Business Analysis for Investment (FNCE2003)

Tutorial 9
Inventories

Question 1:

Acme Enterprises, a hypothetical company that prepares its financial statements in accordance with
IFRS, manufactures tables. In 2018, the factory produced 900,000 finished tables and scrapped 1,000
tables. For the finished tables, raw material costs were €9 million, direct labour conversion costs
were €18 million, and production overhead costs were €1.8 million. The 1,000 scrapped tables
(attributable to abnormal waste) had a total production cost of €30,000 (€10,000 raw material costs
and €20,000 conversion costs; these costs are not included in the €9 million raw material and €19.8
million total conversion costs of the finished tables). During the year, Acme spent €1 million for
freight delivery charges on raw materials and €500,000 for storing finished goods inventory. Acme
does not have any work-in-progress inventory at the end of the year.

a. What costs should be included in inventory in 2018?

b. What costs should be expensed in 2018

Solution:

a. What costs should be included in inventory in 2018?

Total inventory costs for 2018 are as follows;

Raw materials € 9,000,000

Direct labor 18,000,000
Production overhead 1,800,000
Transportation for raw 1,000,000
materials
Total inventory costs € 29,800,000
b. What costs should be expensed in 2018

Total costs that should be expensed (not included in inventory) are as follows:

Abnormal waste € 30,000

Storage of finished goods 500,000
inventory
Total € 530,000

Question 2:

Global Sales, Inc. (GSI) is a hypothetical Dubai-based distributor of consumer products, including bars
of luxury soap. The soap is sold by the kilogram. GSI began operations in 2018, during which it
purchased and received initially 100,000 kg of soap at 110 dirham (AED)/kg, then 200,000 kg of soap
at 100 AED/kg, and finally 300,000 kg of soap at 90 AED/kg. GSI sold 520,000 kg of soap at 240
AED/kg. GSI stores its soap in its warehouse so that soap from each shipment received is readily
identifiable. During 2018, the entire 100,000 kg from the first shipment received, 180,000 kg of the
second shipment received, and 240,000 kg of the final shipment received were sent to customers.
Answers to the following questions should be rounded to the nearest 1,000 AED.
a. What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under
the specific identification method?

b. What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under
the weighted average cost method?

c. What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under
the FIFO method?

d. What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under
the LIFO method?

Solution:

a. What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under
the specific identification method?

Under the specific identification method, the physical flow of the specific inventory items sold is
matched to their actual cost.

Sales = 520,000 * 240 = 124,800,000 AED

Cost of sales = (100,000 * 110) + (180,000 * 100) + (240,000 * 90)= 50,600,000 AED

Gross profit = 124,800,000 – 50,600,000 = 74,200,000 AED

Ending inventory = (20,000 * 100) + (60,000 * 90) = 7,400,000 AED

Note that in spite of the segregation of inventory within the warehouse, it would be inappropriate to
use specific identification for this inventory of interchangeable items. The use of specific
identification could potentially result in earnings manipulation through the shipment decision.

b. What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under
the weighted average cost method?

Under the weighted average cost method, costs are allocated to cost of sales and ending inventory
by using a weighted average mix of the actual costs incurred for all inventory items. The weighted
average cost per unit is determined by dividing the total cost of goods available for sale by the
number of units available for sale.

Weighted average cost = [(100,000 * 110) + (200,000 * 100) + (300,000 * 90)]/600,000

= 96.667 AED/kg

Sales = 520,000 *240 = 124,800,000 AED

Cost of sales = 520,000 * 96.667 = 50,267,000 AED

Gross profit = 124,800,000 – 50,267,000 = 74,533,000 AED

Ending inventory = 80,000 * 96.667 = 7,733,360 AED

c. What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under
the FIFO method?
Under the FIFO method, the oldest inventory units acquired are assumed to be the first units sold.
Ending inventory, therefore, is assumed to consist of those inventory units most recently acquired.

Sales = 520,000 * 240 = 124,800,000 AED

Cost of sales = (100,000 * 110) + (200,000 * 100) + (220,000 * 90) = 50,800,000 AED

Gross profit = 124,800,000 – 50,800,000 = 74,000,000 AED

Ending inventory = 80,000 * 90 = 7,200,000 AED

d. What are the reported cost of sales, gross profit, and ending inventory balances for 2018 under
the LIFO method?

Under the LIFO method, the newest inventory units acquired are assumed to be the first units sold.
Ending inventory, therefore, is assumed to consist of the oldest inventory units.

Sales = 520,000 * 240 = 124,800,000 AED

Cost of sales = (20,000 * 110) + (200,000 * 100) + (300,000 * 90) = 49,200,000 AED

Gross profit = 124,800,000 – 49,200,000 = 75,600,000 AED

Ending inventory = 80,000 * 110 = 8,800,000 AED

The following table (in thousands of AED) summarizes the cost of sales, the ending inventory, and
the cost of goods available for sale that were calculated for each of the four inventory valuation
methods. Note that in the first year of operation, the total cost of goods available for sale is the
same under all four methods. Subsequently, the cost of goods available for sale will typically differ
because beginning inventories will differ. Also shown is the gross profit figure for each of the four
methods. Because the cost of a kg of soap declined over the period, LIFO had the highest ending
inventory amount, the lowest cost of sales, and the highest gross profit. FIFO had the lowest ending
inventory amount, the highest cost of sales, and the lowest gross profit.

Inventory Specific ID Weighted FIFO LIFO

Valuation Average Cost
Method
Cost of sales 50,600 50,267 50,800 49,200
Ending 7,400 7,733 7,200 8,800
inventory
Total cost of 58,000 58,000 58,000 58,000
goods
available for
sale
Gross profit 74,200 74,533 74,000 75,600

Question 3:

Company L and Company F are identical in all respects except that Company L uses the LIFO method
and Company F uses the FIFO method. Each company has been in business for five years and
maintains a base inventory of 2,000 units each year. Each year, except the first year, the number of
units purchased equalled the number of units sold. Over the five-year period, unit sales increased 10
percent each year, and the unit purchase and selling prices increased at the beginning of each year
to reflect inflation of 4 percent per year. In the first year, 20,000 units were sold at a price of $15.00
per unit, and the unit purchase price was $8.00.

a. What were the end of year inventory, sales, cost of sales, and gross profit for each

company for each of the five years?

b. Compare the inventory turnover ratios (based on ending inventory carrying amounts) and

gross profit margins over the five-year period and between companies?

Solution:

a. What were the end of year inventory, sales, cost of sales, and gross profit for each company
for each of the five years?

Company L Year 1 Year 2 Year 3 Year 4 Year 5

Using LIFO
Ending $16,000 $16,000 $16,000 $16,000 $16,000
inventorya
Salesb $300,000 $343,200 $392,621 $449,158 $513,837
Cost of 160,000 183,040 209,398 239,551 274,046
c
sales
Gross profit $140,000 $160,160 $183,223 $209,607 $239,791
a Inventory is unchanged at $16,000 each year (2,000 units × $8). 2,000 of the units acquired in
the first year are assumed to remain in inventory.

b Sales Year X = (20,000 × $15)(1.10)X–1(1.04)X–1. The quantity sold increases by 10 percent

each year, and the selling price increases by 4 percent each year.

c Cost of sales Year X = (20,000 × $8)(1.10)X–1(1.04)X–1. In Year 1, 20,000 units are sold with a
cost of $8. In subsequent years, the number of units purchased equals the number of units sold,
and the units sold are assumed to be those purchased in the year. The quantity purchased
increases by 10 percent each year, and the purchase price increases by 4 percent each year.

Note that if the company sold more units than it purchased in a year, inventory would decrease.
This is referred to as LIFO liquidation. The cost of sales of the units sold in excess of those
purchased would reflect the inventory carrying amount. In this example, each unit sold in excess
of those purchased would have a cost of sales of $8 and a higher gross profit.

Company F Year 1 Year 2 Year 3 Year 4 Year 5

Using FIFO
Ending $16,000 $16,640 $17,306 $17,998 $18,718
inventorya
Salesb $300,000 $343,200 $392,621 $449,158 $513,837
Cost of 160,000 182,400 208,732 238,859 273,326
salesc
Gross profit $140,000 $160,800 $183,889 $210,299 $240,511
a Ending Inventory Year X = 2,000 units × Cost in Year X = 2,000 units [$8 × (1.04)X–1 ]. 2,000 units of
the units acquired in Year X are assumed to remain in inventory.

b Sales Year X = (20,000 × $15)(1.10)X–1(1.04)X–1

c Cost of sales Year 1 = $160,000 (= 20,000 units × $8). There was no beginning inventory.

Cost of sales Year X (where X * 1) = Beginning inventory plus purchases less ending inventory =
(Inventory at Year X–1) + [(20,000 × $8)(1.10)X–1(1.04)X–1] – (Inventory at Year X) = 2,000($8)
(1.04)X–2 + [(20,000 × $8)(1.10)X–1(1.04)X–1] – [2,000 ($8)(1.04)X–1]

For example, cost of sales Year 2 = 2,000($8) + [(20,000 × $8)(1.10)(1.04)] – [2,000 ($8)(1.04)] =
$16,000 + 183,040 – 16,640 = $182,400.

b. Compare the inventory turnover ratios (based on ending inventory carrying amounts) and
gross profit margins over the five-year period and between companies?

Company L F
Year 1 2 3 4 5 1 2 3 4 5
Inventory turnover 10 11.4 13.1 15 17.1 10 11 12.1 13.3 14.6
Gross profit margin (%) 46.7 46.7 46.7 46.7 46.7 46.7 46.9 46.8 46.8 46.8
Inventory turnover ratio = Cost of sales ÷ Ending inventory. The inventory turnover ratio
increased each year for both companies because the units sold increased, whereas the units in
ending inventory remained unchanged. The increase in the inventory turnover ratio is higher for
Company L because Company L’s cost of sales is increasing for inflation but the inventory
carrying amount is unaffected by inflation. It might appear that a company using the LIFO
method manages its inventory more effectively, but this is deceptive. Both companies have
identical quantities and prices of purchases and sales and only differ in the inventory valuation
method used.

Gross profit margin = Gross profit ÷ Sales. The gross profit margin is stable under LIFO because
both sales and cost of sales increase at the same rate of inflation. The gross profit margin is
slightly higher under the FIFO method after the first year because a proportion of the cost of
sales reflects an older purchase price.

Question 4:

Reliable Fans, Inc. (RF), a hypothetical company, sells high-quality fans and has been in business

since 2015. Exhibit 4 provides relevant data and financial statement information about RF’s

inventory purchases and sales of fan inventory for the years 2015 through 2018. RF uses the LIFO

method and a periodic inventory system. What amount of RF’s 2018 gross profit is due to LIFO

liquidation?

RF Financial Statement Information under LIFO

2015 2016 2017 2018

Fans units purchased 12,000 12,000 12,000 12,000
Purchase cost per fan $100 $105 $110 $115
Fans units sold 10,000 12,000 12,000 13,000
Sales price per fan $200 $205 $210 $215
LIFO Method
Beginning inventory $0 $200,000 $200,000 $200,000
Purchases 1,200,000 1,260,000 1,320,000 1,380,000
Goods available for sale 1,200,000 1,460,000 1,520,000 1,580,000
 Ending inventory* -200,000 -200,000 -200,000 -100,000
Cost of goods sold $1,000,000 1,260,000 $1,320,000 $1,480,000
Income Statement
Sales $2,000,000 $2,460,000 $2,520,000 $2,795,000
Cost of goods sold 1,000,000 1,260,000 1,320,000 1,480,000
Gross profit $1,000,000 $1,200,000 $1,200,000 $1,315,000
Balance Sheet
Inventory $200,000 $200,000 $200,000 $100,000
* Ending inventory 2015, 2016, and 2017 = (2,000  $100); Ending inventory 2018 = (1,000
 $100).

Solution:

RF’s reported gross profit for 2018 is $1,315,000. RF’s 2018 gross profit due to LIFO liquidation is
$15,000. If RF had purchased 13,000 fans in 2018 rather than 12,000 fans, the cost of goods sold
under the LIFO method would have been $1,495,000 (13,000 fans sold at $115.00 purchase cost per
fan), and the reported gross profit would have been $1,300,000 ($2,795,000 less $1,495,000). The
gross profit due to LIFO liquidation is $15,000 ($1,315,000 reported gross profit less the $1,300,000
gross profit that would have been reported without the LIFO liquidation). The gross profit due to
LIFO liquidation may also be determined by multiplying the number of units liquidated times the
difference between the replacement cost of the units liquidated and their historical purchase cost.
For RF, 1,000 units times $15 ($115 replacement cost per fan less the $100 historical cost per fan)
equals the $15,000 gross profit due to LIFO liquidation.