Gossett, Thomas E.

Newlove, G. H.

English

eGrove (Univ. of Mississippi)

Management Services: A Magazine of Planning, Systems, and Controls Volume 2 Number 4 Article 7 7-1965 Inventory Gains and Losses Thomas E. Gossett G. H. Newlove Follow this and additional works at: https://egrove.olemiss.edu/mgmtservices  Part of the Accounting Commons Recommended Citation Gossett, Thomas E. and Newlove, G. H. (1965) "Inventory Gains and Losses," Management Services: A Magazine of Planning, Systems, and Controls: Vol. 2: No. 4, Article 7. Available at: https://egrove.olemiss.edu/mgmtservices/vol2/iss4/7 This Article is brought to you for free and open access by eGrove. It has been accepted for inclusion in Management Services: A Magazine of Planning, Systems, and Controls by an authorized editor of eGrove. For more information, please contact egrove@olemiss.edu. Most of the standard inventory control formulas ignore the effect of price fluctuations on carrying costs. These authors suggest a way to calculate eco­nomic order quantities with allowance for —INVENTORY GAINS AND LOSSESby Thomas E. Gossett and G. H. NewloveThe University of TexasInventory control is probably closer to being an exact sci­ence than any other area of man­agement. Formulas for calculatingTHOMAS E. GOSSETT, CPA, is assistant profes­sor of accounting at The University of Texas in Austin. Formerly he served as accountant for Ernst & Ernst, senior ac­countant for F. G. Mas­quelette & Co., and for nine years as secretary,treasurer, and director of Thermal Supply, Inc. He holds M.B.A. and LL.B. degrees from the University of Houston. G. H. NEW­LOVE, Ph.D., CPA, is professor of accounting at The University of Texas and has been associated with various universities since 1916. He is a member of the National Association of Accountants and former president of the Amer­ican Association of Ac­countants. He is a fre­quent contributor to ac­counting literature. economic order quantities, reorder points, and buffer stocks are widely disseminated, and their users often report sizable savings in inventory carrying costs. One major element of inventory planning, however, has received little attention from the proponents of scientific inventory control. Hold­ing gains and losses as a result of price fluctuations are seldom com­ponents of inventory control for­mulas. Some theorists include a provision in inventory carrying cost for possible price reductions to clear finished goods from inventory, but the possibility of price changes in commodities or materials is rarely taken into account. Yet price fluctuations do occur, sometimes on such a scale as to wipe out most of the advantages of economic order  quantity calculation.In the discussion that follows the reader will be assumed to have at least an elementary understanding of the traditional method for com­puting optimum economic order quantities. The technique was ex­plained in some detail in an earlier issue of Management Services (see "Inventory Control” by Robert D. Niemeyer, M/S, July-August, 1964, p. 25); it has also been discussed in a number of books and maga­zines.This article, accordingly, deals only with the frequently over­looked subject of inventory holding gains and losses caused by price changes. It emphasizes their im­portance as an element of inventory carrying cost and suggests how to provide for them in computing economic order quantities.ImportanceIn several periods of our eco ­nomic history the severity of price52 Management Services 1Gossett and Newlove: Inventory Gains and LossesPublished by eGrove, 1965AVERAGE PRICES OF ELECTROLYTIC COPPER - CENTS PER POUNDYear Average Price Change from Prev. Year % Change1949 19.361950 21.46 2.10 10.851951 24.37 2.91 13.561952 24.37 ——1953 28.92 4.55 18.671954 29.82 .90 3.111955 37.39 7.57 25.391956 41.88 4.49 12.011957 29.99 11.89* 28.39*1958 26.13 3.86* 12.87*1959 30.82 4.69 17.951960 32.16 1.34 4.351961 30.15 2.01* 6.25*1962 30.83 .68 2.261963 30.83 — —* DecreaseEXHIBIT Ifluctuations has compelled many businessmen to “manage” inven­tories with consideration of an­ticipated price changes as a prime factor. Frequently this “inventory management” has merely taken the form of educated guessing about quantities rather than of allowing for anticipated price changes by introducing a factor determined by scientific measurement.One example is that period ex­tending from the beginning of the Korean War through most of 1957. During this period most companies found that the holding gains in in­ventory, i.e., the increases in cost prices applicable to inventories on hand, often exceeded the carrying costs of the inventories. It was argued during this period, with some justification, that poor in­ventory management frequently re­sulted in increased profits because a position of overstock increased profits.The magnitude of the year-to- year price variations of industrial raw materials may be established by reference to tabulations of prices applicable to almost any of the basic commodities of consequence in manufacture or conversion of product. Copper is one raw ma­terial having extensive application in manufacturing whose price struc ­ture shows no extreme patterns of either wide or narrow fluctuation and which therefore may be taken as representative of many basic materials. Average prices for cop­per from 1949 to 1963 (inclusive) are tabulated in Exhibit 1 on this page.During this period poor inven­tory management was most often attributed to those companies using rigid scientific inventory methods. This may be explained by the fact that almost all inventory control formulas in use failed to recognize holding gains and losses, and a rigidly adhered to system that did not include this factor could not be effective in maximizing profits. While exclusion of this element has the effect of concentrating man­agement’s efforts and decisions on the nonprojective aspects of the business and of limiting specula­tive tendencies, in today’s economy the feasibility of such a constraint is certainly subject to serious ques­tion.Attempts to avoid the possible consequences of speculation in in­ventories and to focus on the manu­facture or acquisition and market­ing of goods have a long, and for the most part unsuccessful, history. These attempts probably resulted in the first use of hedging and cer­tainly were the largest single con­tributors to the establishment of the commodity market.Probably a review of the history of this market would indicate that, instead of eliminating or restricting speculation, in many instances it has produced just the opposite ef­fect. Where it is possible to obtain sale and purchase commitments al­most simultaneously, or where very clean competitive conditions exist, inventory speculation may be avoided; yet, unfortunately, the number of these situations is lim­ited. More frequently business is presented with a situation where a competitor has stocked in antici­pation of a cost increase and is thereby enabled either to hold the resale prices level and build good­will with customers or to raise re­sale prices concurrently with the industry adjustments and strengthen its earnings without injuring its competitive standing. Similar ad­justments are, of course, possible when costs are dropping if a com­petitor is in a safety-stock-only po­sition and is able to drop resale prices immediately.Inventory speculation as a prod­uct of managerial whim is not a proper function of the manufac­turer and/or distributor of mer­chandise and is better left to peopleJuly-August, 1965 53 2Management Services: A Magazine of Planning, Systems, and Controls, Vol. 2 [1965], No. 4, Art. 7https://egrove.olemiss.edu/mgmtservices/vol2/iss4/7EXHIBIT 2Number OrdersValue of  Each OrderAverage Working  InventoryEOQ - FIRST EXAMPLETotal  CostsPrice Change AdjustmentNet  CostCarrying CostsOrder  Costs1 $10,000 $5,000 $1,000 $ 10 $1,010 $500 $5102 5,000 2,500 500 20 520 250 2703 3,333 1,667 333 30 363 167 1964 2,500 1,250 250 40 290 125 1655 2,000 1,000 200 50 250 100 1506 1,667 834 167 60 227 831447 1,429 715 143 70 213 72 1418 1,250 625 125 80 205 6314291,111556 111 90 20156 14510 1,000 500 100 100 200 50 15011 909 455 91 110 201 46 15512 833 417 83120203 42 161in the business of speculation. However, prudent allowance for possible price changes affecting inventories of products regularly marketed is a normal part of busi­ness operations in this dynamic economy and is recognized as such by almost all management. It is surprising, therefore, to find that provision is seldom made for this factor in the formula most often recommended for economic reorder quantity calculations:2CUIWhere Q = Economic order quan ­tity in dollarsWhere U = Annual usage in dollars  Where C = Cost of an order in dol­larsWhere I = Inventory carrying cost as a percentage of work­ing inventory invest­mentDuring the period cited earlier — when holding gains in inven­tories often exceeded carrying costs — application and use of this for­mula would obviously not have established inventory levels at a point where maximum profits were realized. During other periods price movements have tended downward to the extent that application of the formula would lead to an eco­nomic overstock.MethodProbably in most instances the consideration of holding gains and losses in inventory is best introduced into the calculation of economic re­order quantity by including antici­pated, or probable, price increases or decreases, expressed as a per­centage of working inventory in­vestment, as a reduction of or ad­dition to carrying costs. On occa­sion this method will result in a negative carrying cost factor; thus, additional considerations are neces­sarily involved.Working inventory investment is specified because in many instances customer service safety stocks are a major factor and should not be diminished for speculative pur­poses. There are several ways of providing for customer service and/or lost-profit factors in inven­tory management. One of these methods, establishment of a base stock in units for each item of in­ventory and limiting calculations of inventory order quantities to the excess over the base stock, is fre­quently used in practice; because of its simplicity, it is used in the fol­lowing illustrations. The other methods, while probably more ac­curate in many instances, involve application of probabilistic tech­niques that are beyond the scope of this article. The reader is cau­tioned that there is a need for care­ful analysis when introducing the factor for holding gains and losses in the more complex models for EOQ calculation.ExampleTo illustrate the effect of this factor, assume the following data concerning a class of products: Annual usage Cost of an orderCarrying costsAnticipated price in­crease$10,000$1020% of work­ing inven­tory in­vestment10% of work­ing inven­tory in­vestmentApplication of the formula with­out a factor for price fluctuation would be as follows:Q=  2(10) (10,000)  .20Q = $1,00054Management SendeesQ =3Gossett and Newlove: Inventory Gains and LossesPublished by eGrove, 1965EXHIBIT 3Number OrdersEOQ-SECOND EXAMPLENet  CostValue of Each OrderAverage Working  InventoryCarrying  CostsOrder  CostsTotal  CostsPrice Change Arrangements1 $10,000 $5,000 $500 $ 10 $510 $1,000$ (490)2 5,000 2,500 250 20 270 500 (230)33,333 1,667 167 30 197 333 (136)4 2,500 1,250 125 40 165 250( 85)5 2,000 1,000 100 50 150 200( 50)6 1,667 834 83 60143167 ( 24)7 1,429 715 72 70 142 143 181,250 625 63 80 143125 1891,111556 56 90 146 111 35101,000 500 50 100 150 100 5011 909 455 46 110 156 91 6512 833 417 42 12016283 79Application of the formula in­cluding the factor for anticipated price increases as a reduction of carrying costs would be as fol­lows:Q=   2(10) (10,000)   .10Q = $1,414Another method of determining economic reorder point is to tabu­late the total costs of inventory ac­quisition and ownership to the date of sale and then to select the re­order value that results in the low­est total cost. The example just il­lustrated when solved in this way may assume the tabular form shown in Exhibit 2 on page 54.Note that the total cost column indicates the same reorder point as previously calculated by use of the formula that did not include a fac­tor for price changes and that the net cost column indicates the same reorder point as calculated by the formula that did include a factor for price changes. Note also that reorder quantity for these selected data would vary more than 40 per cent depending upon whether the factor for holding gains is included in the computation. Carrying costs of 20 per cent may be considered only conservatively high, and an­nual price fluctuations of 10 per cent or even more are not unusual.To extend the illustration of this factor to a more extreme, although still a reasonable, situation, assume a company with idle space, ample borrowing capacity, etc., and in­cremental carrying costs of 10 per cent. Additionally, assume the fol­lowing: Annual usage Cost of an orderAnticipated price in­creases$10,000$1020% of work­ing inven­tory invest­mentApplication of the formula with­out a factor for price fluctuation would yield the following results:Q=  2(10) (10,000)   .10Q = $1,414Application of the formula in­cluding a factor for the anticipated price increases as a reduction of  carrying costs would be as follows:Q=  2(10) (10,000)   -.10Q=  -2,000,000(Since the square root of this quan­tity is a complex number, some other solution method must be ap­plied. )The tabulation method applied to this illustration is shown in Ex­hibit 3 above.DiscussionBoth of the methods illustrated indicate that the more inventory owned, the more “profit” realized An examination of some of the items typically included as carry­ing costs in calculations such as this will show that the indicated conclusion is valid only within cal­culable limits.The most frequently illustrated carrying costs include (a) interest on inventory investment, (b) in­surance, (c) deterioration and ob­solescence, (d) property taxes on inventory, and (e) occupancy costs. Some of these costs must react to changes in inventory owned in the manner of a step function with new cost plateaus reached as limitations of capital, space, time, or other causative factors are approached and passed. Obviously, when addi­tional space is required for inven­tory storage, new facilities, with associated incidental occupancy costs, will cause a step increase in carrying costs. The same is trueJuly-August, 1965 554Management Services: A Magazine of Planning, Systems, and Controls, Vol. 2 [1965], No. 4, Art. 7https://egrove.olemiss.edu/mgmtservices/vol2/iss4/7EXHIBIT 4Number OrdersValue of  Each OrderAverage Working  InventoryEOQ —THIRD EXAMPLETotal  CostsPrice Change AdjustmentsNet  CostCarrying CostsOrder  Costs1 $10,000 $5,000 $1,000$ 10 $1,010 $500 $1,51025,000 2,500 500 20 520 250 7703 3,333 1,667 333 30 363 167 5304 2,500 1,250 250 40 290 125 41552,000 1,000 200 50 250 100 3506 1,667 83416760 227 83 3107 1,429 71514370 213 72 2858 1,250 625 125 80 205 63 26891,111 556 111 90 201 56 25710 1,000 500 100100200 50 25011 909 455 91 110 201 46 24712 833 417 83120203 42 24513 769 385 77130207 39 24614 714 357 7140212 36 24815 667 334 67 150 217 33 250o£ interest on inventory investment as practical borrowing capacity is approached. Property taxes on in­ventories are most often based up­on inventories owned as of a par­ticular date and therefore might well change in significance when speculative purchases cause a large carryover of inventory beyond this date. For any given company then, many of the elements included in carrying cost will remain in stable relationship with inventory owned only within ascertainable limits.Consequently, it would seem that when a company faces the pros­pect of rising prices, practicality would dictate, depending upon the circumstances, that one of two courses be adopted:1. Set reorder quantities at the  highest level at which management is willing and able to speculate in market price fluctuations, or2. Recalculate the incremental  carrying costs upward until the amount exceeds the anticipated price fluctuations and then apply the formula including the factor for holding gains and losses.Price reductionsThe effect of this factor where prices are expected to trend down­ward may be illustrated as follows:Annual usageCost of an orderCarrying costsAnticipated price de­crease$10,000$1020% of work­ing inven­tory invest­ment10% of work­ing inven­tory invest­mentApplication of the formula with­out a factor for price fluctuation would be as follows:Q=  2(10) (10,000)Q = $1,000Application of the formula in­cluding a factor for anticipated price decreases as an additional carrying cost would be as follows:Q=  2(10) (10,000)Q= .30Q = $816The tabular method applied to this illustration would yield the re­sults shown in Exhibit 4 on this page.It should again be pointed out that the costs under consideration will react in the step manner pre­viously discussed. Therefore, as re­order quantity diminishes with ap­plication of the formula, a new cost plateau may be reached. Extreme changes in reorder quantity will undoubtedly require a re-examina­tion of carrying costs and order costs.ConclusionHolding gains and losses are an important influence in inventory planning and control. Exclusion of such gains and losses from consid­eration by failure to provide for them in economic reorder quantity calculations tends to negate the usefulness of such calculations. When the size of this element is unusually large, management must be informed of its materiality and also that use of the resulting cal­culations introduces a major specu­lative aspect into the business oper ­ations. Even if the size of this fac­tor is not unusually large, it still should not be ignored. Price fluc­tuations are a business reality and usually at least as important as other individual costs in inventory management and control.56 Management Services 5Gossett and Newlove: Inventory Gains and LossesPublished by eGrove, 1965

Inventory Gains and Losses

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Inventory Gains and Losses

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