ANALYSIS OF INVENTORIES 1Đặng Thị Thu Hằng

INTRODUCTION Compare the effects of the FIFO/ LIFO choice along these dimensions and demonstrates how the analyst can adjust from one method to another. 2Đặng Thị Thu Hằng

Inventory Management Inventory is one of the most expensive assets of many companies. It represents as much as 40% of total invested capital. 3Đặng Thị Thu Hằng

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). 4Đặng Thị Thu Hằng

FIFO/ LIFO EI = BI + P – COGS BI + P = COGS + EI P: the purchase of goods COGS: cost of goods sale BI: the beginning sale EI: the ending inventory 5Đặng Thị Thu Hằng

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 6Đặng Thị Thu Hằng

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 7Đặng Thị Thu Hằng

EXAMPLE: COSTS INCLUDED IN INVENTORY 8Đặng Thị Thu Hằng

9 Vindaloo company manufactures a single product. The following information was taken from the company’s production and cost records last year: Units produced: 5000 Raw materials: Conversion cost for finished goods: Freight in to plant: 800 Storage cost for finished goods: 500 Abnormal waste: 100 Freight out to customers: Đặng Thị Thu Hằng

Question: assuming no abnormal waste is included in conversion cost, calculate the total capitalized cost? Cost per unit? 10Đặng Thị Thu Hằng

INVENTORY VALUATION METHODS Specific identification FIFO LIFO Weighted average cost 11Đặng Thị Thu Hằng

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 12 Jan 1 (beginning inventory) 2 units x $2 per unit$4 Jan 7 purchase3 units x $3 per unit$9 Jan 19 purchase5 units x $ 5 per unit$25 Cost of goods availble10 units$38 Units sold during Jan7 units Đặng Thị Thu Hằng

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SCENARY 1: STABLE PRICE BI + P = COGS + EI $ $ 5000 = $ $ Đặng Thị Thu Hằng

SCENARY 2: RISING PRICES FIFO: BI + P = COGS + EI $ $ 6250 = $ $ 3950 LIFO: BI + P = COGS + EI $ $ 6250 = $ $ Đặng Thị Thu Hằng

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 16Đặng Thị Thu Hằng

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 17Đặng Thị Thu Hằng

LIFO VERSUS FIFO: INCOME, CASH FLOW AND WORKING CAPITAL EFFECTS LIFOFIFO Cost of goods soldHigherLower Income before taxesLowerHigher Income taxesLowerHigher Net incomeLowerHigher Cash flowsHigherLower Inventory balanceLowerHigher Working capitallowerHigher 18Đặng Thị Thu Hằng

The income statement FIFOLIFO Sales$ COGS Income before tax Tax 40% Net income Đặng Thị Thu Hằng

The cash flows FIFOLIFO Sales inflows$ Purchases6250 Inflows before tax3750 Tax paid Net cash flows Đặng Thị Thu Hằng

The change in balance sheet account FIFOLIFO Cash$ 1470$ 1810 Inventory Working capital Retained earnings Cash: net cash flow for period Inventory: purchases less COGS Retained earning: net income for period 21Đặng Thị Thu Hằng

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. 22Đặng Thị Thu Hằng

Calculate COGS and ending inventory under the FIFO and LIFO cost flow methods using a perpetual inventory system 23 Jan 1 (beginning inventory)2 units x $ 2 per unit Jan 7 purchase3 units x $ 3 per unit Jan 12 sale4 units Jan 19 purchase5 units x $5 per unit Jan 29 sale3 units Đặng Thị Thu Hằng

FINANCIAL RATIOS: FIFO VERSUS LIFO Profitability: gross profit margin: assuming inflation, higher COGS under LIFO will result in lower gross profit. 24Đặng Thị Thu Hằng

QUARTERCOSTPRICEUNITSDOLLARS 1$ 11$ $ 12 $ $ 13$ $ 14$ TOTAL SALESCOGSGROSS PROFIT PERCENT FIFO / = 57% LIFO / = 48,5% Đặng Thị Thu Hằng

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. 26Đặng Thị Thu Hằng

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. 27Đặng Thị Thu Hằng