THOUGHT LEADERSHIP SERIES

6 Questions CFOs Should Ask About

Inventory to Reduce Costs
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by Andy Thurmond, Karmak, Inc.

6 Questions CFOs Should Ask About

Inventory to Reduce Costs

One decision facing business managers is the method used to value inventory.* The decision has a great
impact on a businesss organization and day-to-day operations, and must be considered carefully before a
costing method is adopted or changed. There are many inventory valuation methods. The two most
common methods used in the heavy-duty transportation industry are average cost and replacement cost.

What is the average cost method?

The average cost method is used when inventory is valued at the average cost of all the parts that are
currently on hand. The parts are received into inventory at the purchase cost and the average cost is
recalculated. Inventory is relieved by the average cost of the parts on hand when they are sold.
Average Cost of Parts on Hand

Quantity on Hand (before receiving)

Quantity Received
New Totals

Total Quantity on Hand

10.0000

$40.00

$9.00

3
7

$27.00
$67.00

$67.00

Parts Purchased at a Discount

Cost of Parts Received

Average Cost Recalculation

Total Cost of Inventory on Hand
New Average Cost

9.5714

9.5714

Post Transaction to Accounting

Debit
27.00

Parts Inventory
Accounts Payable

Credit
27.00

New Inventory Value

Average Cost

Quantity on Hand (after receiving)

9.5714

$67.00

Quantity Received
New Totals

$12.00

3
10

$36.00
$103.00

Total Quantity on Hand

$103.00

10

$10.30

Parts Purchased at a Premium

Cost of Parts Received

Average Cost Recalculation

Total Cost of Inventory on Hand
New Average Cost

10.3000

Post Transaction to Accounting

Debit
36.00

Parts Inventory
Accounts Payable

Credit
36.00

New Inventory Value

Average Cost

Quantity on Hand (after receiving)

Karmak, Inc. | www.karmak.com | 800-622-6311

10.3000

10

$103.00

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6 Questions CFOs Should Ask About

Inventory to Reduce Costs

What is the replacement cost method?

The replacement cost method is used when inventory is valued at a cost per item, which typically comes
from a price file or price list supplied by the vendor (supplier). When purchases are made for an amount
that differs from this supplied cost, the difference must be accounted for to an account other than parts
inventory. The inventory is relieved by the replacement cost of the parts on hand when they are sold.
Replacement Cost of Parts on Hand

Quantity on Hand (before receiving)

Quantity Received

11.0000

$44.00

$9.00

$27.00

Parts Are Purchased at a Discount

Cost of Parts Received

Post Transaction to Accounting

Debit
33.00

Parts Inventory
Discounts Earned
Accounts Payable

Credit
6.00
27.00

New Inventory Value

Replacement Cost

Quantity on Hand (after receiving)

11.0000

$77.00

Quantity Received

$12.00

$36.00

Parts Are Purchased at a Premium

Cost of Parts Received

Post Transaction to Accounting

Debit
33.00
3.00

Parts Inventory
Premiums Paid
Accounts Payable

Credit

36.00

New Inventory Value

Replacement Cost

Quantity on Hand (after receiving)

11.0000

10

$110.00

1. What is the difference between average and replacement cost methods?

In these two methods, there is a difference in the process for receiving inventory and posting it to the
General Ledger. The business system should be able to do the calculations for average cost. Accordingly,
the accounting entry is simple and can be done by a clerk in the Accounting Department. However, in
replacement cost, employees will need to calculate the difference between the actual purchase price
and the replacement cost by deciding where to enter the difference. While this is a simple task to
complete, it must be applied to every transaction, which can accumulate time and effort quickly. In
addition, the decision for discounts and premiums is often made in the Parts Department, which again
adds time to the process, delaying the posting of the AP invoices.

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6 Questions CFOs Should Ask About

Inventory to Reduce Costs

Since the majority of purchase transactions will likely be at a cost other than replacement cost, an extra
line of detail is needed for the AP clerk on invoices. Like the employee calculations, this may seem a
minor task, but when multiplied by the volume of parts invoices, it becomes a much larger task.

2. How do you want to handle price file updates from vendors?

If average cost is used, nothing needs to be done. The new prices will be implemented as business
continues. However, if replacement cost is used, a report should be run in the software that quantifies
the value of inventory on hand that has changed due to the application of updated price. In an
inflationary society, this will typically be an increase to the inventory value, with the offset as income.
It is a common practice in the heavy-duty transportation industry not to record this gain when the
update takes place. This is done because, usually, the software cannot calculate the amount. Also, when
physical inventory is taken, the increase will offset any potential inventory problems. The reconciling
amount will be minimal or potentially show a gain. This is not a good practice. Other inventory issues,
such as theft, damage or poor warehouse practices, may be masked by this process. It is recommended
to book the difference created by the price update and treat the physical inventory as a separate issue.

3. How do you value slow-moving parts?

If replacement cost is used and the increases typically associated with updates are recorded, over time
the value of slow-moving parts is inflated. In average cost methodology, these parts remain in the
inventory at their value at the time of purchase. Using average cost, reports based on value presents a
more accurate picture of slow-moving or obsolete inventory.

4. How do you pay your employees?

If purchasing is done well, average cost should generate lower costs, which generates higher gross
profits at the time of sale. This must be addressed in deciding how employees are paid. If inventory uses
average cost methodology, sales personnel should be able to be paid on replacement cost. Executives
must determine whether to pay sales personnel based on the results of good purchasing or not. In
addition, some purchasing decisions may have been to invest significant cash in inventory to buy more
than would be stocked to take advantage of a good deal from a vendor. Most companies do not want to
give employees a raise simply because they were willing and able to invest in inventory.

5. How do you monitor purchasing?

Either method allows the ability to monitor the job being done by purchasing. If average cost is used,
reports should be run to compare average costs to replacement costs. If replacement cost is used,
monitoring the purchase discounts and premiums paid accounts should provide an easy metric for the
job being done. It is recommended that these accounts be maintained separately rather than posting
both the losses and gains to the same account. Purchase discounts should be numerous and premiums
paid should be rare if inventory is being managed properly.
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6 Questions CFOs Should Ask About

Inventory to Reduce Costs

6. How do you time posting income to the business?

If purchasing is done wellbuying parts in volume and taking advantage of available programsparts
should be consistently bought at a discount. By booking discounts earned at the time of purchase,
income is recognized at the time of purchase rather than at the time of sale.
For example, if $2,000,000 is sold a month at a 26 percent gross profit, there were purchase discounts of
two percent and inventory is turned five times a year, parts inventory would be overstated by $96,000.
This amount is income that has been realized at the time of purchase rather than at the time of sale and
that taxes have likely been paid on. If purchasing habits remain the same, the tax on this amount is, in
essence, an interest-free loan granted to taxing authorities forever.
In addition, the practice of recognizing income at the time of purchase rather than the time of sale can
be particularly dangerous if the purchasing manager or parts manager has compensation based on net
profit.

The verdict: average vs. replacement cost

Average cost is the preferred method of costing parts inventory for many reasons. Reduced work in both
the Parts and Accounting Departments account for purchases when they are made. No additional
entries are recorded when prices are updated from the vendor. There is full visibility of potential
inventory control issues. Slow-moving and obsolete inventory is valued properly. There is recognition of
income and payment of taxes at the time of sale rather than at the time of purchase.

About Karmak
Karmak, Inc. is a leading provider of business management solutions for the commercial transportation
industry. With more than 30 years of heavy-duty experience, we offer a unique approach combining
innovative technology, strategic advice and best practices. Our success programs produce measurable
results by improving ROI, mitigating risks and achieving operational excellence.
Serving more than 1,800 locations across North America, Karmak is an employee-owned company with
headquarters in Carlinville, Illinois.

*Inventory can be, and often is, valued differently for accounting and tax purposes. The scope of this discussion is limited to the
valuation for book purposes. Contact a tax professional for the benefits and drawbacks of inventory valuation methods for tax
purposes.
2013 Karmak, Inc. All rights reserved.

Karmak, Inc. | www.karmak.com | 800-622-6311

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