Telecom Infrastructure)

   • Process Costing: NTC’s network expansion treats each telecom tower installation as a process (site preparation → equipment installation → testing), with costs allocated per tower or kilometer of fiber laid.
   • Capital Budgeting (Linked to Inventory): While not pure inventory, NTC’s spare parts inventory (e.g., cables, transmitters) is managed using EOQ to balance stockout risks (service disruptions) and holding costs.

5. Pathao (Ride-Hailing)

   • JIT for Driver Supplies: Pathao drivers often restock snacks, water, or phone chargers just before their shift (JIT principle).
   • ABC Analysis for Fleet: Pathao prioritizes maintenance costs for high-mileage vehicles (A items) over low-mileage bikes (C items).

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9. Numerical Example: Kathmandu Retail Shop

Scenario: A retail shop in Thamel sells handicrafts. The shopkeeper maintains inventory for three items:

1. Wooden Carvings (High value, slow-moving)
2. Silver Jewelry (Very high value, occasional sales)
3. Postcards (Low value, fast-moving)

Given Data (March 2024):

Tasks:

1. Valuate ending inventory using FIFO, LIFO, and WAC.
2. Classify items using ABC analysis.
3. Recommend an ordering strategy (EOQ or JIT).

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Step 1: Valuate Ending Inventory

Assumptions:

• Wooden Carvings: FIFO (physical flow matches oldest units sold first).
• Silver Jewelry: LIFO (tax benefits in inflationary periods).
• Postcards: WAC (simplicity for high-volume items).

A. Wooden Carvings (FIFO)

• Opening: 10 units @ Rs 2,000
• Purchased: 5 units @ Rs 2,200
• Sold: 8 units (first 8 from opening stock)
• Ending Inventory: 7 units (2 from opening + 5 purchased)
  • 2 units @ Rs 2,000 = Rs 4,000
  • 5 units @ Rs 2,200 = Rs 11,000
  • Total: Rs 15,000

B. Silver Jewelry (LIFO)

• Opening: 3 units @ Rs 10,000
• Purchased: 2 units @ Rs 10,500
• Sold: 1 unit (last purchased)
• Ending Inventory: 4 units (2 from opening + 2 purchased, but LIFO assumes newest sold first)
  • Correction: LIFO for 1 unit sold = latest purchase (2 units @ Rs 10,500) → 1 unit @ Rs 10,500 sold.
  • Remaining: 3 (opening) + 1 (purchased) = 4 units
    • 3 units @ Rs 10,000 = Rs 30,000
    • 1 unit @ Rs 10,500 = Rs 10,500
    • Total: Rs 40,500

C. Postcards (WAC)

• Opening: 500 units @ Rs 50 = Rs 25,000
• Purchased: 300 units @ Rs 55 = Rs 16,500
• Total Units: 800
• Total Cost: Rs 25,000 + Rs 16,500 = Rs 41,500
• Average Cost: Rs 41,500 ÷ 800 = Rs 51.875
• Sold: 600 units → COGS: 600 × Rs 51.875 = Rs 31,125
• Ending Inventory: 200 units × Rs 51.875 = Rs 10,375

Summary Table:

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Step 2: ABC Analysis

Observation:

• Silver Jewelry and Wooden Carvings (A Items) account for Rs 111,900 (85% of total value).
• Postcards (C Item) account for Rs 378,000 but are fast-moving and low-cost.

Recommendation:

• Tight control on A items (weekly stock checks).
• Bulk ordering for C items (postcards) with longer lead times.

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Step 3: Ordering Strategy

1. Wooden Carvings (A Item):

   • EOQ Approach:
     • Annual Demand (D) = 24 units
     • Ordering Cost (S) = Rs 500 per order
     • Holding Cost (H) = 20% of Rs 2,100 = Rs 420 per unit per year $$EOQ=\sqrt{\frac{2\times 24\times 500}{420}}\approx 4.36\approx 4\text{ units per order}$$
   • Recommendation: Order every 6 months (24 ÷ 4).

2. Postcards (C Item):

   • JIT Approach:
     • High demand → daily/weekly replenishment.
     • Suppliers deliver small batches to avoid bulk storage.

3. Silver Jewelry (A Item):

   • Hybrid Approach:
     • EOQ for bulk purchases (e.g., 6 units every 6 months).
     • JIT for high-end custom orders (e.g., wedding jewelry).

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Exam Tip

1. Inventory Valuation:

   • Always show calculations for FIFO, LIFO, and WAC.
   • Compare COGS and ending inventory under different methods.
   • Memorize the formula for EOQ and know when to apply it.

2. Costing Techniques:

   • Job Costing: Use for custom orders (e.g., hotel events).
   • Process Costing: Use for mass production (e.g., rice mills).
   • ABC Analysis: Rank items by value and classify into A, B, C.

3. Real-World Applications:

   • Hotels: FIFO for food, job costing for events, ABC for linen.
   • Retail: EOQ for electronics, JIT for perishables.
   • Manufacturing: Process costing for bulk goods.

4. Common Pitfalls:

   • Mixing methods (e.g., using FIFO for some items and LIFO for others without justification).
   • Ignoring holding costs in EOQ calculations.
   • Overlooking ABC analysis in inventory management questions.

5. Numerical Questions:

   • Always assume a method if not specified (e.g., FIFO for perishables).
   • Show all steps (e.g., T-accounts for inventory adjustments).
   • Link to real businesses (e.g., "Like Daraz’s warehouse management...").

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Final Note: Inventory management is critical for profitability in hospitality. Whether you’re running a hotel, restaurant, or retail shop, choosing the right valuation method, costing technique, and ordering strategy can save costs, reduce waste, and improve service quality. Practice numerical problems to master calculations, and relate theories to real-world examples (like eSewa’s liquidity management or Daraz’s ABC analysis) to score full marks in exams!