Question

More food for thought: Total product costs = Inventory + COGS. The main concept, then, is in reporting, because the above holds true: high inventory would generally mean low COGS and higher profits. The reverse also would hold. If the company sells all or most of its products over the accounting period (typically a year), then both the CM approach and absorption will yield similar results. However, if production is consistently above sales, inventory would be higher under absorption since it includes all product costs in ending inventory. This is neither right nor wrong conceptually; the debate, under this last scenario: Is the company overstating profits by showing lower COGS? Would overproduction lead to obsolete and potentially unsellable inventory? What if we, as investors, were making decisions regarding whether to invest in a company that shows high profits and high inventories? Would we want to know the composition of these inventories (thinking about possible obsolete items)?

Answer 1

Yes, if production is consistently above sales, cost of ending inventory would be higher under absorption costing, and since absorption costing method is used for external reporting purposes, the COGS would consequently be lower and the profits would be higher.

Agreed producing more than sales on a consistent basis cannot be proved to be conceptually right or wrong or unethical. But if the sales do not pick up in subsequent accounting periods, this practice could lead to a large build-up of unsold inventories, and the inventory turnover can be sluggish leading to a liquidity crunch.

Overproduction can have the following adverse effects:

• For products with limited shelf life ( food products, chocolates, tea, coffee ) or products with seasonal demand , overproduction can lead to obsolete and non-moving inventory.
• Overproduction can also lead to illiquidity, as a large amount of capital remains blocked in unsold inventory.
• Overproduction can also lead to higher warehousing and allied costs as storage space would be needed to stock all the excess inventory.
• Overproduction can also lead to higher finance charges as funds would be needed to be invested in inventory.

Therefore, before making investment in a company with higher profits and higher inventory, it would be safer to look at the inventory turnover and the inventory conversion period, and compare the same with the industry averages.

Yes, the investor should also look at the composition of the ending inventory by doing an FSN ( Fast-moving, Slow-moving or Non-moving) analysis to make sure that there are no obsolete items.