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Buy Low, Sell High
The difference between a product’s sale price and its cost is called the gross margin or gross profit. Obviously, the higher the margin, the better. The cost of the product is called cost of goods sold. We would hope that computing gross profit would involve a simple subtraction of the total cost of goods sold from total sales. Alas, things turn out to be more complicated.
Adding total sales generally poses no great measurement problem, but calculating the cost of goods sold is not as straightforward. The basic difficulty arises when a business does not completely sell all its goods during the accounting period. In fact, most firms finish their year with unsold inventory. Valuing the unsold year end inventory is the primary source of complexity in figuring out the cost of goods sold.
Example. Janis buys and sells a silicon gel compound used in the production of cosmetic surgery implants. Assume that Janis can sell an ounce of compound for $500 that costs her $250. Let’s say Janis bought and sold precisely 100 ounces of compound during the year. What is her gross profit?
Now change the scenario and assume she bought 150 ounces of compound, but sold only 100 ounces during 2004. This means she has 50 ounces left at the end of the year. What is her gross profit now?
The $37,500 cost of goods sold is derived by multiplying 150 times $250. But this does not make sense because the unsold compound on hand at the end of the year should not be treated as an expense. Treating unsold year-end inventory as an expense violates the matching concept and common sense. Instead, the computation of the cost of goods sold is complicated by taking into account ending inventory as follows:
Cost of Goods Sold = Beginning Inventory + Purchases - Ending inventoryWhat would Janis’ cost of goods sold look like, assuming she had no beginning inventory, using the above formula?
This matches our previously computed cost of goods sold figure. To arrive at the $12,500 ending inventory figure, the 50 unsold ounces was multiplied by the purchase price of $250 per ounce. In this example, all Janis’ purchases were made at the same price, $250 per ounce. In the real world, the per ounce cost is likely to fluctuate. Also, Janis, like many businesses, may offer more than one type of product with fluctuating prices. In order to accurately compute the cost of goods sold, Janis has to be able to get an accurate count of unsold inventory on hand and she also has to assign the “correct” costs to these products.
In assigning a cost to unsold inventory you would expect to use its actual cost. This is not as easy as you might think. For Janis to use the actual cost paid she must be able to identify the cost associated with the batches of compound on hand at the end of the period. However, these batches might come from more than one purchase, each with a different purchase price.
Assume Janis stores her purchases in one big storage tank. Also assume that purchase prices fluctuated during the year. Because she keeps her product in one tank she cannot physically tell which batches go with which costs. She can certainly measure the amount of compound she has on hand at the end of the year, but how does she know the unit price to assign to her ending inventory?
In order to assign a cost to her ending inventory Janis will have to make assumptions about the flow of compound in and out of her tank. One plausible flow assumption is called FIFO, standing for first in, first out. Under this assumption, ending inventory is associated with costs from the most recent deliveries. An alternative flow assumption is called LIFO, standing for last in, first out. Under this flow assumption, ending inventory is associated with the oldest purchase costs. Alternatively, Janis might avoid making any flow assumption by simply using the weighted average cost of deliveries to value ending inventory.
The Effect of Different Flow Assumptions on Reported Gross Profit
You may think the choice of flow assumptions in assigning costs to ending inventory is a relatively minor issue. However, the choice of inventory flow assumption can dramatically affect the reported cost of goods sold, gross profit, and net income.
Example. Assume that Janis received four shipments during the year as follows:
If she has 50 ounces of compound unsold at the end of the year, different flow assumptions will yield different ending inventory figures. If she uses a FIFO approach, she will assume that the remaining inventory comes from the two most recent purchases:
If she uses a LIFO approach, she will assume that the remaining inventory derives from the oldest two purchases:
Alternatively, Janis could use a weighted average cost approach:
You can see that the three different approaches lead to a range of $7,900-17,000 in ending inventory value. The following table shows the variation in computed gross profit:
Because the example uses relatively small dollar amounts, the dollar variation in gross profits under the different flow assumptions may not seem extreme. The gross profit percentages reveal more startling differences. Gross profit is reported as 59% of sales using FIFO, but only 41% of sales using LIFO. If you are looking at a company with millions in sales you can see just how dramatic an impact inventory flow assumption can have on reported earnings.
GAAP: Do Your Own Thing
Does GAAP stipulate the specific flow assumption a business has to use? Actually, GAAP allows a business to use any flow assumption it chooses, as long as it does so on a consistent basis. This means that the flow assumption used in one year must be used in the next.
Allowing different inventory flow assumptions means that two businesses with identical operating results can report dramatically different amounts of profit. To avoid this possibility, GAAP would have to require that all firms use the same inventory flow assumptions. As desirable as it might be for GAAP to reduce the number of acceptable, but widely divergent inventory flow assumptions, this is not likely to happen any time soon. This means that financial statement users must be aware of the effect of these flow assumptions in comparing one firm’s performance to another
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