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# Inventory Cost Flow Assumptions

 p. 404Regardless of whether the perpetual or periodic system is used, it's necessary to assign dollar amounts to the physical quantities of goods sold and goods remaining in ending inventory. Unless each item of inventory is specifically identified and traced through the system, assigning dollars is accomplished by making an assumption regarding how units of goods (and their associated costs) flow through the system. We examine the common cost flow assumptions next. In previous illustrations, dollar amounts of the cost of goods sold and the cost of ending inventory were assumed known. However, if various portions of inventory are acquired at different costs, we need a way to decide which units were sold and which remain in inventory. Illustration 8-5 will help explain. ●  LO4

 ILLUSTRATION 8-5Cost FlowGoods available for sale include beginning inventory plus purchases.

The Browning Company began 2011 with \$22,000 of inventory. The cost of beginning inventory (Beg. inv.) is composed of 4,000 units purchased for \$5.50 each. Merchandise transactions during 2011 were as follows:

As the data show, 7,000 units were purchased during 2011 at various prices and 6,500 units were sold. What is the cost of the 6,500 units sold? If all units, including beginning inventory, were purchased at the same price, then the answer would be simple. However, that rarely is the case.

The year started with 4,000 units, 7,000 units were purchased, and 6,500 units were sold. This means 4,500 units remain in ending inventory. This allocation of units available for sale is depicted in Graphic 8-3.

GRAPHIC 8-3
Allocation of Units Available

If a periodic system is used, what is the cost of the 4,500 units in ending inventory? In other words, which of the 11,000 (4,000 + 7,000) units available for sale were sold? Are they the more expensive ones bought toward the end of the year, or the less costly ones acquired before prices increased? Using the numbers given, let's consider the question as follows:

p. 405

The \$71,500 in cost of goods available for sale must be allocated to ending inventory and cost of goods sold. The allocation decision is depicted in Graphic 8-4.

GRAPHIC 8-4
Allocation of Cost of Goods Available

Let's turn our attention now to the various inventory methods that can be used to achieve this allocation.

Specific Identification

It's sometimes possible for each unit sold during the period or each unit on hand at the end of the period to be matched with its actual cost. Actual costs can be determined by reference to the invoice representing the purchase of the item. This method is used frequently by companies selling unique, expensive products with low sales volume which makes it relatively easy and economically feasible to associate each item with its actual cost. For example, automobiles have unique serial numbers that can be used to match a specific auto with the invoice identifying the actual purchase price.

The specific identification method each unit sold during the period or each unit on hand at the end of the period to be matched with its actual cost., however, is not feasible for many types of products either because items are not uniquely identifiable or because it is too costly to match a specific purchase price with each item sold or each item remaining in ending inventory. Most companies use cost flow methods to determine cost of goods sold and ending inventory. Cost flow methods are based on assumptions about how inventory might flow in and out of a company. However, it's important to note that the actual flow of a company's inventory does not have to correspond to the cost flow assumed. The various motivating factors that influence management's choice among alternative methods are discussed later in this chapter. We now explore the three most common cost flow methods: average cost, first-in, first-out (FIFO) and last-in, first-out (LIFO).

 Average CostThe average cost method assumes cost of goods sold and ending inventory consist of a mixture of all the goods available for sale. assumes that cost of goods sold and ending inventory consist of a mixture of all the goods available for sale. The average unit cost applied to goods sold or to ending inventory is not simply an average of the various unit costs of purchases during the period but an average unit cost weighted by the number of units acquired at the various unit costs. The average cost method assumes that items sold and items in ending inventory come from a mixture of all the goods available for sale.
 p. 406PERIODIC AVERAGE COST.  In a periodic inventory system, this weighted average is calculated at the end of the period as follows: (K) In a perpetual inventory system, the average cost method is applied by computing a moving-average unit cost each time additional inventory is purchased.

The calculation of average cost is demonstrated in Illustration 8-5A using data from Illustration 8-5.

 ILLUSTRATION 8-5AAverage Cost—Periodic Inventory System

Cost of goods sold also could be determined directly by multiplying the weighted-average unit cost of \$6.50 by the number of units sold (\$6.50 × 6,500 = \$42,250).

PERPETUAL AVERAGE COST. The weighted-average unit cost in a perpetual inventory system becomes a moving-average unit cost. A new weighted-average unit cost is calculated each time additional units are purchased. The new average is determined after each purchase by (1) summing the cost of the previous inventory balance and the cost of the new purchase, and (2) dividing this new total cost (cost of goods available for sale) by the number of units on hand (the inventory units that are available for sale). This average is then used to cost any units sold before the next purchase is made. The moving-average concept is applied in Illustration 8-5B.

 ILLUSTRATION 8-5BAverage Cost—Perpetual Inventory System

On January 17 the new average of \$5.667 (rounded) is calculated by dividing the \$17,000 cost of goods available (\$11,000 from beginning inventory + \$6,000 purchased on January 17) by the 3,000 units available (2,000 units from beginning inventory + 1,000 units acquired on January 17). The average is updated to \$6.333 (rounded) with the March 22 purchase. The 1,500 units sold on April 15 are then costed at the average cost of \$6.333.

p. 407

Periodic average cost and perpetual average cost generally produce different allocations to cost of goods sold and ending inventory.

First-In, First-Out (FIFO)

 The first-in, first-out (FIFO) method assumes that units sold are the first units acquired. Beginning inventory is sold first, followed by purchases during the period in the chronological order of their acquisition. In our illustration, 6,500 units were sold during 2011. Applying FIFO, these would be the 4,000 units in beginning inventory, the 1,000 units purchased on January 17, and 1,500 of the 3,000 units from the March 22 purchase. By default, ending inventory consists of the most recently acquired units. In this case, the 4,500 units in ending inventory consist of the 3,000 units purchased on October 15, and 1,500 of the 3,000 units purchased on March 22. Graphically, the flow is as follows: The first-in, first-out (FIFO) method assumes that items sold are those that were acquired first.Ending inventory applying FIFO consists of the most recently acquired items.FIFO flow

PERIODIC FIFO. Recall that we determine physical quantities on hand in a periodic inventory system by taking a physical count. Costing the 4,500 units in ending inventory this way automatically gives us the cost of goods sold as well. Using the numbers from our illustration, we determine cost of goods sold to be \$38,500 by subtracting the \$33,000 ending inventory from \$71,500 cost of goods available for sale as shown in Illustration 8-5C.

 ILLUSTRATION 8-5CFIFO—Periodic Inventory System

Of course, the 6,500 units sold could be costed directly as follows:

p. 408

PERPETUAL FIFO. The same ending inventory and cost of goods sold amounts are always produced in a perpetual inventory system as in a periodic inventory system when FIFO is used. This is because the same units and costs are first in and first out whether cost of goods sold is determined as each sale is made or at the end of the period as a residual amount. The application of FIFO in a perpetual system is shown in Illustration 8-5D.

 ILLUSTRATION 8-5DFIFO—Perpetual Inventory System

Last-In, First-Out (LIFO)

 The last-in, first-out (LIFO) method assumes units sold are the most recent units purchased. assumes that the units sold are the most recent units purchased. In our illustration, the 6,500 units assumed sold would be the 6,500 units acquired most recently: the 3,000 units acquired on October 15, the 3,000 units acquired on March 22, and 500 of the 1,000 units purchased on January 17. Ending inventory, then, consists of the units acquired first; in this case, the 4,000 units from beginning inventory and 500 of the 1,000 units purchased on January 17. Graphically, the flow is as follows: The last-in, first-out (LIFO) method assumes that items sold are those that were most recently acquired.Ending inventory applying LIFO consists of the items acquired first.LIFO flow

PERIODIC LIFO.  The cost of ending inventory determined to be \$25,000 (calculated below) by the LIFO assumption and using a periodic system is subtracted from cost of goods available for sale to arrive at the cost of goods sold of \$46,500 as shown in Illustration 8-5E.

p. 409

 ILLUSTRATION 8-5ELIFO—Periodic Inventory System

The 6,500 sold could be costed directly as follows:

PERPETUAL LIFO. The application of LIFO in a perpetual system is shown in Illustration 8-5F. Each time inventory is purchased or sold, the LIFO layers are adjusted. For example, after the March 22 purchase, we have three layers of inventory at different unit costs listed in the chronological order of their purchase. When 1,500 units are sold on April 15, we assume they come from the most recent layer of 3,000 units purchased at \$7.00.

 ILLUSTRATION 8-5FLIFO—Perpetual Inventory System

Notice that \$44,000 of the cost of goods available for sale is allocated to cost of goods sold by perpetual LIFO and \$27,500 to ending inventory (the balance after the last transaction), which is different from the periodic LIFO result of \$46,500 and \$25,000. Unlike FIFO, applying LIFO in a perpetual inventory system will generally result in an ending inventory and cost of goods sold different from the allocation arrived at applying LIFO in a periodic system. Periodic LIFO applies the last-in, first-out concept to total sales and total purchases only at the conclusion of the reporting period. Perpetual LIFO applies the same concept, but several times during the period—every time a sale is made.

 p. 410   For example, when 2,000 units are sold on January 10, perpetual LIFO costs those units at \$5.50, the beginning inventory unit cost. Periodic LIFO, by contrast, would be applied at year-end. By the end of the year, enough purchases have been made that the beginning inventory would be assumed to remain intact, and the January 10 units sold would be costed at a more recent price. Perpetual LIFO generally results in cost of goods sold and inventory amounts that are different from those obtained by applying periodic LIFO.

Comparison of Cost Flow Methods

 The three cost flow methods are compared below assuming a periodic inventory system. Comparison of cost flow methods

Notice that the average cost method in this example produces amounts that fall in between the FIFO and LIFO amounts for both cost of goods sold and ending inventory. This will usually be the case. Whether it will be FIFO or LIFO that produces the highest or lowest value of cost of goods sold and ending inventory depends on the pattern of the actual unit cost changes during the period.

 During periods of generally rising costs, as in our example, FIFO results in a lower cost of goods sold than LIFO because the lower costs of the earliest purchases are assumed sold. LIFO cost of goods sold will include the more recent higher cost purchases. On the other hand, FIFO ending inventory includes the most recent higher cost purchases which results in a higher ending inventory than LIFO. LIFO ending inventory includes the lower costs of the earliest purchases. Conversely, if costs are declining, then FIFO will result in a higher cost of goods sold and lower ending inventory than LIFO.7 If unit costs are increasing, LIFO will result in a higher cost of goods sold and lower ending inventory than FIFO.

Each of the three methods is permissible according to generally accepted accounting principles and frequently is used. Also, a company need not use the same method for all of its inventory. For example, International Paper Company uses LIFO for its raw materials and finished pulp and paper products, and both the FIFO and average cost methods for other inventories. Because of the importance of inventories and the possible differential effects of different methods on the financial statements, a company must identify in a disclosure note the method(s) it uses. The chapter's opening case included an example of this disclosure for ConocoPhillips, and you will encounter additional examples later in the chapter.

 FINANCIALReporting Case

Q1,p.395
A company must disclose the inventory method(s) it uses.

Graphic 8-5 shows the results of a survey of inventory methods used by 500 large public companies in 2008 and 600 companies in 1973.8 FIFO is the most popular method in both periods, but there has been a significant increase in the use of LIFO since the earlier period. Notice that the column total for the number of companies is greater than 500 (600 in 1973), indicating that many companies included in this sample do use multiple methods.

GRAPHIC 8-5
Inventory Cost Flow Methods Used in Practice

*“Other” includes the specific identification method and miscellaneous less popular methods.

p. 411

 INTERNATIONAL FINANCIAL REPORTING STANDARDS

Inventory Cost Flow Assumptions. IAS No. 29 does not permit the use of LIFO. Because of this restriction, many U.S. multinational companies use LIFO only for their domestic inventories and FIFO or average cost for their foreign subsidiaries. A disclosure note included in a recent annual report of General Mills provides an example:

Inventories (in part)
 All inventories in the United States other than grain are valued at the lower of cost, using the last-in, first-out (LIFO) method, or market. … Inventories outside of the United States are valued at the lower of cost, using the first-in, first-out (FIFO) method, or market.

Real World Financials

This difference could prove to be a significant impediment to U.S. convergence to international standards. Unless the U.S. Congress repeals the LIFO conformity rule (see page 412), convergence would cause many corporations to lose a valuable tax shelter, the use of LIFO for tax purposes. If these companies were immediately taxed on the difference between LIFO inventories and inventories valued using another method, it would cost companies billions of dollars. Some industries would be particularly hard hit. Most oil companies and auto manufacturers, for instance, use LIFO. As an example, it would cost ExxonMobil over \$4 billion. The companies affected most certainly will lobby heavily to retain the use of LIFO for tax purposes.

 DECISION MAKERS’ PERSPECTIVE—Factors Influencing Method Choice
 What factors motivate companies to choose one method over another? What factors have caused the increased popularity of LIFO? Choosing among alternative accounting methods is a complex issue. Often such choices are not made in isolation but in such a way that the combination of inventory cost flow assumptions, depreciation methods, pension assumptions, and other choices meet a particular objective. Also, many believe managers sometimes make these choices to maximize their own personal benefits rather than those of the company or its external constituents. But regardless of the motive, the impact on reported numbers is an important consideration in each choice of method. The inventory choice determines (a) how closely reported costs reflect the actual physical flow of inventory, (b) the timing of reported income and income tax expense, and (c) how well costs are matched with associated revenues. (K) (9.0K) LO5

PHYSICAL FLOW.  If a company wanted to choose a method that most closely approximates specific identification, then the actual physical flow of inventory in and out of the company would motivate the choice of method.

 For example, companies often attempt to sell the oldest goods in inventory first for some of their products. This certainly is the case with perishable goods such as many grocery items. The FIFO method best mirrors the physical flow in these situations. The average cost method might be used for liquids such as chemicals where items sold are taken from a mixture of inventory acquired at different times and different prices. There are very few inventories that actually flow in a LIFO manner. It is important for you to understand that there is no requirement that companies choose an inventory method that approximates actual physical flow and few companies make the choice on this basis. In fact, as we discuss next, the effect of inventory method on income and income taxes is the primary motivation that influences method choice. A company is not required to choose an inventory method that approximates actual physical flow.
p. 412

INCOME TAXES AND NET INCOME.  If the unit cost of inventory changes during a period, the inventory method chosen can have a significant effect on the amount of income reported by the company to external parties and also on the amount of income taxes paid to the Internal Revenue Service (IRS) and state and local taxing authorities. Over the entire life of a company, cost of goods sold for all years will equal actual costs of items sold regardless of the inventory method used. However, as we have discussed, different inventory methods can produce significantly different results in each particular year.

 When prices rise and inventory quantities are not decreasing, LIFO produces a higher cost of goods sold and therefore lower net income than the other methods. The company's income tax returns will report a lower taxable income using LIFO and lower taxes will be paid currently. Taxes are not reduced permanently, only deferred. The reduced amount will be paid to the taxing authorities when either the unit cost of inventory or the quantity of inventory subsequently declines. However, we know from our discussion of the time value of money that it is advantageous to save a dollar today even if it must be paid back in the future. Recall from the recent survey results exhibited earlier that the popularity of LIFO increased significantly between 1973 and 2008. The main reason for this increased popularity is attributable to high inflation (increasing prices) during the 1970s which motivated many companies to switch to LIFO in order to gain this tax benefit. Many companies choose LIFO in order to reduce income taxes in periods when prices are rising.

A corporation's taxable income comprises revenues, expenses (including cost of goods sold), gains, and losses measured according to the regulations of the appropriate taxing authority. Income before tax as reported in the income statement does not always equal taxable income. In some cases, differences are caused by the use of different measurement methods.10 However, IRS regulations, which determine federal taxable income, require that if a company uses LIFO to measure taxable income, the company also must use LIFO for external financial reporting. This is known as the LIFO conformity rule if a company uses LIFO to measure taxable income, the company also must use LIFO for external financial reporting. with respect to inventory methods.

 Because of the LIFO conformity rule, to obtain the tax advantages of using LIFO in periods of rising prices, lower net income is reported to shareholders, creditors, and other external parties. The income tax motivation for using LIFO may be offset by a desire to report higher net income. Reported net income could have an effect on a corporation's share price,11 on bonuses paid to management, or on debt agreements with lenders. For example, research has indicated that the managers of companies with bonus plans tied to income measures are more likely to choose accounting methods that maximize their bonuses (often those that increase net income).12 If a company uses LIFO to measure its taxable income, IRS regulations require that LIFO also be used to measure income reported to investors and creditors (the LIFO conformity rule ).

In 1981, the LIFO conformity rule was liberalized to permit LIFO users to report non-LIFO inventory valuations in a supplemental disclosure note, but not on the face of the income statement. For example, Graphic 8-6 shows the note provided in a recent annual report of The Great Atlantic & Pacific Tea Company, Inc., a large supermarket chain, disclosing its use of LIFO for part of its inventories.13

 FINANCIALReporting Case

Q2,p.395

LIFO RESERVES.  Many companies use LIFO for external reporting and income tax purposes but maintain their internal records using FIFO or average cost. There is a variety of reasons, including: (1) the high recordkeeping costs for LIFO, (2) contractual agreements such as bonus or profit sharing plans that calculate net income with a method other than LIFO, and (3) using FIFO or average cost information for pricing decisions.

p. 413

GRAPHIC 8-6
Inventories Disclosure—The Great Atlantic & Pacific Tea Company, Inc.

 Summary of Significant Accounting Policies (in part) InventoriesStore inventories are stated principally at the lower of cost or market. As of February 28, 2009, and February 28, 2008, cost of 61.0% and 61.1% of our inventories, respectively, was determined using the first-in, first-out (“FIFO”) method and the cost of 39.0% and 38.9% of our inventories was determined using the last-in, first-out (“LIFO”) method. At February 28, 2009, and February 23, 2008, if valued on a FIFO basis, the LIFO inventory carrying values would have been approximately \$10 million and \$2 million higher, respectively. Real World Financials●  LO6

Generally, the conversion to LIFO from the internal records occurs at the end of the reporting period without actually entering the adjustment into the company's records. Some companies, though, enter the conversion adjustment—the difference between the internal method and LIFO—directly into the records as a “contra account” to inventory. This contra account is called either the LIFO reserve or the LIFO allowance.

For illustration, let's say that the Doubletree Corporation began 2011 with a balance of \$475,000 in its LIFO reserve account, the difference between inventory valued internally using FIFO and inventory valued using LIFO. At the end of 2011, assume this difference increased to \$535,000. The entry to record the increase in the reserve is:

If the difference between inventory valued internally using FIFO and inventory valued using LIFO had decreased, this entry would be reversed. Companies such as Doubletree often use a disclosure note to show the difference between ending inventory valued using the internal method and the LIFO inventory amount reported in the balance sheet. As an example, Graphic 8-7 shows the disclosure note from a recent annual report of Winnebago Industries, Inc., that indicated the composition of the company's inventories:

GRAPHIC 8-7
Inventories Disclosure—Winnebago Industries, Inc.

Real World Financials

 (K)
 LIFO LIQUIDATIONS.   Earlier in the text, we demonstrated the importance of matching revenues and expenses in creating an income statement that is useful in predicting future cash flows. If prices change during a period, then LIFO generally will provide a better match of revenues and expenses. Sales reflect the most recent selling prices, and cost of goods sold includes the costs of the most recent purchases.   For the same reason, though, inventory costs in the balance sheet with LIFO generally are out of date because they reflect old purchase transactions. It is not uncommon for a company's LIFO inventory balance to be based on unit costs actually incurred several years earlier. Proponents of LIFO argue that it results in a better match of revenues and expenses.

This distortion sometimes carries over to the income statement as well. When inventory quantities decline during a period, then these out-of-date inventory layers are liquidated and cost of goods sold will partially match noncurrent costs with current selling prices. If costs have been increasing (decreasing), LIFO liquidations produce higher (lower) net income than would have resulted if the liquidated inventory were included in cost of goods sold at current costs. The paper profits (losses) caused by including out of date, low (high) costs in cost of goods sold is referred to as the effect on income of liquidations of LIFO inventory.

p. 414

To illustrate this problem, consider the example in Illustration 8-6.

 ILLUSTRATION 8-6LIFO Liquidation

National Distributors, Inc., uses the LIFO inventory method. The company began 2011 with inventory of 10,000 units that cost \$20 per unit. During 2011, 30,000 units were purchased for \$25 each and 35,000 units were sold.

National's LIFO cost of goods sold for 2011 consists of:

 Included in cost of goods sold are 5,000 units from beginning inventory that have now been liquidated. If the company had purchased at least 35,000 units, no liquidation would have occurred. Then cost of goods sold would have been \$875,000 (35,000 units × \$25 per unit) instead of \$850,000. The difference between these two cost of goods sold figures is \$25,000 (\$875,000 − 850,000). This is the before tax income effect of the LIFO liquidation. Assuming a 40% income tax rate, the net effect of the liquidation is to increase net income by \$15,000 [\$25,000 × (1 − .40)]. The lower the costs of the units liquidated, the more severe the effect on income.   A company must disclose in a note any material effect of LIFO liquidation the decline in inventory quantity during the period. on net income. For example, Graphic 8-8 shows the disclosure note included with recent financial statements of SuperValue Inc., one of the largest grocery chains in the United States. A material effect on net income of LIFO layer liquidation must be disclosed in a note.

GRAPHIC 8-8
LIFO Liquidation Disclosure—SuperValue Inc.

Real World Financials

 Summary of Significant Accounting Policies (in part) InventoriesDuring fiscal 2009, 2008, and 2007, inventory quantities in certain LIFO layers were reduced. These reductions resulted in a liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years as compared with the cost of fiscal 2009, 2008, and 2007 purchases. As a result, cost of goods sold decreased by \$10, \$5, and \$6 million in fiscal 2009, 2008, and 2007, respectively, and net income increased by approximately \$6, \$3, and \$3.6 million, respectively.

In our illustration, National Distributors, Inc. would disclose that LIFO liquidations increased income by \$15,000 in 2011, assuming that this effect on income is considered material.

We've discussed several factors that influence companies in their choice of inventory method. A company could be influenced by the actual physical flow of its inventory, by the effect of inventory method on reported net income and the amount of income taxes payable currently, or by a desire to provide a better match of expenses with revenues. You've seen that the direction of the change in unit costs determines the effect of using different methods on net income and income taxes. While the United States has experienced persistent inflation for many years (increases in the general price-level), the prices of many goods and services have experienced periods of declining prices (for example, personal computers).

 CONCEPT REVIEW EXERCISE

INVENTORY COST FLOW METHODS

The Rogers Company began 2011 with an inventory of 10 million units of its principal product. These units cost \$5 each. The following inventory transactions occurred during the first six months of 2011.

p. 415

On June 30, 2011, 12 million units were on hand.

Required:

1.

Prepare journal entries to record the above transactions. The company uses a periodic inventory system.

2.

Prepare the required adjusting entry on June 30, 2011, applying each of the following inventory methods:

 a. Average b. FIFO c. LIFO

3.

Repeat requirement 1 assuming that the company uses a perpetual inventory system.

SOLUTION

1.

Prepare journal entries to record the above transactions. The company uses a periodic inventory system.

2.

Prepare the required adjusting entry on June 30, 2011, applying each method.

Calculation of Ending Inventory and Cost of Goods Sold:

 a. Average: (K) p. 416Cost of ending inventory: (K) b. FIFO: (K)Cost of ending inventory: (K) c. LIFO: (K)

Cost of ending inventory:

3.

Repeat requirement 1 assuming that the company uses a perpetual inventory system.

p. 417

Calculation of Cost of Goods Sold:

 a. Average:   Cost of goods sold: (K) b. FIFO:   Cost of goods sold: (K) c. LIFO:   Cost of goods sold: (K)

 DECISION MAKERS’ PERSPECTIVE
 INVENTORY MANAGEMENT.   Managers closely monitor inventory levels to (1) ensure that the inventories needed to sustain operations are available, and (2) hold the cost of ordering and carrying inventories to the lowest possible level.14 Unfortunately, these objectives often conflict with one another. Companies must maintain sufficient quantities of inventory to meet customer demand. However, maintaining inventory is costly. Fortunately, a variety of tools are available, including computerized inventory control systems and the outsourcing of inventory component production, to help balance these conflicting objectives.15 (K)
 A just-in-time (JIT) system a system used by a manufacturer to coordinate production with suppliers so that raw materials or components arrive just as they are needed in the production process. is another valuable technique that many companies have adopted to assist them with inventory management. JIT is a system used by a manufacturer to coordinate production with suppliers so that raw materials or components arrive just as they are needed in the production process. Have you ever ordered a personal computer from Dell Inc.? If so, the PC you received was not manufactured until you placed your order, and many of the components used in the production of your PC were not even acquired by Dell until then as well. This system enables Dell to maintain relatively low inventory balances. At the same time, the company's efficient production techniques, along with its excellent relationships with suppliers ensuring prompt delivery of components, enables Dell to quickly meet customer demand. In its January 30, 2009, fiscal year-end financial statements, Dell reported an inventory balance of \$867 million. With this relatively low investment in inventory, Dell was able to generate over \$61 billion in sales revenue. To appreciate the advantage this provides, compare these numbers with Hewlett Packard (HP), a company that includes PCs among its wide variety of technology products. For its fiscal year ended October 31, 2008, HP reported product revenue of \$91 billion. However, to achieve this level of sales, HP's investment in inventory was nearly \$8 billion. A company should maintain sufficient inventory quantities to meet customer demand while at the same time minimizing inventory ordering and carrying costs.
p. 418

It is important for a financial analyst to evaluate a company's effectiveness in managing its inventory. As we discussed in Chapter 5, one key to profitability is how well a company utilizes its assets. This evaluation is influenced by the company's inventory method choice. The choice of inventory method is an important and complex management decision. The many factors affecting this decision were discussed in a previous section. The inventory method also affects the analysis of a company's liquidity and profitability by investors, creditors, and financial analysts. Analysts must make adjustments when evaluating companies that use different inventory methods. During periods of rising prices, we would expect a company using FIFO to report higher income than a LIFO or average cost company. If one of the companies being analyzed uses LIFO, precise adjustments can often be made using the supplemental disclosures provided by many LIFO companies. Recall that the LIFO conformity rule was liberalized to permit LIFO users to report in a note the effect of using a method other than LIFO for inventory valuation.

For example, the disclosure note shown in Graphic 8-6 on page 413 reveals that The Great Atlantic & Pacific Tea Company, Inc (GAPT) uses both the LIFO and FIFO methods, with 39% of its inventories valued using LIFO. Additional information from the company's recent financial statements is provided below.

 FINANCIALReporting Case

Q3,p.395

Real World Financials

 Suppose an analyst wanted to compare GAPT with a competitor that used all FIFO, or that used both LIFO and FIFO but with different percentages of LIFO and FIFO. To compare apples with apples, we can convert GAPT's inventories and cost of goods sold (and the competitor's if necessary) to a 100% FIFO basis before comparing the two companies by using the information provided in Graphic 8-6. Inventories recorded at LIFO were lower by approximately \$10 million at February 28, 2009, and \$2 million at February 23, 2008, than if they had been valued at FIFO: (K) Supplemental LIFO disclosures can be used to convert LIFO inventories and cost of goods sold amounts.

If GAPT had used FIFO instead of LIFO, beginning inventory would have been \$2 million higher, and ending inventory would have been higher by \$10 million. As a result, cost of goods sold for the 2009 fiscal year would have been \$8 million lower. This is because an increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. Purchases for 2009 are the same regardless of the inventory valuation method used. Cost of goods sold, then, would have been \$6,605 million (\$6,613 – 8) if FIFO had been used for all inventories.

We can now use the 100% FIFO amounts to compare the two companies. Since cost of goods sold is lower by \$8 million, income taxes and net income require similar adjustments before calculating a profitability ratio. Also, the converted inventory amounts can be used to compute liquidity ratios.

 p. 419   One useful profitability indicator that involves cost of goods sold is gross profit highlights the important relationship between net sales revenue and cost of goods sold. or gross margin, highlights the important relationship between net sales revenue and cost of goods sold. which highlights the important relationship between net sales revenue and cost of goods sold. The gross profit ratio highlights the important relationship between net sales revenue and cost of goods sold. is computed as follows: (9.0K)LO7

 The higher the ratio, the higher is the markup a company is able to achieve on its products. For example, a product that costs \$100 and sells for \$150 provides a gross profit of \$50 (\$150 − 100) and the gross profit ratio is 33% (\$50 ÷ \$150). If that same product can be sold for \$200, the gross profit increases to \$100 and the gross profit ratio increases to 50% (\$100 ÷ \$200), so more dollars are available to cover expenses other than cost of goods sold. The gross profit ratio indicates the percentage of each sales dollar available to cover other expenses and provide a profit.

The 2009 gross profit (\$ in millions), for GAPT, using the 100% FIFO amounts, is \$2,911 (\$9,516 − 6,605), and the gross profit ratio is 30.6% (\$2,911 ÷ \$9,516). The same ratio for the grocery industry is 20%, indicating that GAPT is able to sell its products at significantly higher markups than the average for its competitors. GAPT's percentage of each sales dollar available to cover other expenses and to provide a profit is 50% higher than the industry average.

Monitoring this ratio over time can provide valuable insights. For example, a declining ratio might indicate that the company is unable to offset rising costs with corresponding increases in selling price, or perhaps that sales prices are declining without a commensurate reduction in costs. In either case, the decline in the ratio has important implications for future profitability.

In Chapter 5 we were introduced to an important ratio, the inventory turnover ratiomeasures a company’s efficiency in managing its investment in inventory., which is designed to evaluate a company's effectiveness in managing its investment in inventory. The ratio shows the number of times the average inventory balance is sold during a reporting period. The more frequently a business is able to sell or turn over its inventory, the lower its investment in inventory must be for a given level of sales. Usually, the higher the ratio the more profitable a company will be. Monitoring the inventory turnover ratio over time can highlight potential problems. A declining ratio generally is unfavorable and could be caused by the presence of obsolete or slow-moving products, or poor marketing and sales efforts.

Recall that the ratio is computed as follows:

If the analysis is prepared for the fiscal year reporting period, we can divide the inventory turnover ratio into 365 days to calculate the average days in inventory indicates the average number of days it normally takes to sell inventory., which indicates the average number of days it normally takes the company to sell its inventory.

For GAPT, the inventory turnover ratio for the 2009 fiscal year, using the 100% FIFO amounts, is 13.33 (\$6,605 ÷ [(\$484 + 507) ÷ 2]) and the average days in inventory is 27 days (365 ÷ 13.33). This compares to an industry average of 23 days. GAPT's products command a higher markup (higher gross profit ratio) but take longer to sell (higher average days in inventory) than the industry average.

Inventory increases that outrun increases in cost of goods sold might indicate difficulties in generating sales. These inventory buildups may also indicate that a company has obsolete or slow-moving inventory. This proposition was tested in an important academic research study. Professors Lev and Thiagarajan empirically demonstrated the importance of a set of 12 fundamental variables in valuing companies' common stock. The set of variables included inventory (change in inventory minus change in sales). The inventory variable was found to be a significant indicator of returns on investments in common stock, particularly during high and medium inflation years.16

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EARNINGS QUALITY.  Changes in the ratios we discussed above often provide information about the quality of a company's current period earnings. For example, a slowing turnover ratio combined with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory, or a need to decrease prices to sell inventory (which will then decrease gross profit ratios and net income).

The choice of which inventory method to use also affects earnings quality, particularly in times of rapidly changing prices. Earlier in this chapter we discussed the effect of a LIFO liquidation on company profits. A LIFO liquidation profit (or loss) reduces the quality of current period earnings. Fortunately for analysts, companies must disclose these profits or losses, if material. In addition, LIFO cost of goods sold determined using a periodic inventory system is more susceptible to manipulation than is FIFO. Year-end purchases can have a dramatic effect on LIFO cost of goods sold in rapid cost-change environments. Recall again our discussion in Chapter 4 concerning earnings quality. Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings. We discuss these issues in the next chapter.

7 The differences between the various methods also hold when a perpetual inventory system is used.

8Accounting Trends and Techniques—2009 and 1974 (New York, New York: AICPA, 2009 and 1974), p. 195.

9 “Inventories,” International Accounting Standard No. 2 (IASCF), as amended effective January 1, 2009.

10 For example, a corporation can take advantage of incentives offered by Congress by deducting more depreciation in the early years of an asset's life in its federal income tax return than it reports in its income statement.

11 The concept of capital market efficiency has been debated for many years. In an efficient capital market, the market is not fooled by differences in accounting method choice that do not translate into real cash flow differences. The only apparent cash flow difference caused by different inventory methods is the amount of income taxes paid currently. In an efficient market, we would expect the share price of a company that switched its method to LIFO and saved tax dollars to increase even though it reported lower net income than if LIFO had not been adopted. Research on this issue is mixed. For example, see William E. Ricks, “Market's Response to the 1974 LIFO Adoptions,” Journal of Accounting Research (Autumn 1982), and Robert Moren Brown, “Short-Range Market Reaction to Changes to LIFO Using Preliminary Earnings Announcement Dates,” Journal of Accounting Research (Spring 1980).

12 For example, see P. M. Healy, “The Effect of Bonus Schemes on Accounting Decisions,” Journal of Accounting and Economics (April 1985), and D. Dhaliwal, G. Salamon, and E. Smith, “The Effect of Owner Versus Management Control on the Choice of Accounting Methods,” Journal of Accounting and Economics (July 1982).

13 The Great Atlantic and Pacific Tea Company uses both the FIFO and LIFO cost methods. Earlier in the chapter we noted that a company need not use the same inventory method for all of its inventories.

14The cost of carrying inventory includes the possible loss from the write-down of obsolete inventory. We discuss inventory write-downs in Chapter 9. There are analytical models available to determine the appropriate amount of inventory a company should maintain. A discussion of these models is beyond the scope of this text.

15 Eugene Brigham and Joel Houston, Fundamentals of Financial Management, 12th ed. (Florence, Kentucky: South-Western, 2010).

16 B. Lev and S. R. Thiagarajan, “Fundamental Information Analysis,” Journal of Accounting Research (Autumn 1993). The main conclusion of the study was that fundamental variables, not just earnings, are useful in firm valuation, particularly when examined in the context of macroeconomic conditions such as inflation.

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