LIFO Method in Accounting for Inventories - Case Study Example

Part A) For each element explain how the situation may have arisen, and the problems that may arise if it is allowed to continue Budget Actual Raw material stocks 150 000 186 000 Finished stocks 45 000 66 000 Debtors 60 000 90 000 Bank 4 500 - 39 000 259 500 303 000 Creditors 66 000 51 000 Working capital 193 500 252 000 Given that the actual sales income and production costs were very near to the budgeted figures Raw material stocks: There is a 24% increase in raw material stocks compared to budget. The increase in raw material stocks may be due to higher quantity of raw materials purchased made than was necessary for the production of budgeted sales. The higher quantity of purchases may be either for one or several raw materials. If the situation is allowed to continue, the company would continue to build its raw material stocks and incur inventory cost on them. The suppliers would start demanding payments for the raw material and in the long-term, this would lead to higher working capital requirement. Finished stocks: While the sales are close to budgeted figures, the finished stocks have increased by 46% compared to budget. The increase in finished stocks means that the production of finished goods was more than sales. In planning for production, the previous stocks that the company already had may not have take been into account. Another possible reason for increase in finished stocks could be return of goods from customers that bought the goods in previous budget period. If the finished stocks are allowed to continue to increase, the company would incur unnecessary inventory cost. After a certain stage, this would become unsustainable as finished goods would stay in inventory with inventory turnover decreasing and leading to higher working capital requirement. Debtors: The outstanding receivables have increased by 50% compared to budget with sales same as budgeted. The increase in debtors’ may have been due to more sales made on credit to the customers/distributors or due to fewer payments received from them. If this is allowed to continue, the company would have lesser money available to pay the suppliers or to service the bank debt. This would mean that the company would then need to raise more money either get more bank loan or raise equity capital. Bank: The bank component turning negative means that the company has used up all the money in its account and now has a loan from the bank to the amount of £ 39,000. If this is allowed to continue, the bank would keep charging interest leading to lower profitability for the company. For any new payments to be made, the company would need to draw more credit from the bank or would need to pass on all money received from customers to the suppliers. The company’s cost of capital would increase making investments in some projects less lucrative. Creditors: The liability to creditors has decreased by 77% compared to budget. The decrease in the creditors’ component means that the suppliers have been paid off a higher percentage than budgeted. Because the raw material stocks have increase and the creditors’ component has decreased, it means that all previous credit from suppliers has been repaid and a larger proportion of purchases during this budget period have been paid off as well. If this is allowed to continue, the company would be effectively paying its suppliers before getting money from the customers leading to high working capital requirement for the company, in turn leading to necessity of raising more money for the company. B) Procedures that could be put in place to control the various elements Raw material stocks: In order to reduce the raw material stocks in the short-term, the company needs to be stricter on the re-order level of the raw materials. If not already defined, the re-order levels for all raw materials needs to be defined with the procurement department and strict adherence must be ensured in placing to new orders. No new orders for raw materials should be made until the stock quantity reaches the re-order level. Depending on the industry, if possible some raw material could be sold directly in the market as spares as well. For example, in case of cars, the company could sell its distributors and repair network some extra raw material in its inventory as spare parts. The company needs to be as close as possible to “Just in Time” (JIT) way of production and inventory management. Finished stocks: To reduce the finished stocks, depending on the level of inventory of finished goods, the company needs to reduce or even stop the production of new stocks for a while so that the current finished stocks are liquidated first. New production should be made only for the products whose stocks are high in demand and are low in stocks. The company could try to push its distributors to take more stock than usual. In acute cases, some stock may be sold even on discount in order to quickly reduce the inventory and get money from the customers. In the long-term, the solution could be to have production more streamlined with the sales and distribution departments so that timely inputs from them can be used to decide the production levels. Debtors: For debtors, the company needs to be more firm in reducing the credit period of its distributors/customers. The policy for customer credit may need to be reworked to reduce the credit period for customers. The company could make a system for tracking customer payment delays. Based on supplier payment schedules, a threshold number of days must be assigned beyond which a customer cannot hold the payment to the company. As soon as the customer starts to get near this threshold time for credit, the company must actively start pursuing customers for payments. Bank: The bank balance has turned from positive to negative. Depending on the interest rate levied by the bank (compared to the cost of capital), the company must return the bank overdraft as soon as possible. If the bank interest rate is too high, the company must urgently negotiate credit period with the suppliers and instead transfer its receipts to the bank in order to avoid hefty interest. In the long-term, the company needs to understand fully how its total cost of capital is affected by the different sourcing of funding it has (Weighted Average Cost of Capital - WACC). Based on this, it could decide an optimum level of credit from the bank. Creditors: In order to control the creditors’ component, the company needs to make sure that it has proper agreement with its suppliers concerning payment schedule and credit duration for raw materials. This should be negotiated with the suppliers based on the expected cycle for money coming from customers. Once this is done, the company must strictly adhere to the agreed terms at least for not reducing the number of days of credit from suppliers. Part 2 Methods for valuing stock issues There are several methods for valuation of stock issue. Some of them are discussed below: 1) FIFO (First In, First Out) Under this method for valuing stocks, it is assumed that the inventories are consumed in order of purchases meaning that whatever inventory was purchased first, is consumed first. Thus for valuing stocks, the cost of goods purchased most recently is used to value the inventory stock. Effectively, the cost used for goods sold or issued follows the same order in which goods were received. Thus, the cost of goods sold is based on the earliest purchase price and the cost of inventory is based on cost of material bought latest in the year. If the cost of goods purchased is increasing, under FIFO valuing of stocks, the profits appear higher than some other methods like AVCO. Some advantages of using this method are a) It is realistic as companies would generally use goods bought first b) It is easy to calculate c) Stock valuation is done at actual cost of purchase At the same time, there are some disadvantages of this method too: a) If the prices are rising, profits are higher than other methods leading to higher taxes b) From administrative purpose, it is time consuming to maintain the purchase records 2) HIFO method HIFO refers to Highest In, First Out. Under this method, the inventory purchased at highest cost is first accounted for when the inventory is sold or issued. As a result, the profits of the company appear low, which could be beneficial if the company wants to reduce its tax payments. The cost of goods sold is based on the most recent purchase price and the cost of inventory is based on the earliest purchase price during the year. 3) Weighted average cost method Under this method, the weighted average costs are used to value stocks. It is a complex method as weighted averages need to be calculated for the stocks. At the same time, by taking the weighted average cost of items, unusual peaks or drops in cost are taken care of. For example, for an airline company, when in early to mid 2008, the prices of oil reached $130 as opposed to then normal price of $60-70, if the company was using AVCO, the effect of this sudden increase in price of oil would have been less noticeable in the financial reports of the first two quarters in 2008. However, the effect of this high price would have spilled over one or two extra quarters for these companies due to weighted average cost. Overall, the cost of goods sold and the cost of inventory are based on all units currently in stock at the time of reporting. 4) LIFO method Under this method, the inventory purchased last is first accounted for when sold or issued. So, the cost of goods sold is based on the latest purchase price, while the inventory is valued at the cost of materials bought earlier in the year. This results in lower profit for the company. Especially during times of high inflation, the cost of goods sold will be the highest and the value of inventory will be the lowest, leading to lower profits. Conclusion Firms often adopt LIFO method in accounting for inventories when there is high inflation and the firms want to save on tax. If a firm switches from FIFO to LIFO, the net profit is reduced (higher cost of goods sold) but an increase in the cash flow (lower value of inventories). There is effect on cash flow only if the company changes from one system to another. References A2 Accounting for AQA. Accessed May 24 2011. http://www.osbornebooks.co.uk/files/a2_stock_valuation.pdf Demirakos et al. 2004. Accounting Horizons. Vol.18, No. 4. Page 218. Mtetwa M. Inventory or stock valuation. Accounting by Suite 101. Accessed 24 May 2011 http://www.suite101.com/content/inventory-or-stock-valuation-a196463 Materials cost. Accessed 24 May 2011. http://www.osbornebooks.co.uk/files/costing_t_ch2.pdf Read More