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Value under LIFO: 274,163 @ 15.25 4,180,986
$4,180,986

Value under WEIGHTED AVERAGE:
274,163 @ $11.68 $3,202,224
70 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


during the year. Using FIFO, the ending inventory is assumed to
consist of the most recent purchases (which is all of November™s
purchase plus a few left over from September™s buy”a total of
274,163 units). Their value comes to $3,250,000. Okay so far?
The cost of goods sold and net income would then be
$26,358,500 and $1,509,601 respectively. See Figure 6-2 for how
all that shakes out on A.I.™s in-
BT est come statement.
ip As you can see, this income
statement is identical to the one
Most businesses will find it
difficult if not impossible to use you met back in chapter two.
That™s because A.I. uses FIFO to
the specific invoice method to
value its inventory.
value inventory.
LIFO. LIFO assumes that the
last units received were the first
ones sold (Last In, First Out). That doesn™t jibe with the way
most inventory usually flows through a business, except for things
that might be stored in bins like nuts and bolts.
But we can assume a theoretical LIFO movement neverthe-
less. If we do, then the ending inventory (the goods sitting in
the warehouse on December 31) are leftovers from last January™s
beginning inventory.
Why would any company choose to value inventory in a way
that contradicts the real flow of goods through a company? We™ll
get to that in a few pages.
Look at Figure 6-1 again. Using LIFO, the units in A.I.™s end-
ing inventory”274,163 pieces”are presumed to be leftovers
from the 274,754 pieces it started the year with, so they would
be valued at $4,180,986 (which, you™ll notice, is $930,986 more
than the ending inventory™s FIFO value).
That changes all the numbers”for the better. The cost of
goods sold and net income would then be $25,427,514 and
$2,086,812 respectively.
Figure 6-3 (next page) shows how A.I.™s income statement
would look if ending inventory and cost of goods sold were
71
Inventory Valuation



Figure 6-2: Income statement under FIFO

Avaricious Industries
Consolidated Earnings Statement
For Year Ended December 31, 19XX


Net sales $38,028,500
Cost of goods sold:
Inventory, January 1 4,190,000
Purchases (net) 25,418,500
Goods available for sale 29,608,500
Less inventory, December 31 3,250,000
Cost of goods sold: 26,358,500
Gross profit 11,670,000
Operating expenses
Selling:
Sales salaries expense 1,991,360
Advertising expense 3,527,650
Sales promotion expense 987,745
Depreciation expense”
selling equipment 403,850 6,910,605
General and administrative:
Office salaries expense 1,124,650
Repairs expense 112,655
Utilities expense 39,700
Insurance expense 48,780
Equipment expense 63,750
Interest expense 211,020
Misc. expenses 650,100
Depreciation expense”
office equipment 73,900 2,324,555
Total operating expenses 9,235,160
Earnings before income tax 2,434,840
Income tax 925,239
Net income $1,509,601

Common stock shares outstanding: 2,500,000
Earnings per share of common stock: $0.60
72 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS



Figure 6-3: Income statement under LIFO

Avaricious Industries
Consolidated Earnings Statement
For Year Ended December 31, 19XX


Net sales $38,028,500
Cost of goods sold:
Inventory, January 1 4,190,000
Purchases (net) 25,418,500
Goods available for sale 29,608,500
Less inventory, December 31 4,180,986
Cost of goods sold: 25,427,514
Gross profit 12,600,986
Operating expenses
Selling:
Sales salaries expense 1,991,360
Advertising expense 3,527,650
Sales promotion expense 987,745
Depreciation expense”
selling equipment 403,850 6,910,605
General and administrative:
Office salaries expense 1,124,650
Repairs expense 112,655
Utilities expense 39,700
Insurance expense 48,780
Equipment expense 63,750
Interest expense 211,020
Misc. expenses 650,100
Depreciation expense”
office equipment 73,900 2,324,555
Total operating expenses 9,235,160
Earnings before income tax 3,365,826
Income tax 1,279,014
Net income $2,086,812

Common stock shares outstanding: 2,500,000
Earnings per share of common stock: $0.83
73
Inventory Valuation


valued by the company accountants under a LIFO assumption.
Because the value of the inventory using LIFO is $930,986
higher than FIFO, that automatically makes the cost of goods
sold $930,986 lower and net income $930,986 higher.
Think this through a couple of times (we™ll wait). It makes
sense. If the ending inventory is higher, cost of goods sold is less.
If cost of goods sold is less, then net income grows. And in this
case, the difference between FIFO and LIFO made darn nearly
$1 million difference in the company™s profit picture (pre-tax).
But we™re not done yet.
Weighted Average. Here™s yet another way to assign a value
to an ending inventory. Go back
BT
to loyal old Figure 6-1 again (it est
ip
must be getting tired by now), and
you™ll see a weighted average cost How you value inventory can
per unit of $11.68.Where did that make a big difference in the
come from? Well, A.I. had a total net income for a given year.
of 2,534,963 units available for
sale this year (the sum of its be-
ginning inventory plus all its purchases), and the total cost was
$29,608,500. The weighted average cost per unit?
$29,608,500
= $11.68
2,534,963 units

$11.68 X 274,163 units in ending inventory = $3,202,224
Figure 6-4 on the following page shows how Avaricious In-
dustries™ income statement would look in that situation. Natu-
rally, the cost of goods sold and net income are different from
the amounts you saw on either the FIFO or LIFO income state-
ments.
If you value A.I.™s ending inventory using the weighted aver-
age method, the net income ends up being $29,621 less than it
was under FIFO and $606,832 less than it was under LIFO. Quite
a difference, but that™s the way it is.
74 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS



Figure 6-4: Income statement under weighted average

Avaricious Industries
Consolidated Earnings Statement
For Year Ended December 31, 19XX


Net sales $38,028,500
Cost of goods sold:
Inventory, January 1 4,190,000
Purchases (net) 25,418,500
Goods available for sale 29,608,500
Less inventory, December 31 3,202,224
Cost of goods sold: 26,406,276
Gross profit 11,622,224
Operating expenses
Selling:
Sales salaries expense 1,991,360
Advertising expense 3,527,650
Sales promotion expense 987,745
Depreciation expense”
selling equipment 403,850 6,910,605
General and administrative:
Office salaries expense 1,124,650
Repairs expense 112,655
Utilities expense 39,700
Insurance expense 48,780
Equipment expense 63,750
Interest expense 211,020
Misc. expenses 650,100
Depreciation expense”
office equipment 73,900 2,324,555
Total operating expenses 9,235,160
Earnings before income tax 2,387,064
Income tax 907,084
Net income $1,479,980

Common stock shares outstanding: 2,500,000
Earnings per share of common stock: $0.59
75
Inventory Valuation


The company™s balance sheet, of course, would reflect a cor-
responding change in the value of its assets (because inventory is
an asset) and stockholders™ equity (because net income on the
income statement is added to the beginning retained earnings
balance to produce the year-end retained earnings balance).

Be Consistent
Companies will typically pick one method for valuing their
ending inventory and cost of goods sold and stick with it for
several years. If they don™t, their
BTest
accounting statements won™t be
ip
comparable from one year to the
next. That makes it difficult to do There™s no “best” way to value
the year-to-year vertical analysis inventory, but you must be
comparisons you learned about in consistent from year to year.
the last chapter.
Also, companies can™t just opt
for the method that makes the bottom line look the best each
year. The IRS won™t allow it.
The inventory valuation method that a company uses should
be mentioned either on the financial statement itself or in the
notes at the end of the statements.

Which One™s Best?
There is no “best” way to value inventory, and all are legal.
When prices are rising, FIFO will assign the highest cost to
inventory and the lowest to cost of goods sold, thus producing
the highest net income. LIFO would do the opposite, assigning
the lowest cost to inventory and the highest to cost of goods
sold, resulting in a lower net income than FIFO. In times of
rising prices, weighted average would produce amounts some-
where between those of FIFO and LIFO.
During times of high inflation, such as the late 1970s and
early 1980s, many companies changed to LIFO to get a tax break,
because it yielded the lowest taxable income. It™s important to
76 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


realize, however, that the Internal Revenue Service requires com-
panies that want to use LIFO for tax-reporting purposes use it
for financial reporting purposes too. In such cases, notes at the
end of the financial statements may show the value of the inven-
tory and cost of goods sold under other methods such as FIFO
or weighted average.
LIFO and FIFO are the most popular of the four valuation
methods. Companies sometimes prefer to use LIFO for finan-

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