Chapter - 6

Analysis of inventories
 Inventory And COGS: Basic
relationships
The inventory account is affected by two events:
• The purchase (or manufacture) of goods (P) and
• Their subsequent sale (COGS).

The relationship between these events

and the balance of beginning inventory (BI) and
ending inventory (EI) can be expressed as
(1) EI = BI + P – COGS

(2) BI + P = COGS + EI
Beginning Inventory = 200 units @ $10/ unit

Purchase = 500 units

Units sold: 100 units per quarter for a total of

400 units in the year

Ending Inventory= 200 + 500- 400

Scenario 1: Stable Prices:
COGS = 400*$10 = $4000
EI = 300*$10 = $3000

BI + P = COGS + EI
$2000 + $5000 = $4000 +$3000
But price may not stable in the real world

Scenario 2: Rising Prices:

BI + Purchase = $8250
At the time of calculating the COGS we
can follow 3 technique:
.FIFO .LIFO
.Weighted average cost.
 Scenario 2: Rising Prices:
Quarter Purchase Unit Cost Purchase
Unit Amount

1 100 11 1100
2 150 12 1800
3 150 13 1950
4 100 14 1400
FIFO:
COGS EI
200@$10 = $2000 100@$14 = $1400
100@$11 = $1100 150@$13 = $1950
100@$12 = $1200 50@$12 = $600
400 Units = $4300 300 Units = $3950

LIFO:
COGS EI
100@$14 = $1400 200@ $10 =$1400
150@$13 = $1950 100@$11 = $1100
150@$12 = $1800
400 Units = $5150 300 Units = $3100
Weighted Average
$8250
= $11.876
700
COGS EI
400 * $11.876 = $4714 300 * $11.876 =$3536

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

Weighted average$2000 + $6250 =$4714 + $3536

LIFO $2000 + $6250 =$5150 + $3100

 Comparison of Information by
Alternative Methods:
Balance Sheet Information: Inventory Account
In an environment of increasing prices,
FIFO allocates the earlier cost to COGS,
leaving the most recent costs in EI.
Where as LIFO allocates earliest
(outdated) costs to EI.
From B/S perspective, inventories
based on FIFO are preferable to those
presented under LIFO, as carrying values
most closely reflect current cost.
Income Statement Information:
Cost of Goods Sold
•During periods of changing prices
and stable or growing inventories,
LIFO is the most informative
accounting method for income
statement purposes.

•Because it provides a better

measure of current income and future
profitability.
 LIFO Vs FIFO: Income, Cash
Flow & Working Capital Effect
In periods of rising prices and stable
or increasing inventory quantities, the use of
LIFO results in higher COGS lower reported
income.
In absence of income taxes, there
would be no difference in CF.

When LIFO is a permitted method

for income taxes, however, lower income
translates into lower taxes and thus higher
operating cash flow.
 LIFO Vs FIFO: Income, Cash
Flow & Working Capital Effect
• IRS regulations require that the same
method of inventory accounting used for
tax purposes also be used for financial
reporting.

•From an economic perspective, given rising

prices, LIFO is the better choice, as taxes will
be lower and cash flows will be higher despite
the lower reported income.
LIFO accounting results in higher cash
flows, but it reports lower working capital
because the inventory balances retain
earlier (lower) costs and the cash saved is
only a percentage (the marginal tax rate) of
the difference in inventory values
In periods of rising prices and stable or
increasing inventory quantities, the impact of
LIFO and FIFO on the financial statements
can be summarized as follows:
LIFO FIFO
•COGS Higher Lower
•EBT Lower Higher
•Income Tax Lower Higher
•NI Lower Higher
•Cash Flow Higher Lower
•Inventory Lower Higher
•Working
capital Lower Higher
 Income statement impact

LIFO
higher/Lo
  FIFO LIFO wer by
Sales 10,000 10,000 0
COGS -4,300 -5,150 850
Income before tax 5700 4850 -850
Income tax 2280 1940
-340
 

Net income 3420 2910   -510

Cash flow impact

LIFO
higher/Lower
  FIFO LIFO by

Sales inflows 10,000 10,000 0

Purchases -6,250 -6,250 0

Income before
tax 3750 3750 0

Income tax 2280 1940 -340

Operating cash
flow 1470 1810 340
 Impact over balance sheet:
LIFO higher/Lower
  FIFO LIFO by
Operating cash 1,470 1,810 340
Inventory 1,950 1,100 -850

Working capital 3420 2910 -510

       
Liabilities and stock holders' equity
 
       
LIFO higher/Lower
  FIFO LIFO by
Retained
earnings 3420 2910 -510
Income difference = (1- tax rate) x COGS difference
510 = 0.6 x 850

Cash flow difference = Tax rate x COGS difference

340 = 0.4 x 850

•These difference are opposite directions, with higher

Income for the FIFO firms and higher operating cash
Flow for the LIFO firm. The difference in working
Capital is the net difference in inventory balance and
Cash flow:

510 = 850 - 340

Adjustment from LIFO to FIFO
Adjustment of inventory balances:
LIFO inventory balances contain older costs
with no relation ship to current cost. That’s why
firms are required to disclose LIFO reserve.
To adjust inventory balances of firms using
LIFO to FIFO cost, we must add the LIFO
reserve to the LIFO inventory. We express this
as
LIFO reserve  InventoryF  InventoryL

InventoryF  InventoryL  LIFO reserve

Adjustment of cost of goods sold:
COGS can be derived by the following equation:
COGS = BI +P - EI
So purchases can be derived as follows:
P  COGS L  EI L  BI L
Cost of goods sold can be adjusted as follows:

COGS F  COGS L  Change in LIFO reserve

 Adjustment of income to current
cost income
The adjustment of FIFO COGS to reflect current cost.
There are two reasons to make this adjustment:

•First, we want to see the impact of price changes

over COGS and want to differentiate between price
effect and operating effect.

•Second, to compare the firm with other firm in the

same industry using LIFO accounting.
Only the adjustment of FIFO COGS to LIFO is
relevant.
Adjustment of income to current cost
income:
Adjustment can be done by the following
formula,

COGS L  COGS F  BI F X r 

Where, r is the specific inflation rate
appropriate for the product in which the
firm deals.
Alternatively, r can be obtained as follows:
LIFO reserve
r
BI F
 Financial ratios: LIFO versus
FIFO
The FIFO/LIFO choice impacts reported
profitability, liquidity, activity and leverage
ratios.

The general guide line is to use LIFO

numbers for ratio components that are
income related and FIFO based data that are
balance sheet related.
 Profitability
Gross profit margin
LIFO is a better measure for
gross profit margin. LIFO gives a
more accurate forecast of the firm’s
prospects by removing the impact of
price changes.
 Liquidity: Working capital
LIFO misstates working capital based ratios
because inventory component of working capital
reports outdated costs.Use of current value of
inventory (FIFO) results in the better measure.
 Activity: Turnover
Inventory turnover is often
meaningless for LIFO firm due to
mismatching of cost. The numerator
represents current cost where as the
denominator reports out dated cost.
Thus to arrive at a reasonable
approximation of the inventory turnover
ratio for a LIFO firm we must convert
stated inventory to FIFO
Inventory theory and turnover ratios:
As for all turnover ratios, ones first instinct is
to believe that higher is better, that more
rapid inventory turnover indicates a more
efficient use of capital. In practice,
assumption may be overly simplistic.

Economic order quantity:

The EOQ model argues that optimal level
inventory is proportionate to the square root
of demand. Generally, under the EOQ model,
turnover ratios will rise as sales increases
and smaller firms should have lower
turnover ratios.
Just in time:
Under just in time system inventory turnover
ratio approaching to infinity with zero
inventory held. We would expect the turnover
ratios of Japanese firms to be considerably
higher than those of American firms.
Solvency: Debt to equity ratio:
Firm’s stockholders equity
should increase by the same amount of
LIFO reserve. The rationale for this
adjustment is that the reported equity of
the firm is understated because the firm
owns inventory whose current value
exceeds its carrying value.