1

Inventory Management
Inventory
2
Overview
Opposing Views of Inventories
Nature of Inventories
Fixed Order Quantity Systems
Fixed Order Period Systems
Other Inventory Models
Some Realities of Inventory Planning
Wrap-Up: What World-Class Companies Do
3
Opposing Views of Inventory
Why We Want to Hold Inventories
Why We Not Want to Hold Inventories
4
Why We Want to Hold Inventories
Improve customer service
Reduce certain costs such as
ordering costs
stockout costs
acquisition costs
start-up quality costs
Contribute to the efficient and effective operation of
the production system
5
Why We Want to Hold Inventories
Finished Goods
Essential in produce-to-stock positioning strategies
Necessary in level aggregate capacity plans
Products can be displayed to customers
Work-in-Process
Necessary in process-focused production
May reduce material-handling & production costs
Raw Material
Suppliers may produce/ship materials in batches
Quantity discounts and freight/handling $$ savings
6
Why We Do Not Want to Hold Inventories
Certain costs increase such as
carrying costs
cost of customer responsiveness
cost of coordinating production
cost of diluted return on investment
reduced-capacity costs
large-lot quality cost
cost of production problems
7
Nature of Inventory
Two Fundamental Inventory Decisions
Terminology of Inventories
Independent Demand Inventory Systems
Dependent Demand Inventory Systems
Inventory Costs
8
Two Fundamental Inventory Decisions
How much to order of each material when orders are
placed with either outside suppliers or production
departments within organizations
When to place the orders
9
Independent Demand Inventory Systems
Demand for an item carried in inventory is
independent of the demand for any other item in
inventory
Finished goods inventory is an example
Demands are estimated from forecasts and/or
customer orders
10
Dependent Demand Inventory Systems
Items whose demand depends on the demands for
other items
For example, the demand for raw materials and
components can be calculated from the demand for
finished goods
The systems used to manage these inventories are
different from those used to manage independent
demand items
11
Inventory Costs
Costs associated with ordering too much (represented
by carrying costs)
Costs associated with ordering too little (represented
by ordering costs)
These costs are opposing costs, i.e., as one increases
the other decreases
. . . more
12
Inventory Costs (continued)
The sum of the two costs is the total stocking cost
(TSC)
When plotted against order quantity, the TSC
decreases to a minimum cost and then increases
This cost behavior is the basis for answering the first
fundamental question: how much to order
It is known as the economic order quantity (EOQ)
13
Balancing Carrying against Ordering Costs
Annual Cost ($)
Order Quantity
Minimum
Total Annual
Stocking Costs
Annual
Carrying Costs
Annual
Ordering Costs
Total Annual
Stocking Costs
Smaller Larger
L
o
w
e
r

H
i
g
h
e
r

EOQ
14
Fixed Order Quantity Systems
Behavior of Economic Order Quantity (EOQ)
Systems
Determining Order Quantities
Determining Order Points
15
Behavior of EOQ Systems
As demand for the inventoried item occurs, the
inventory level drops
When the inventory level drops to a critical point, the
order point, the ordering process is triggered
The amount ordered each time an order is placed is
fixed or constant
When the ordered quantity is received, the inventory
level increases
. . . more
16
Behavior of EOQ Systems
An application of this type system is the two-bin
system
A perpetual inventory accounting system is usually
associated with this type of system
17
Determining Order Quantities
Basic EOQ
EOQ for Production Lots
EOQ with Quantity Discounts
18
Fixed order quantity system






Maximum stock
ROL
Q
Av
T1
T2
Average inventory
Q/2
LT
Point of order Point of re order
T
19
A company makes 2000 units p.a.. Each unit needs a component Z.
Z costs Rs 10 per unit and its holding cost is Rs 2.4 per anum.
Cost of placing an order is Rs 150 and is not related to size.
Company works for 250 days an year.
Lead time for delivery is 15 Days.
Let Q be the fixed order quantity. Q= D/N
N be the number of orders placed. N= D/Q
C be the Carrying cost per unit per anum. C= Q/2* Rate
D be the annual demand
S be the ordering cost per order. S = given fixed rate

20
100 20 120 3000 3120
200 10 240 1500 1740
400 5 480 750 1230
500 4 600 600 1200
1000 2 1200 300 1500
2000 1 2400 150 2550
Order
Quantity
No of
orders
Carrying
costs
Ordering
costs
Total variable
cost
Q
N =
D/Q
C=Q/2
X 2.4
S = N X
150 TVC = C+S
Iterations
Daily consumption of Z = 2000/250= 8
ROR= 8 X 15 =120 pcs.

21
Model I: Basic EOQ
Typical assumptions made
annual demand (D), carrying cost (C) and ordering
cost (S) can be estimated
average inventory level is the fixed order quantity
(Q) divided by 2 which implies
no safety stock
orders are received all at once
demand occurs at a uniform rate
no inventory when an order arrives
. . . more
22
Model I: Basic EOQ
Assumptions (continued)
Stockout, customer responsiveness, and other costs
are inconsequential
acquisition cost is fixed, i.e., no quantity discounts
Annual carrying cost = (average inventory level) x
(carrying cost) = (Q/2)C
Annual ordering cost = (average number of orders per
year) x (ordering cost) = (D/Q)S
. . . more
23
C DS / 2 = EOQ
Model I: Basic EOQ
Total annual stocking cost (TSC) = annual carrying
cost + annual ordering cost = (Q/2)C + (D/Q)S
The order quantity where the TSC is at a minimum
(EOQ) can be found using calculus (take the first
derivative, set it equal to zero and solve for Q)

24
Example: Basic EOQ
Zartex Co. produces fertilizer to sell to
wholesalers. One raw material calcium nitrate is
purchased from a nearby supplier at $22.50 per ton.
Zartex estimates it will need 5,750,000 tons of
calcium nitrate next year.
The annual carrying cost for this material is 40%
of the acquisition cost, and the ordering cost is $595.
a) What is the most economical order quantity?
b) How many orders will be placed per year?
c) How much time will elapse between orders?
25
Example: Basic EOQ
Economical Order Quantity (EOQ)

D = 5,750,000 tons/year
C = .40(22.50) = $9.00/ton/year
S = $595/order



= 27,573.135 tons per order
EOQ = 2DS/C
EOQ = 2(5,750,000)(595)/9.00
26
Example: Basic EOQ
Total Annual Stocking Cost (TSC)
TSC = (Q/2)C + (D/Q)S
= (27,573.135/2)(9.00)
+ (5,750,000/27,573.135)(595)
= 124,079.11 + 124,079.11
= $248,158.22
Note: Total Carrying Cost
equals Total Ordering Cost
27
Example: Basic EOQ
Number of Orders Per Year
= D/Q
= 5,750,000/27,573.135
= 208.5 orders/year
Time Between Orders
= Q/D
= 1/208.5
= .004796 years/order
= .004796(365 days/year) = 1.75 days/order
Note: This is the inverse
of the formula above.
28
Model II: EOQ for Production Lots
Used to determine the order size, production lot, if an
item is produced at one stage of production, stored in
inventory, and then sent to the next stage or the
customer
Differs from Model I because orders are assumed to
be supplied or produced at a uniform rate (p) rate
rather than the order being received all at once
29
Model II: EOQ for Production Lots
It is also assumed that the supply rate, p, is greater
than the demand rate, d
The change in maximum inventory level requires
modification of the TSC equation
TSC = (Q/2)[(p-d)/p]C + (D/Q)S
The optimization results in
(

d p
p
C
DS 2
= EOQ
30
Model 2 determining EOQ for production lots
d=rate at which units are used
p= rate at which units are produced
Maximum inventory level= inventory build up rate X
period of delivery= (p-d) (Q/p)
Average inventory level=1/2(max +min inventory)=
{(p-d) (Q/p)+0}=Q/2{(p-d)/p}
31
Example: EOQ for Production Lots
Highland Electric Co. buys coal from Cedar
Creek Coal Co. to generate electricity. CCCC can
supply coal at the rate of 3,500 tons per day for
$10.50 per ton. HEC uses the coal at a rate of 800
tons per day and operates 365 days per year.
HECs annual carrying cost for coal is 20% of the
acquisition cost, and the ordering cost is $5,000.
a) What is the economical production lot size?
b) What is HECs maximum inventory level for coal?
32
Example: EOQ for Production Lots
Economical Production Lot Size

d = 800 tons/day; D = 365(800) = 292,000 tons/year
p = 3,500 tons/day
S = $5,000/order C = .20(10.50) = $2.10/ton/year



= 42,455.5 tons per order

EOQ = (2DS/C)[p/(p-d)]
EOQ = 2(292,000)(5,000)/2.10[3,500/(3,500-800)]
33
Example: EOQ for Production Lots
Total Annual Stocking Cost (TSC)
TSC = (Q/2)((p-d)/p)C + (D/Q)S
= (42,455.5/2)((3,500-800)/3,500)(2.10)
+ (292,000/42,455.5)(5,000)
= 34,388.95 + 34,388.95
= $68,777.90

Note: Total Carrying Cost
equals Total Ordering Cost
34
Example: EOQ for Production Lots
Maximum Inventory Level
= Q(p-d)/p
= 42,455.5(3,500 800)/3,500
= 42,455.5(.771429)
= 32,751.4 tons Note: HEC will use 23%
of the production lot by the
time it receives the full lot.
35
Model III: EOQ with Quantity Discounts
Under quantity discounts, a supplier offers a lower
unit price if larger quantities are ordered at one time
This is presented as a price or discount schedule, i.e.,
a certain unit price over a certain order quantity range
This means this model differs from Model I because
the acquisition cost (ac) may vary with the quantity
ordered, i.e., it is not necessarily constant
. . . more
36
Model III: EOQ with Quantity Discounts
Under this condition, acquisition cost becomes an
incremental cost and must be considered in the
determination of the EOQ
The total annual material costs (TMC) = Total annual
stocking costs (TSC) + annual acquisition cost

TSC = (Q/2)C + (D/Q)S + (D)ac

. . . more
37
Model III: EOQ with Quantity Discounts
To find the EOQ, the following procedure is used:
1. Compute the EOQ using the lowest acquisition cost.
If the resulting EOQ is feasible (the quantity can
be purchased at the acquisition cost used), this
quantity is optimal and you are finished.
If the resulting EOQ is not feasible, go to Step 2
2. Identify the next higher acquisition cost.
38
Model III: EOQ with Quantity Discounts
3. Compute the EOQ using the acquisition cost from
Step 2.
If the resulting EOQ is feasible, go to Step 4.
Otherwise, go to Step 2.
4. Compute the TMC for the feasible EOQ (just found
in Step 3) and its corresponding acquisition cost.
5. Compute the TMC for each of the lower acquisition
costs using the minimum allowed order quantity for
each cost.
6. The quantity with the lowest TMC is optimal.
39
Example: EOQ with Quantity Discounts
A-1 Auto Parts has a regional tire warehouse in
Atlanta. One popular tire, the XRX75, has estimated
demand of 25,000 next year. It costs A-1 $100 to
place an order for the tires, and the annual carrying
cost is 30% of the acquisition cost. The supplier
quotes these prices for the tire:
Q ac
1 499 $21.60
500 999 20.95
1,000 + 20.90
40
Example: EOQ with Quantity Discounts
Economical Order Quantity



This quantity is not feasible, so try ac = $20.95


This quantity is feasible, so there is no reason to try
ac = $21.60

i i
EOQ = 2DS/C
3
EOQ = 2(25,000)100/(.3(20.90) = 893.00
2
EOQ = 2(25,000)100/(.3(20.95) = 891.93
41
Example: EOQ with Quantity Discounts
Compare Total Annual Material Costs (TMCs)
TMC = (Q/2)C + (D/Q)S + (D)ac
Compute TMC for Q = 891.93 and ac = $20.95
TMC
2
= (891.93/2)(.3)(20.95) + (25,000/891.93)100
+ (25,000)20.95
= 2,802.89 + 2,802.91 + 523,750
= $529,355.80

42
Example: EOQ with Quantity Discounts
Compute TMC for Q = 1,000 and ac = $20.90
TMC
3
= (1,000/2)(.3)(20.90) + (25,000/1,000)100
+ (25,000)20.90
= 3,135.00 + 2,500.00 + 522,500
= $528,135.00 (lower than TMC
2
)

The EOQ is 1,000 tires
at an acquisition cost of $20.90.
43
Determining Order Points
Basis for Setting the Order Point
DDLT Distributions
Setting Order Points

44
EOP = 2S / DC
Determining the EOP
Using an approach similar to that used to derive
EOQ, the optimal value of the fixed time between
orders is derived to be

45
Basis for Setting the Order Point
In the fixed order quantity system, the ordering
process is triggered when the inventory level drops to
a critical point, the order point
This starts the lead time for the item.
Lead time is the time to complete all activities
associated with placing, filling and receiving the
order.
. . . more
46
Basis for Setting the Order Point
During the lead time, customers continue to draw
down the inventory
It is during this period that the inventory is vulnerable
to stockout (run out of inventory)
Customer service level is the probability that a
stockout will not occur during the lead time
. . . more
47
Basis for Setting the Order Point
The order point is set based on
the demand during lead time (DDLT) and
the desired customer service level
Order point (OP) = Expected demand during lead
time (EDDLT) + Safety stock (SS)
The amount of safety stock needed is based on the
degree of uncertainty in the DDLT and the customer
service level desired
48
DDLT Distributions
If there is variability in the DDLT, the DDLT is
expressed as a distribution
discrete
continuous
In a discrete DDLT distribution, values (demands)
can only be integers
A continuous DDLT distribution is appropriate when
the demand is very high
49
Setting Order Point
for a Discrete DDLT Distribution
Assume a probability distribution of actual DDLTs is
given or can be developed from a frequency
distribution
Starting with the lowest DDLT, accumulate the
probabilities. These are the service levels for DDLTs
Select the DDLT that will provide the desired
customer level as the order point
50
Example: OP for Discrete DDLT Distribution
One of Sharp Retailers inventory items is now
being analyzed to determine an appropriate level of
safety stock. The manager wants an 80% service
level during lead time. The items historical DDLT
is:
DDLT (cases) Occurrences
3 8
4 6
5 4
6 2
51
OP for Discrete DDLT Distribution
Construct a Cumulative DDLT Distribution
Probability Probability of
DDLT (cases) of DDLT DDLT or Less
2 0 0
3 .4 .4
4 .3 .7
5 .2 .9
6 .1 1.0
To provide 80% service level, OP = 5 cases
.8
52
OP for Discrete DDLT Distribution
Safety Stock (SS)
OP = EDDLT + SS
SS = OP EDDLT
EDDLT = .4(3) + .3(4) + .2(5) + .1(6) = 4.0
SS = 5 4 = 1
53
Setting Order Point
for a Continuous DDLT Distribution
Assume that the lead time (LT) is constant
Assume that the demand per day is normally
distributed with the mean (d ) and the standard
deviation (o
d
)
The DDLT distribution is developed by adding
together the daily demand distributions across the
lead time
. . . more
54
Setting Order Point
for a Continuous DDLT Distribution
The resulting DDLT distribution is a normal
distribution with the following parameters:

EDDLT = LT(d)

o
DDLT
=
LT d ( ) o
2
55
Setting Order Point
for a Continuous DDLT Distribution
The customer service level is converted into a Z value
using the normal distribution table
The safety stock is computed by multiplying the Z
value by o
DDLT
.
The order point is set using OP = EDDLT + SS, or by
substitution

2
d
OP = LT(d) + z LT( )
56
Auto Zone sells auto parts and supplies
including a popular multi-grade motor oil. When the
stock of this oil drops to 20 gallons, a replenishment
order is placed. The store manager is concerned that
sales are being lost due to stockouts while waiting
for an order. It has been determined that lead time
demand is normally distributed with a mean of 15
gallons and a standard deviation of 6 gallons.
The manager would like to know the probability
of a stockout during lead time.
Example: OP - Continuous DDLT Distribution
57
Example: OP - Continuous DDLT Distribution
EDDLT = 15 gallons
o
DDLT
= 6 gallons

OP = EDDLT + Z(o
DDLT
)
20 = 15 + Z(6)
5 = Z(6)
Z = 5/6
Z = .833
58
Example: OP - Continuous DDLT Distribution
Standard Normal Distribution
0 .833
Area = .2967
Area = .5
Area = .2033
z
59
Example: OP - Continuous DDLT Distribution
The Standard Normal table shows an area of .2967
for the region between the z = 0 line and the z = .833
line. The shaded tail area is .5 - .2967 = .2033.
The probability of a stockout during lead time is
.2033
60
Set safety stock level at a percentage of EDDLT
OP = EDDLT + j(EDDLT)

where j is a factor between 0 and 3.
Set safety stock level at square root of EDDLT

OP = EDDLT +
Rules of Thumb in Setting OP
EDDLT
61
Fixed Order Period Systems
Behavior of Economic Order Period (EOP) Systems
Economic Order Period Model
62
Behavior of Economic Order Period Systems
As demand for the inventoried item occurs, the
inventory level drops
When a prescribed period of time (EOP) has elapsed,
the ordering process is triggered, i.e., the time
between orders is fixed or constant
At that time the order quantity is determined using
order quantity = upper inventory target - inventory
level + EDDLT
. . . more
63
Behavior of Economic Order Period Systems
After the lead time elapses, the ordered quantity is
received , and the inventory level increases
The upper inventory level may be determined by the
amount of space allocated to an item
This system is used where it is desirable to physically
count inventory each time an order is placed
64
Other Inventory Models
Hybrid Inventory Models
Single-Period Inventory Models
65
Hybrid Inventory Models
Optional replenishment model
Similar to the fixed order period model
Unless inventory has dropped below a prescribed
level when the order period has elapsed, no order
is placed
Protects against placing very small orders
Attractive when review and ordering costs are
large
. . . more
66
Hybrid Inventory Models
Base stock model
Start with a certain inventory level
Whenever a withdrawal is made, an order of equal
size is placed
Ensures that inventory maintained at an
approximately constant level
Appropriate for very expensive items with small
ordering costs
67
Single Period Inventory Models
Order quantity decision covers only one period
Appropriate for perishable items, e.g., fashion goods,
certain foods, magazines
Payoff tables may be used to analyze the decision
under uncertainty
. . . more
68
Single Period Inventory Models
One of the following rules can be used in the analysis
greatest profit
least total expected long and short costs
least total expected costs
69
Some Realities of Inventory Planning
ABC Classification
EOQ and Uncertainty
Dynamics of Inventory Planning
70
ABC Classification
Start with the inventoried items ranked by dollar
value in inventory in descending order
Plot the cumulative dollar value in inventory versus
the cumulative items in inventory
. . . more
71
ABC Classification
Typical observations
A small percentage of the items (Class A) make up
a large percentage of the inventory value
A large percentage of the items (Class C) make up
a small percentage of the inventory value
These classifications determine how much attention
should be given to controlling the inventory of
different items
72
EOQ and Uncertainty
The TSC and TMC curves are relatively flat,
therefore moving left or right of the optimal order
quantity on the order quantity axis has little effect on
the costs
Estimation errors of the values of parameter used to
compute an EOQ usually do not have a significant
impact on total costs
. . . more
73
EOQ and Uncertainty
Many costs are not directly incorporated in the EOQ
and EOP formulas, but could be important factors
Emergency procedures to replenish inventories
quickly should be established
74
Dynamics of Inventory Planning
Continually review ordering practices and decisions
Modify to fit the firms demand and supply patterns
Constraints, such as storage capacity and available
funds, can impact inventory planning
Computers and information technology are used
extensively in inventory planning
75
Wrap-Up: World-Class Practice
Inventory cycle is the central focus of independent
demand inventory systems
Production planning and control systems are
changing to support lean inventory strategies
Information systems electronically link supply chain
76
Inventories
The cost of inventories is reported on the balance sheet and
reflects the price of goods purchased from other companies
or the costs to manufacture those goods if internally
produced.
Costs will vary over time and for changes in market
conditions.
Consequently, the goods available for sale will likely vary
in cost from one period to the nexteven if the quantity of
goods available remains the same.
77
Inventories
Inventory costs either are reported on the balance
sheet or they are transferred to the income
statement as an expense (cost of goods sold) to
match against sales revenues.
The process for which costs are removed from the
balance sheet is important.
78
Capitalization Costs
Capitalization means that a cost is recorded on the
balance sheet and is not immediately expensed on the
income statement.
Once costs are capitalized, they remain on the balance
sheet as assets until they are used up, at which time they
are transferred from the balance sheet to the income
statement as expense.
If costs are capitalized rather than expensed, then assets,
current income, and current equity are all greater.
79
Cost Capitalization
For purchased inventories (such as with merchandisers),
the amount of cost capitalized is the purchase price.
For manufacturers, the capitalization issue is more
difficult.
Manufacturing costs consist of three components:
1. Raw materials
2. Direct labor
3. Manufacturing overhead (all manufacturing costs
except raw materials and direct labor)
80
Manufacturing Costs
Raw materials cost is relatively easy to compute. Design
specifications list the components of each product, and
their purchase costs are readily determined.
Labor cost in a unit of inventory is based on how long each
unit takes to build and the rates for each labor class
working on that product.
Overhead costs include the manufacturing plant
depreciation, utilities, plant supervisory personnel, and so
forth.
81
Cost of Goods Sold
When inventories are used up in production or are
sold, their cost is transferred from the balance
sheet to the income statement as cost of goods sold
(COGS). COGS is then matched against sales
revenue to yield gross profit:
Sales revenue
- COGS
Gross profit
82
The Cost of Goods Sold Computation
83
Inventory Cost Flows to
Financial Statements
84
Inventory Costing Methods
First-I n. First-Out (FI FO). This method assumes that the
first units purchased are the first units sold.
Last-I n, First-Out (LI FO). The LIFO inventory costing
method assumes that the last units purchased are the first
to be sold.
Average cost. The average cost method assumes that the
units are sold without regard to the order in which they
are purchased. Instead, it computes COGS and ending
inventories as a simple weighted average.

85
86
Inventory Costing Effects on
Income Statement
87
Inventory Costing Effects on
Balance Sheet
In periods of rising prices, and assuming that the
company has not previously liquidated older
layers of inventories, using LIFO would yield
ending inventories at costs that can be markedly
lower than replacement cost.
As a result, balance sheets using LIFO do not
accurately represent the current investment in
inventories.
88
Inventory Costing Effects on Cash Flows
In periods of rising prices, companies can get caught in a
cash flow squeeze as they pay higher taxes and must
replenish inventories at higher replacement costs than
originally purchased. This can lead to liquidity problems.
One reason frequently cited for using LIFO is the reduced
tax liability in periods of rising prices.
Companies using LIFO may also be required to disclose
the amount at which inventories would have been reported
had it used FIFO. The difference between these two
amounts is called the LIFO reserve.
89
CATs LIFO Reserve
90
Impairment of Inventories
Companies are required to write down the carrying amount of
inventories on the balance sheet if, at the statement date, the
reported cost exceeds their market value (determined as the
current replacement cost).
This is called reporting inventories at the lower of cost or
market.
Inventory book value is written down to market value.
Inventory write-down is reflected as an expense (part of
cost of goods sold) on the income statement.
91
Gross profit analysis
Gross profit ratio equals gross profit divided by sales. This
is an important ratio and is frequently monitored by
company management and external equity analysts alike.
The gross profit ratio is frequently used instead of the
dollar amount of gross profit as it allows for comparisons
across companies.
A decline in this ratio is usually cause for concern since it
indicates that the company has less ability to mark up the
cost of its products into selling prices.
92
Possible Causes for a Decline in Gross Profit Ratio
Some possible reasons for a decline in Gross Profit Ratio follow:
Product line is stale. Perhaps it is out of fashion and the
company has had to resort to markdowns to reduce
overstocked inventories. Or, perhaps the product lines
have lost their technological edge and are no longer in
demand.
New competitors enter the market. Since there are now
substitutes available from competitors, increased selling
prices is less likely.
General decline in economic activity. This could reduce
demand for its products. The recession of the early 2000s
resulted in reduced gross profits for many companies.
Inventory is overstocked. If a company produces too many
goods and finds itself in an overstock position, it can
reduce selling prices to move inventory.
93
Inventory Turnover Rates for Selected Companies
94
Long-Term Assets
Long-term assets mainly consist of property,
plant, and equipment (PPE).
These assets often makeup the largest asset
amounts.
Future expenses arising from these long-term
assets often makeup the larger expense amounts
typically reflected in depreciation expense and
asset write-downs.
95
Capitalization of Costs
An expenditure is only reflected on the balance sheet as an asset if it
possesses two characteristics:
1. It is owned or controlled by the entity, and
2. It provides future expected benefits.
Owning the asset means the entity has title to the asset as provided in
a purchase contract.
Future expected benefits usually mean cash inflows.
Companies can only capitalize costs for which the associated cash
inflows are directly linked.
The amount of costs that can be reported as an asset is limited to an
amount no greater than the expected future cash inflows from the
investment.
96
Capitalizing vs. Expensing
The qualification that only those costs for which
the associated cash inflows are directly linked is an
important one.
The following costs are typically expensed:
Research & Development (R&D)
Advertising Costs
Employee Wages
97
Depreciation Factors and Process
Depreciation requires the following estimates:
1. Useful life period of time over which the asset is
expected to generate cash inflows
2. Salvage value Expected disposal amount for the asset
at the end of its useful life
3. Depreciation rate an estimate of how the asset will be
used up over its useful life.
98
Depreciation Rate Assumptions
1. The asset is used up by the same amount each
period
2. The asset is used up more in the early years of its
useful life
3. The asset is used up in proportion to its actual
usage
99
Variance in Depreciation
A company can depreciate different assets using different depreciation
rates (and different useful lives).
Whatever depreciation rate is chosen, however, it must generally be
used throughout the useful life of that asset.
Changes to depreciation rates can be made, but they must be justified
as providing better quality financial reports.
The using up of an asset generally relates to physical or technological
obsolescence.
Physical obsolescence relates to an assets diminished capacity to
produce output.
Technological obsolescence relates to an assets diminished
efficiency in producing output in a competitive manner.
100
Depreciation Methods
All depreciation methods have the following
general formula:


Depreciation Methods:
1. Straight-line method
2. Accelerated Methods (Double-declining-
balance method)
101
Straight-line Method
Straight-line method: Under the straight-line (SL)
method, depreciation expense is recognized evenly
over the estimated useful life of the asset.
Consider the following example
An asset (machine) with the following details:
(1) cost of $100,000
(2) salvage value of $10,000
(3) useful life of 5 years
102
Straight-line Depreciation Example
For the straight-line method, we use our illustrative asset to
assign the following amounts to the depreciation formula:

103
SL Example
For the assets first year of usage, $18,000 ($90,000 * 20%) of
depreciation expense is reported in the income statement. At the end of
that first year the asset is reported on the balance sheet as follows:




Net book value (NBV) is cost less accumulated depreciation.
At the end of year 2, the net book value will be reduced by another
$18,000 to $64,000.
104
Double-declining-balance method
Double-declining-balance method. For the double-
declining-balance (DDB) method, we use our
illustrative asset to assign the following amounts to
the depreciation formula:

105
Double-declining-balance method
The asset is reported on the balance sheet as follows:



In the second year, $24,000 ($60,000 40%) of
depreciation expense is recorded in the income statement
and the NBV of the asset on the balance sheet follows:

106
DDB Depreciation Schedule
107
Comparison of Depreciation Methods
108
Units-of-Output Allocation Method (Allocation Varies
Each Period Depending upon Output)
Annual Allocation =


output s year' current
output total Estimated
salvage) estimated - (Cost

109
Example: Cost = $2,000,000
Estimated Salvage = $100,000
Estimated Useful Life = 8 years
Total Estimated Output Over Life
of Asset = 750,000 units
Current Year Output = 80,000 units
Current Year
Allocation

($2,000,000 - $100,000) 750,000
= $2.533 per unit 80,000 units
= $202,667