ANALYSIS OF INVENTORIES

ANALYSIS OF INVENTORIES

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INTRODUCTION

• Compare the effects of the FIFO/ LIFO choice along these dimensions and demonstrates how the analyst can adjust from one method to another.


Inventory Management

• Inventory is one of the most expensive assets of many companies.

• It represents as much as 40% of total invested capital.


Inventory Management

• Inventory is any stored resource that is used to satisfy a current or future need.

• Raw materials, work-in-process, and finished goods are examples of inventory.

• Two basic questions in inventory management are (1) how much to order (or produce), and (2) when to order (or produce).


FIFO/ LIFO

• EI = BI + P – COGS• BI + P = COGS + EIP: the purchase of goodsCOGS: cost of goods saleBI: the beginning saleEI: the ending inventory


COSTS INCLUDED IN INVENTORIES >< COSTS RECOGNIZED AS EXPENSES IN THE PERIOD

• Costs included in inventories: (product costs)- Purchase cost less trade discounts and rebates- Conversion costs including labor and overhead- Other costs necessary to bring the inventory

to its present location and condition


• Costs recognized as expenses in the period (period costs)

- Abnormal waste of materials, labor or overhead.

- Storage costs (unless required as part of production)

- Administrative overhead- Selling costs


EXAMPLE: COSTS INCLUDED IN INVENTORY


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• Vindaloo company manufactures a single product. The following information was taken from the company’s production and cost records last year:

Units produced: 5000Raw materials: 15.000Conversion cost for finished goods: 20.000Freight in to plant: 800Storage cost for finished goods: 500Abnormal waste: 100Freight out to customers: 1.100

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Question: assuming no abnormal waste is

included in conversion cost, calculate the total

capitalized cost? Cost per unit?


INVENTORY VALUATION METHODS

• Specific identification• FIFO• LIFO• Weighted average cost


• Use the inventory example data in the following figure to calculate the COGS and ending inventory under the FIFO, LIFO, and weighted average cost methods

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Jan 1 (beginning inventory)

2 units x $2 per unit $4

Jan 7 purchase 3 units x $3 per unit $9

Jan 19 purchase 5 units x $ 5 per unit $25

Cost of goods availble 10 units $38

Units sold during Jan 7 units



SCENARY 1: STABLE PRICE

• BI + P = COGS + EI• $ 2000 + $ 5000 = $ 4000 + $ 3000


SCENARY 2: RISING PRICES

• FIFO:BI + P = COGS + EI$ 2000 + $ 6250 = $ 4300 + $ 3950

• LIFO:BI + P = COGS + EI$ 2000 + $ 6250 = $ 5150 + $ 3100


COMPARISION OF INFORMATION PROVIDED BY ALTERNATIVE METHODS

• Balance sheet Information: Inventory account

- LIFO: the earliest costs to cost of goods sold, leaving the most recent costs in ending inventory.

- FIFO: the earliest costs to ending inventory


• Income statement information: Cost of goods sold:

- LIFO: the most informative accounting method in that it provides a better measure of current income and future profitability.

- FIFO: provides the best measure for the balance sheet


LIFO VERSUS FIFO: INCOME, CASH FLOW AND WORKING CAPITAL EFFECTS

LIFO FIFO

Cost of goods sold Higher Lower

Income before taxes Lower Higher

Income taxes Lower Higher

Net income Lower Higher

Cash flows Higher Lower

Inventory balance Lower Higher

Working capital lower Higher


The income statement

FIFO LIFO

Sales $ 10.000 $ 10.000

COGS 4300 5150

Income before tax 5700 4850

Tax 40% 2280 1940

Net income 3420 2910


The cash flows

FIFO LIFO

Sales inflows $ 10.000 $ 10.000

Purchases 6250 6250

Inflows before tax 3750 3750

Tax paid 2280 1940

Net cash flows 1470 1810


The change in balance sheet accountFIFO LIFO

Cash $ 1470 $ 1810

Inventory 1950 1100

Working capital 3420 2910

Retained earnings 3420 2910

Cash: net cash flow for periodInventory: purchases less COGSRetained earning: net income for period


PERPETUAL VERSUS PERIODIC INVENTORY SYSTEMS

• Periodic inventory system: inventory values and COGS are determined at the end of the accounting period.

• Perpetual inventory system: inventory values and COGS are updated continuously.


• Calculate COGS and ending inventory under the FIFO and LIFO cost flow methods using a perpetual inventory system

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Jan 1 (beginning inventory) 2 units x $ 2 per unit

Jan 7 purchase 3 units x $ 3 per unit

Jan 12 sale 4 units

Jan 19 purchase 5 units x $5 per unit

Jan 29 sale 3 units


FINANCIAL RATIOS: FIFO VERSUS LIFO

• Profitability: gross profit margin: assuming inflation, higher COGS under LIFO will result in lower gross profit.


QUARTER COST PRICE UNITS DOLLARS

1 $ 11 $ 22 100 2200

2 $ 12 $ 24 100 2400

3 $ 13 $ 26 100 2600

4 $ 14 $ 28 100 2800

TOTAL 400 10.000

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SALES COGS GROSS PROFIT

PERCENT

FIFO 10.000 4300 5700 5700/10.000 = 57%LIFO 10.000 5150 4850 4850/ 10.000 = 48,5%


• Liquidity: working capital: the FIFO is better than the LIFO due to the inventory components of working capital carries outdated costs.

• Activity: Inventory Turnover: meaning less for LIFO firms due to the mismatching of costs, thus under the LIFO, when prices increase, trend higher irrespective of the trend of physical turnover.


LIFO/ FIFO CHOICE

• The choice of inventory method was closely related to industry and size factors.

• Large firms tend to choose the LIFO and conversely

• LIFO increases inventory management and control costs.


ANALYSIS OF INVENTORIES

Documents

hngng th

jan7 unitsng th

cost records

cost of goods salebi

ending inventory

cost of goods availble10

inventories costs

inventory accountlifo