ANALYSIS OF INVENTORIES
· Inventory Terms
· Impact of Inventory on Corporations
· Full Absorption Costing
· Inventory Flow Assumptions
· LIFO Reserves
· Inventory Rules
· Inventory Disclosure
· Conversion of LIFO to FIFO
· LIFO Liquidation
· Analysis of Inventory
- Impact of Inventory
- Inventory Turnover
INVENTORY TERMS
On the Balance Sheet
· Raw Materials – Cost of materials not yet placed into production
· Work in Process – Accumulated cost of raw materials, labor, and overhead currently in the production process
· Finished Goods – Cost of items completed, but not yet sold
On the Income Statement
· Cost of Goods Sold – Cost of materials, labor, and overhead allocated to sold items
INVENTORY TERMS
Inventory Cycle
IMPACT OF INVENTORIES ON CORPORATIONS
· Why is it necessary for corporations to hold inventory?
· What are the costs associated with holding inventory?
· Where do inventories appear on the balance sheet?
· Is there an expense associated with inventory on the income statement?
FULL ABSORPTION COSTING
GAAP requires full absorption costing for inventories.
Overhead costs allocated to inventories:
· Salaries and benefits of operations workers and management
· Rent on manufacturing facilities
· Depreciation on manufacturing facilities
· Utilities
· Repairs
· Quality Control
Does inventory include:
· Salary of factory worker? YES
· Salary of factory supervisor? YES
· Electricity to run factory equipment? YES
· Depreciation of factory equipment? YES
· Salary of chief financial officer? NO! S,G,&A.
· Advertising costs? NO! Selling.
INVENTORY FLOW ASSUMPTIONS
Commonly Used Flow Assumptions
Most Commonly Used Flow Assumptions:
First In - First Out (also known as FIFO or a “rotating” inventory) – assumes the oldest inventory will be utilized in cost of goods sold.
Last In - First Out (also known as LIFO) – assumes the most recently acquired inventory will be utilized in cost of goods sold. Can result in a “stagnating” layer.
Average – assumes the average purchase price will be used to calculate the inventory and CoGS.
INVENTORY FLOW ASSUMPTIONS
General Rule for Inventory Flow Selection: … the major objective in selecting a method should be to choose the one which … most clearly reflects periodic income.
ARB 43, Chapter 4, Statement 4
Result: The accounting inventory flow often does not match the physical flow of inventory.
þ International Standards do not recognize LIFO as an acceptable flow method.
INVENTORY FLOW ASSUMPTIONS
Purchases Made During the Period
Quarter / Units / Price / Dollar CostBeginning / 200 / $10 / $2,000
Winter / 100 / $11 / $1,100
Spring / 150 / $12 / $1,800
Summer / 150 / $13 / $1,950
Autumn / 100 / $14 / $1,400
GAS / 700 / $8,250
Assuming 400 units are sold and 300 remain in inventory:
FIFO / Units / Price / LIFO / Units / Price200 / $10 / $2,000
100 / $11 / $1,100 / 200 / $10 / $2,000
100 / $12 / $1,200 / 100 / $11 / $1,100
CoGS / 400 / $4,300 / EI / 300 / $3,100
50 / $12 / $600 / 150 / $12 / $1,800
150 / $13 / $1,950 / 150 / $13 / $1,950
100 / $14 / $1,400 / 100 / $14 / $1,400
EI / 300 / $3,950 / CoGS / 400 / $5,150
Weighted Average
$8,250 = $11.786
700
CoGS = 400 * $11.786 = $4,714
EI = 300 * $11.786 = $3,536
INVENTORY FLOW ASSUMPTIONS
Differences Between FIFO and LIFO
Assuming rising prices, LIFO and FIFO will differ as follows:
Account / LIFO / FIFOIncome Statement
Cost of Goods Sold / Higher / Lower
EBIT / Lower / Higher
Income Tax* / Lower / Higher
Net Income / Lower / Higher
Balance Sheet
Inventories / Lower / Higher
Working Capital / Lower / Higher
Cash Flow
CFO* / Higher / Lower
* Under LIFO, cash flow is higher only to the extent that taxes are reduced.
INVENTORY FLOW ASSUMPTIONS
Who Uses What?
Method
Company / Domestic / ForeignMicrosoft / - / -
Office Depot / Average / FIFO
OfficeMax / Average / -
Staples / Average / -
3M Corp. / FIFO / FIFO
Coca-Cola Co. / FIFO / -
Gillette Co. / FIFO / FIFO
Home Depot / FIFO / -
Lowe’s / FIFO / -
Becton Dickinson / LIFO / FIFO
Deere & Co. / LIFO / -
Halliburton / LIFO / Average
Ingersoll-Rand / LIFO / FIFO
Wal-Mart / LIFO / -
Woolworth Corp. / LIFO / FIFO
INVENTORY FLOW ASSUMPTIONS
Use of Inventory Flow Methods
According to a survey of 600 publicly-traded US corporations (2004):
Method / Percent of Users*FIFO / 64%
LIFO
All Inventories / 3%
50% or more / 18%
Less than 50% / 14%
Not Determinable / 5%
LIFO Total / 40%
Average / 28%
No Inventory / 18%
* Greater than 100% because some companies use more than one method.
LIFO RESERVES
Cactus Co. has been in business since 2004 and uses a LIFO inventory. In 2010, their inventory of 840 items was valued as follows:
Layer / Units / Price2004 / 100 / $10.00 / $1,000.00
2005 / 105 / $10.15 / $1,065.75
2006 / 110 / $10.35 / $1,138.50
2007 / 120 / $10.45 / $1,254.00
2008 / 125 / $10.60 / $1,325.00
2009 / 135 / $10.90 / $1,471.50
2010 / 145 / $11.10 / $1,609.50
LIFO Total / 840 / $8,864.25
Cactus has an appraiser determine the current cost of items in inventory. Items are valued at $11.10 each. The LIFO reserve represents the difference between:
Layer / Units / PriceLIFO Total / 840 / $8,864.25
Replacement Cost / 840 / $11.10 / $9,324.00
LIFO Reserve / $ 459.75
RULES FOR INVENTORY ACCOUNTING
· LIFO for Taxes - In the US, if LIFO is used for tax, it must be used for books
· LIFO Reserve - If LIFO is used, the LIFO reserve must be disclosed.
Inventory Value Under FIFO
- LIFO Reserve______
Inventory Value Under LIFO
· Lower of Cost or Market (LCM) - inventories are stated at the lower of cost or market values.
INVENTORY DISCLOSURE
Costing Method – identify the method, example: specific identification, FIFO, LIFO, Average
Composition –
by stage: raw materials, work in process, finished goods
by product: crude oil, natural gas, chemicals
LIFO Reserve – difference between LIFO and cost
LIFO Liquidations – effect on net income from expensing older LIFO layers in CoGS
Purchase Commitments – identify material amounts of legal obligations to secure inventory
Inventory financing arrangements – amounts of inventory pledged as collateral
INVENTORY DISCLOSURE
Estimation Policy
Staples
Inventory:We record inventory at the lower of weighted-average cost or market value. We reserve for obsolescence based on the difference between the weighted-average cost of the inventory and the estimated market value based on assumptions of future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional reserves may be required.
Office Depot
Merchandise Inventories: Inventories are stated at the lower of cost or market value. The weighted average method is used to determine the cost of a majority of our inventory and the first-in-first-out method is used for international operations.
DEERE & CO.
Inventory Note
Most inventories owned by Deere & Company and its United States equipment subsidiaries are valued at cost, on the “last-in, first-out” (LIFO) basis. Remaining inventories are generally valued at the lower of cost, on the “first-in, first-out” (FIFO) basis, or market. The value of gross inventories on the LIFO basis represented 60 percent and 61 percent of worldwide gross inventories at FIFO value on October 31, 2006 and 2005, respectively. If all inventories had been valued on a FIFO basis,
Estimated inventories by major classification at October 31 in millions of dollars would have been as follows:
2006 2005
Raw materials and supplies $712 $716
Work-in-process 372 425
Finished machines and parts 2,013 2,126
Total FIFO value 3,097 3,267
Less adjustment to LIFO value 1,140 1,132
Inventories $1,957 $2,135
CONVERSION FROM LIFO TO FIFO
Why make this conversion:
· LIFO usually does not replicate a physical flow.
· FIFO inventories reflect current costs.
· Necessary to compare to FIFO corporations.
· Necessary to compare to other LIFO corporations.
· Matches to international standards
LIFO
FIFO
Note: It is not possible to convert FIFO inventories to LIFO with the information provided in an annual report.
CONVERSION FROM LIFO TO FIFO
Example
Inventory (in Millions) / 2004 / 2003Inventory LIFO / $3,666 / $3,957
LIFO Reserve / 2,220 / 1,421
FIFO Value / $5,886 / $5,378
Income Statement (in Millions) / 2004
Sales / $ 135,076
Cost of Goods Sold (LIFO) / $90,182
Net Income / $8,129
Determining Purchases for 2004
CoGS = BI + P – EI
P = CoGSLIFO + EILIFO – BILIFO
P = 90,182 + 3,666 – 3,957
P = 89,891
Determining Cost of Goods Sold Under FIFO
Method 1 / Method 2CoGSFIFO = BIFIFO + P - EIFIFO / CoGSFIFO = CoGSLIFO - (RESEND - RESBEG)
CoGSFIFO = 5,378 + 89,891 – 5,886 / CoGSFIFO = 90,182 - (2,220 – 1,421)
CoGSFIFO = 89,383 / CoGSFIFO = 89,383
What is the difference in Cost of Sales if ConocoPhillips had used FIFO instead of LIFO?
CoGSLIFO - CoGSFIFO = $90,182 – $89,383 = $799 million lower
What would net income be if ConocoPhillips had used FIFO instead of LIFO (assuming the tax rate was 35%)?
CoGS net of Tax Benefit = CoGS difference * 1 – tax rate
= $799 * (1 - .35)
= $519 million
Net income under FIFO = NI under LIFO + CoGS net of Tax Benefit
= $8,129 + $519 = $8,648 million
LIFO LIQUIDATIONS
Inventory might be decreased due to:
· Inventory management
· Lower growth rates
· Economic recessions
When LIFO is used, decreasing inventory will include “older” (lower) prices in COGS, increasing net income.
DANGER: Some companies delay purchases at the end of the year to liquidate “cheap” layers to increase net income.
RULE: The effects of LIFO liquidations must be disclosed in a note.
LIFO Liquidation
Shell Oil, Co.
In the 1995 annual report, Shell reported the following:
(in Millions) / 1995 / 1994 / 1993Sales / $27,668 / $24,789 / $25,581
Net Income / 1,520 / 508 / 781
6. Inventories of Oils and Chemicals
Inventories are carried predominantly on a LIFO basis which was lower than current cost by $672 million at December 31, 1995, $1,011 million at December 31, 1994, and $648 million at December 31, 1993. Partial liquidations of inventories valued on a LIFO basis improved 1995 and 1994 net income by $167 million and $29 million, respectively, and impaired 1993 net income by $10 million.
When adjustments are made for “paper profits” resulting from LIFO liquidations, net income might be expressed as follows:
(in Millions) / 1995 / 1994 / 1993Net Income / 1,520 / 508 / 781
Liquidation Adjustment / (167) / (29) / 10
Adjusted Net Income / 1,353 / 479 / 791
Percentage Change / -11.0% / -5.7% / 1.3%
ANALYSIS OF INVENTORIES
Impact of Inventory
1. Inventory as a Percentage of Total Assets
Indicates: Role inventory plays in the corporation
Inventory = __Inventory__
Percentage Total Assets
Interpretation:
Higher - inventory plays a greater role in the corporation.
Lower - inventory plays a lesser role in the corporation.
Caution – comparisons to industry standards are essential; high ratios in comparison to the industry may indicate over accumulation of inventory; low ratios in comparison to the industry may indicate the danger of stock outs.
2. Cost of Goods Sold as a Percentage of Sales
Indicates: Degree acquired goods (for retailer) or manufacturing costs affect profit
Cost = __Cost of Goods Sold__
Percentage Net Sales
Interpretation:
High in comparison to industry average or previous years – acquired goods (for retailer) or manufacturing costs are reducing profits
What Companies Depend on Inventories?
2008 Fiscal Years
Company / Inventory /Total Assets / CoGS / Sales
Home Depot / 26.5% / 66.4%
Lowe’s / 24.7% / 65.3%
Wal-Mart / 21.5% / 76.5%
Target / 15.2% / 66.1%
Ford / 8.5% / 92.4%
Toyota / 5.5% / 82.4%
Note: For retail companies, inventories can be the most significant asset.
ANALYSIS OF INVENTORIES
Turnover Ratios
1. Inventory Turnover Ratio
Indicates: Frequency in which inventories are accumulated and then sold.
Inventory = Cost of Good Sold
Turnover Average Inventory
Interpretation:
Higher - inventory is acquired and sold at a rapid rate.
Lower - inventory may not be marketable or may be obsolete.
Caution - it may not be practical to calculate an inventory turnover for multi-product corporations
2. Number of Days of Inventory
Indicates: Number of days an average item is maintained in inventory.
Number of Days = 365______
in Inventory Inventory Turnover
Interpretation:
Shorter - indicates inventory is sold quickly.
Longer - indicates lagging sales or inventory obsolescence.
ANALYSIS OF INVENTORIES
Productivity Ratios
1. Inventory Yield
Indicates: Return on dollars invested in inventory
Inventory = Gross Profit___
Yield Average Inventory
Gross Profit = Sales – Cost of Sales
Average Inventory = (Beginning Inventory - Ending Inventory) / 2
Interpretation:
Higher - inventory is productive.