Search Financial-Accounting.us

Analysis of Inventories in Financial Accounting

The income statement contains information about profitability and the balance sheet contains useful information about inventory levels.

Profitability - The income statement contains information about cost of goods sold and gross profit. Gross profit is often expressed as a percentage of sales:

Gross profit % = Gross profit / Sales

A higher gross profit percentage helps cover other expenses and contributes to net income. Figure 5.10 contains inventory-related information for OB. The gross profit percentages in Figure 5.10 are calculated as follows:

Figure 5.10 - Financial Statement Information

OB’s gross profit percentage showed a reasonable increase between 1996 and 1997. Several factors may have caused this. First, OB’s inventory costs may have fallen. Second, competitive forces may have enabled OB to increase its selling prices. Finally, keep in mind that OB’s different products probably have varying gross profit percentages. A change in the mix of products sold can affect the gross profit percentage. OB’s gross profit percentage compares favorably to other apparel manufacturers.

Industries differ with respect to gross profit percentage. For example, the pharmaceutical industry’s average gross profit percentage exceeds 50%. Drug companies incur substantial costs when researching and developing their products. Accordingly, they must sell their goods at relatively high markups so that they can cover these costs and remain profitable.

Case study 5.2 examines the effect on gross profit of applying the LCM inventory valuation rule.

Case Study 5.2

California Micro Devices Corporation (CMD) manufactures and markets integrated thin-film, silicon-based termination and filtering components and active electronic circuitry. During the year ended March 31, 1998, CMD recorded inventory write-downs of $900,000. The write-downs were due to potential obsolescence and severe price competition by Asian manufacturers. CMD reported the following results (in thousands):

Assume that the write-down is reflected in cost of sales.

Required

a. Calculate CMS’s gross profit percentages for 1998 and 1997.
b. Recalculate the 1998 gross profit percentage, assuming that the write-down did not occur.
c. What concerns are raised by the trend in gross profit percentages and the effect of the write-down?

Solution

a
.

b. Had the write-down not occurred, gross profit would have been:

Gross profit, as reported = $8,342,000
Plus: Write-down = 900,000

Cost of sales, adjusted = $9,242,000

Based on this, an adjusted gross profit percentage can be calculated.

Gross profit percentage = Gross profit / Sales
= $9,242 / $33,043
= 28%

As can be seen, the write-down reduced the 1998 gross profit percentage by almost three percentage points.

c. CMD would have experienced a significant decline in gross profit percentage even in the absence of the inventory write-down. The decline in gross profit percentage, coupled with the causes for the write-down (obsolescence and pricing pressures from Asian manufacturers) suggest that CMD is in a rapidly changing and competitive industry. CMD must develop a plan to increase its profitability.

Inventory Levels - The balance sheet contains information about the cost of inventories remaining on hand at year-end. This provides insights into whether the level of inventory is adequate to meet customer demands. Inadequate levels may result in lost sales and reduced profitability, while excessive levels increase carrying costs, which also has a negative impact on profitability. Carrying costs include storage, handling, insurance, and the opportunity cost of the funds invested in inventory. An opportunity cost exists because cash invested in inventory that remains on hand for several months cannot be invested in more profitable alternative opportunities.

The number of days’ sales in ending inventory (NDS) is frequently used to measure inventory levels. It is computed in two steps. First, divide cost of goods sold by 365. This indicates the cost of inventory sold in one day.

CGS per day = CGS / 365

Next divide ending inventory by CGS per day to obtain NDS.

NDS = Ending inventory / CGS per day

NDS reflects inventory size relative to the level of sales activity. OB’s NDS for 1997 and 1996 are calculated as follows:

OB’s NDS increased from 81 days in 1996 to 99 days in 1997. This occurred because inventory levels increased while sales (and cost of goods sold) declined. Recall that OB ceased dealing with certain wholesalers and curtailed its European operations, which resulted in a smaller scale of operations. OB does not seem to have fully adjusted its inventory levels to this smaller scale.

It is interesting to contrast apparel manufacturers’ NDS with that of food stores, who maintain about 40 days’ sales of inventory on hand. This reflects the perishable nature of food stores’ inventories, coupled with their high volume of sales.

Current Assets Topics