Materials: Inventory Systems and Costing

Learning objectives

By the end of this chapter you should be able to:

• Explain how materials move through an organisation and how inventory is controlled through key documents and authorisations.
• Calculate ordering and holding costs, and interpret the economic order quantity (EOQ) as a cost-minimising order size.
• Determine a reorder level (and when relevant, safety inventory) to reduce the risk of stockouts during supplier lead time.
• Cost material issues and closing inventory using FIFO and weighted average methods in a perpetual stores ledger.
• Identify common pitfalls (returns, discounts, stock discrepancies, and timing issues) and apply appropriate corrections and reconciliations.

Overview & key concepts

Materials (inventory) often represent a large proportion of working capital. Managing them well means having the right items available when needed, without holding more than necessary. Inventory decisions affect:

• cash tied up in stock (working capital),
• operating costs (storage, handling, insurance, deterioration),
• production continuity (avoiding stoppages caused by stockouts), and
• reported profit (through cost of sales and closing inventory valuation).

This chapter connects two perspectives:

1. Operational control(how stock is ordered, received, issued, and safeguarded).
2. Costing and reporting(how receipts and issues are priced, and how stock losses, returns, and discounts are recorded).

Inventory systems

Perpetual and periodic systems (what changes in practice)

• Perpetual system:the inventory record is updated for every receipt, issue, return, and adjustment. A stocktake checks reliability and identifies discrepancies.
• Periodic system:inventory is counted at intervals and cost of sales is derived from opening inventory + purchases − closing inventory.

A periodic system can still use strong control documents and authorisation routines; the main difference is how frequently the inventory record is updated, not whether controls exist.

This chapter focuses on a perpetual approach, because it aligns naturally with inventory control and stores ledger techniques.

Inventory control

Inventory control is a set of procedures designed to ensure:

• stock is available when required,
• losses and errors are reduced, and
• total inventory cost (ordering + holding + shortage/disruption costs) is kept under control.

A strong control environment normally includes:

• clear authorisation of purchases and issues,
• segregation of ordering, receiving, and recording duties,
• numbered documentation and systematic checks, and
• independent stock counts and investigation of differences.

Materials flow and documentation

Materials typically move through the organisation in the following sequence:

1. Identify need:a department raises a purchase requisition (internal request to buy).
2. Authorise purchase:purchasing issues a purchase order to the supplier.
3. Receive and inspect:goods arrive with supplier documentation; the receiving team checks quantity/condition and raises a goods received note.
4. Record receipt:the stores ledger is updated and the supplier invoice is processed.
5. Issue to production:production requests materials using a materials requisition note; stores issues goods and updates the ledger.
6. Review and count:stock counts confirm quantities and trigger investigation of any discrepancies.

A well-controlled materials cycle creates an evidence trail from request → approval → receipt → recording → issue. Each stage should leave a document or system record that supports the next stage, so that exceptions (unexpected quantities, unapproved purchases, price anomalies, missing deliveries) are flagged and investigated rather than absorbed into inventory balances.

Ordering and holding costs

Ordering costs

These are incurred each time an order is placed, regardless of order size (within a normal range). Examples include:

• supplier selection and purchase processing,
• ordering administration and approvals,
• delivery arrangement and receiving administration.

Holding costs

These arise from keeping inventory in store. Examples include:

• warehousing and handling,
• insurance and security,
• deterioration, obsolescence, and shrinkage risk,
• financing cost of cash tied up in stock (often reflected as an internal cost of capital).

The key idea is that ordering costs tend to fall when orders are less frequent, while holding costs tend to rise when average inventory is higher.

Economic order quantity (EOQ)

EOQ is a model that identifies the order quantity that minimises the total of ordering costs and holding costs under simplified assumptions.

EOQ = sqrt((2 × D × Co) / Ch)

Where:

• D = annual demand (units)
• Co = ordering cost per order
• Ch = holding cost per unit per year

EOQ assumptions (commonly tested)

EOQ works best when the following are assumed:

• demand is steady and known,
• ordering cost per order and holding cost per unit are stable,
• no planned shortages (stockouts) are allowed,
• no quantity discountsapply (unit price does not change with order size), and
• replenishment arrives in a single deliveryat the end of lead time (not gradual replenishment during the period).

Interpretation:

• Ordering more than EOQ increases holding costs faster than it saves ordering costs.
• Ordering less than EOQ saves holding costs but increases ordering costs.

Reorder level and safety inventory

The reorder level is the stock level that triggers a new order so that inventory arrives before stock reaches zero (or an unacceptable level).

Reorder level (ROL) = demand per period × lead time (in the same periods)

If demand and/or lead time are uncertain, a safety buffer is added:

Reorder level (with safety inventory) = (expected demand during lead time) + safety inventory

Examiner-style note on “which demand” to use

• If the question providesmaximum usageandmaximum lead timeand asks for a conservative approach, a common approach is:
• ROL = maximum usage × maximum lead time
• If the question providesaverage usageandaverage lead time, use:
• ROL = average usage × average lead time
• (and add safety inventory if the requirement asks for it, or if the data clearly supports a buffer calculation).

Costing methods for issues and closing inventory

A stores ledger records receipts and issues in quantities and values. To value issues, a consistent pricing method is applied.

FIFO (first-in, first-out)

Issues are valued using the oldest costs first. Remaining inventory is valued using the most recent costs still in store.

• Helpful where physical flow broadly matches “oldest used first” (e.g., perishable goods).
• In periods of rising prices, FIFO tends to leave higher costs in closing inventory and lower costs in cost of issues.

Weighted average cost (AVCO)

An average unit cost is calculated and applied to issues.

Two common approaches:

• Moving weighted average (perpetual):recalculate the average after each receipt.
• Periodic weighted average:compute one average for the entire period.

Moving weighted average smooths price changes and reduces the impact of timing on issue costs.

Mini illustration: moving weighted average after a receipt

Suppose the ledger shows 100 units at £4.00 (value £400). A receipt arrives: 60 units at £4.50 (value £270). New average cost:

New average cost = total value / total units
New average cost = (£400 + £270) / (100 + 60)
New average cost = £670 / 160 = £4.1875 per unit

Any subsequent issues are priced at £4.1875 per unit until the next receipt changes the average.

Discounts, returns and adjustments (ledger treatment)

Trade discounts

Trade discounts reduce the purchase price and are reflected directly in the inventory cost (record receipts at the net price).

Settlement discounts (early payment discounts)

A settlement discount depends on how and when the invoice is paid, not on the supplier’s list price. For internal costing, organisations choose a policy that keeps inventory and issue costs sensible and consistent. For financial reporting, practice varies by policy and materiality; whichever approach is used, the aim is to avoid overstating inventory and cost of sales.

Two common approaches are:

1. Treat the discount as reducing the effective purchase cost when it is actually taken.This prevents inventory and material costs being overstated when the discount is earned.
2. Record the discount separately (for example, as other income/finance benefit) and leave the recorded purchase cost unchanged.

In a perpetual stores ledger, timing matters. If you reduce the batch cost and some units from that batch have already been issued, you must also adjust the cost of those issues for the units already issued (otherwise inventory may be correct but cost of issues/cost of sales will be misstated, and the ledger will not reconcile cleanly).

Returns to suppliers

When goods are returned, reverse the inventory at the same unit cost used when the goods were originally recorded (typically the batch cost in FIFO, or the prevailing average cost in AVCO).

Stock discrepancies (shrinkage and errors)

A stocktake may reveal missing units (theft, damage, evaporation, miscounts) or record errors. In a perpetual system, discrepancies are recorded as an adjustment (often an inventory loss) and investigated. Under FIFO, write-offs are normally priced using the oldest costs still in store at the date of the adjustment; under AVCO, the write-off uses the current average cost.

Impact on financial statements

Inventory affects:

• Statement of financial position:inventory is a current asset; errors directly affect working capital.
• Profit:issue pricing determines material cost (and for a manufacturer, cost of production). Overstated closing inventory overstates profit; understated closing inventory understates profit.
• Cash:ordering patterns and reorder levels influence how much cash is locked into inventory.

Worked example

Narrative scenario

A manufacturing company uses a perpetual inventory system for a single raw material. During March 2026 the following occurred:

• Opening inventory: 500 units at £10.00 each.
• Receipt 1: 1,000 units at £9.50 each.
• Issue 1 to production: 800 units.
• Return to supplier: 50 defective units from the £9.50 batch (credit note received).
• Receipt 2: 500 units at £9.80 each.
• Issue 2 to production: 400 units.
• Stocktake at month end reveals 5 units missing (shrinkage).
• The company takes a 2% settlement discount on Receipt 2 by paying within the discount period.

Additional data for planning calculations:

• Annual demand (D): 18,000 units
• Ordering cost per order (Co): £45
• Holding cost per unit per year (Ch): £0.60
• Working year: 250 days
• Lead time: 10 days

Required

1. Calculate the EOQ.
2. Determine the reorder level.
3. Cost issues to production using FIFO.
4. Value closing inventory using FIFO (including the effects of returns, shrinkage, and settlement discount policy).
5. Reconcile the stores ledger (quantities and values).

Solution

1) EOQ

EOQ = sqrt((2 × D × Co) / Ch)

EOQ = sqrt((2 × 18,000 × 45) / 0.60)
EOQ = sqrt(2,700,000)
EOQ ≈ 1,643 units

2) Reorder level

Daily demand:

Daily demand = 18,000 / 250
Daily demand = 72 units per day

Reorder level:

ROL = daily demand × lead time
ROL = 72 × 10
ROL = 720 units

(If safety inventory were required, it would be added to 720 units.)

3) Cost issues to production using FIFO

Transaction 1: Opening inventory

• 500 units @ £10.00

Transaction 2: Receipt 1

• 1,000 units @ £9.50

Transaction 3: Issue 1 (800 units)

FIFO issues the oldest costs first:

• 500 @ £10.00 = £5,000
• 300 @ £9.50 = £2,850

Issue 1 value = £7,850

Remaining after Issue 1:

• 700 units @ £9.50 (because 1,000 − 300 = 700)

Transaction 4: Return to supplier (50 units from £9.50 batch)

• 50 @ £9.50 = £475 (reduces inventory)

Remaining after return:

• 650 units @ £9.50

Transaction 5: Receipt 2

• 500 units @ £9.80 (before settlement discount adjustment)

Transaction 6: Issue 2 (400 units)

FIFO uses the oldest remaining layer:

• 400 @ £9.50 = £3,800

Issue 2 value = £3,800

Total issues to production:

Total issue value = £7,850 + £3,800 = £11,650

Remaining before stocktake:

• 250 units @ £9.50 (650 − 400)
• 500 units @ £9.80

4) Closing inventory valuation using FIFO (including shrinkage and settlement discount)

Transaction 7: Stocktake shrinkage (5 units missing)

Write off the oldest units still in store (FIFO):

• 5 @ £9.50 = £47.50

Remaining after shrinkage:

• 245 units @ £9.50
• 500 units from Receipt 2

Transaction 8: Settlement discount on Receipt 2 (2%)

Receipt 2 invoice value: 500 × £9.80 = £4,900
Discount (2%): £98
Net cost for Receipt 2 batch: £4,802

Net unit cost for Receipt 2 batch:

Net unit cost = £9.80 × (1 − 0.02)
Net unit cost = £9.604 per unit

(Here, the discount is treated as reducing the effective purchase cost when taken. Note: if any units from Receipt 2 had been issued before the discount was confirmed, the issue cost for those units would also need adjustment. In this scenario, Issue 2 comes from the £9.50 layer, so no issue-cost adjustment is required.)

Closing inventory valuation:

• 245 @ £9.50 = £2,327.50
• 500 @ £9.604 = £4,802.00

Closing inventory value = £2,327.50 + £4,802.00 = £7,129.50

Closing inventory quantity:

Closing units = 245 + 500 = 745 units

5) Reconcile the stores ledger

Quantity reconciliation

Opening units: 500
Receipts: +1,000 +500 = +1,500
Goods available: 2,000

Issues: −800 −400 = −1,200
Return to supplier: −50
Shrinkage: −5

Closing units = 2,000 − 1,200 − 50 − 5 = 745 units

Value reconciliation (FIFO, with settlement discount reducing Receipt 2 batch cost)

Opening value: 500 × £10.00 = £5,000

Receipts at invoice prices:

• Receipt 1: 1,000 × £9.50 = £9,500
• Receipt 2: 500 × £9.80 = £4,900
• Total receipts (invoice) = £14,400

Settlement discount taken on Receipt 2: £98
Net receipts recognised in inventory = £14,302

Issues to production (from above): £11,650
Returns to supplier: 50 × £9.50 = £475
Shrinkage write-off: 5 × £9.50 = £47.50

Closing value:

Closing value = £5,000 + £14,302 − £11,650 − £475 − £47.50
Closing value = £7,129.50

This agrees to the closing inventory valuation from the remaining FIFO layers.

Common pitfalls and misunderstandings

• Using inconsistent time units in reorder calculations:lead time and demand must be in matching periods (days with days, weeks with weeks).
• Not spotting whether the question expects average or maximum values:conservative reorder levels commonly use maximum usage and maximum lead time where provided.
• Mixing up ordering and holding costs in EOQ:ordering cost is per order; holding cost is per unit per year.
• Forgetting EOQ assumptions:quantity discounts and gradual replenishment break the basic EOQ model.
• Treating returns at the wrong price:return inventory at the same recorded unit cost for that batch (FIFO) or the prevailing average (AVCO).
• Ignoring stocktake adjustments in a perpetual system:missing stock must be written off and investigated; otherwise records will not agree to physical stock.
• Applying FIFO “in total” rather than transaction-by-transaction:FIFO depends on layers remaining after each movement; sequence matters.
• Settlement discounts handled without timing logic:if the batch cost is adjusted after some units are already issued from that batch, issue costs must be adjusted too.
• Assuming EOQ is always feasible:supplier minimum order quantities, storage limits, and volatile demand can override the model output.

Summary

Inventory management links operational reliability with financial performance. EOQ helps identify an order size that balances ordering and holding costs under simplified assumptions, while reorder levels support continuity by triggering replenishment before stock runs out. FIFO and weighted average provide systematic methods to value material issues and closing inventory in a perpetual ledger. Accurate treatment of returns, discounts, and stock discrepancies is essential for reliable inventory records and meaningful cost information.

FAQ

What does EOQ actually minimise?

EOQ minimises the combined cost of placing orders and holding inventory, assuming stable demand and costs, no quantity discounts, and replenishment arriving in one delivery after lead time.

Why does FIFO often change reported profit when prices move?

FIFO issues older costs first. If purchase prices rise, FIFO typically records lower costs in issues (higher profit) and higher costs in closing inventory (higher asset). If prices fall, the effect can reverse.

When is weighted average more suitable than FIFO?

Weighted average is often preferred when receipts occur frequently at varying prices and the business wants a smoother issue cost that is less sensitive to the timing of purchases.

How should shrinkage be treated?

Shrinkage is recorded as an inventory reduction with a corresponding expense (often an inventory loss). The write-off is priced using the method applied in the ledger (FIFO layers or the current average cost).

How should settlement discounts be treated in a stores ledger?

Policies differ. Some organisations adjust the effective purchase cost when the discount is actually taken; others record it separately as income/finance benefit. Whichever policy is used, the aim is to avoid overstating inventory and cost of sales, and the timing must be handled correctly (adjust issue costs too if units were issued from the discounted batch before the adjustment).

Glossary

Inventory
Materials and goods held for use in production or for sale, normally presented as a current asset.

Perpetual inventory system
A system where inventory records are updated continuously for each receipt, issue, return, and adjustment.

Periodic inventory system
A system where inventory records are updated at intervals, and cost of sales is derived from opening inventory + purchases − closing inventory.

Stores ledger
A detailed record of inventory movements showing quantities and values for receipts, issues, and balances.

Ordering cost
Cost incurred each time an order is placed (e.g., procurement processing and receiving administration).

Holding cost
Cost of carrying inventory (e.g., storage, insurance, handling, obsolescence, and the cost of funds tied up).

Economic order quantity (EOQ)
The order quantity that minimises combined ordering and holding costs under simplified assumptions.
EOQ = sqrt((2 × D × Co) / Ch)

Lead time
Time between placing an order and receiving goods into store.

Reorder level (ROL)
The stock level at which a new order should be placed.
ROL = demand per period × lead time

Safety inventory
Extra units held to reduce the risk of stockouts when demand or lead time is uncertain.

FIFO
Issue pricing method where issues are costed using the oldest inventory costs first.

Weighted average (AVCO)
Issue pricing method where an average cost per unit is used (recalculated after each receipt in a perpetual system, or for the period in a periodic system).

Trade discount
A reduction in list price granted at the point of sale, reflected directly in the recorded purchase price.

Settlement discount
A reduction in the amount payable granted for early payment. Depending on policy, it may be treated as an adjustment to effective purchase cost when taken, or recorded separately as income/finance benefit.

Shrinkage
Unexplained inventory losses revealed by stock counts (e.g., theft, damage, miscounts, or recording errors).