Question

You are recently hired as a staff accountant for a small finished goods manufacturing company. Part of your duties include doing the month end inventory of finished goods. After a few months you do not look forward to this as the amount of inventory seems to be increasing. In order to satisfy your thoughts on this increase of inventory you decide to review the financial information for the last few months.

Looking over the Income Statement you see the profits have been steady, but the gross profit percentage has increased, and the cost of goods sold have decreased. This does not seem possible as the company has increased the amount of inventories.

Identify why this situation could exist, providing an explanation which can be given to the CFO.

In order to assist in controlling the costs and providing a lower inventory carrying cost, select a costing system and explain why it should be utilized.

Answer 1

The company is ordering stocks in advance without an estimate of the usage of the inventories which is leading to the pile up of inventories and subsequently the costs related with the inventories. In case of a situation of inflation and when FIFO is used to account for inventories, the cost of goods sold is lower and gross profit is higher. In this situation, the company first must draw up a purchase and raw materials inventory budget by considering all facts and must forecast demand accurately. The company must incorporate Just in time costing system i.e. inventory is ordered as and when required for the production process. This method will aid in reducing the holding costs and also improve operational efficiency. With Just in time, the inventory turnover ratio is quicker and also will help in better allocation of resources.