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ANALYSIS OF INVENTORIES

ANALYSIS OF INVENTORIES. INTRODUCTION. Compare the effects of the FIFO/ LIFO choice along these dimensions and demonstrates how the analyst can adjust from one method to another. Inventory Management. Inventory is one of the most expensive assets of many companies.

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ANALYSIS OF INVENTORIES

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  1. ANALYSIS OF INVENTORIES Đặng Thị Thu Hằng

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

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

  4. 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). Đặng Thị Thu Hằng

  5. 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 Đặng Thị Thu Hằng

  6. 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 Đặng Thị Thu Hằng

  7. 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 Đặng Thị Thu Hằng

  8. EXAMPLE: COSTS INCLUDED IN INVENTORY Đặng 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: 15.000 Conversion cost for finished goods: 20.000 Freight in to plant: 800 Storage cost for finished goods: 500 Abnormal waste: 100 Freight out to customers: 1.100 Đặng Thị Thu Hằng

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

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

  12. 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 Đặng Thị Thu Hằng

  13. Đặng Thị Thu Hằng

  14. SCENARY 1: STABLE PRICE • BI + P = COGS + EI • $ 2000 + $ 5000 = $ 4000 + $ 3000 Đặng Thị Thu Hằng

  15. SCENARY 2: RISING PRICES • FIFO: BI + P = COGS + EI $ 2000 + $ 6250 = $ 4300 + $ 3950 • LIFO: BI + P = COGS + EI $ 2000 + $ 6250 = $ 5150 + $ 3100 Đặng Thị Thu Hằng

  16. 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 Đặng Thị Thu Hằng

  17. 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 Đặng Thị Thu Hằng

  18. LIFO VERSUS FIFO: INCOME, CASH FLOW AND WORKING CAPITAL EFFECTS Đặng Thị Thu Hằng

  19. The income statement Đặng Thị Thu Hằng

  20. The cash flows Đặng Thị Thu Hằng

  21. The change in balance sheet account Cash: net cash flow for period Inventory: purchases less COGS Retained earning: net income for period Đặng Thị Thu Hằng

  22. 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. Đặng Thị Thu Hằng

  23. Calculate COGS and ending inventory under the FIFO and LIFO cost flow methods using a perpetual inventory system Đặng Thị Thu Hằng

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

  25. Đặng Thị Thu Hằng

  26. 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. Đặng Thị Thu Hằng

  27. 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. Đặng Thị Thu Hằng

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