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

It is to be noted that profits are in a steady state but gross profit is increasing which indicates there is an increase in sales. And the contention of accountant that gradual increase in amount of inventories. As net profit is not increasing and gross profit is increasing which shows there is continuous increase in operating cost in proportion with Gross profit. The situation is illustrated below:

Year	20x1	20x2	20x3	20x4
Sales	2500	3000	3500	5500
COGS	2000	2300	2600	3900
% Of COGS/Sales	0.80	0.77	0.74	0.71
Gross Profit	500	700	900	1100
Operating Expenses	200	400	600	800
Net Profit	300	300	300	300

It is to be noted that cost of goods sold is decreasing with increasing sales this is due to increase in purchasing power, buying the goods in bulk availed higher discount etc.

The accountant need to analyze the expenses which are increasing in background in proportion to sales and take appropriate actions in locate them. The major and probable cost will be carrying cost of inventory as it is evident from the situation that increase in inventory which leads to carrying costa and blocking of working capital which in turn will increase the cost of finance.

The Staff Accountant should suggest CFO for JIT Inventory system:

The just-in-time inventory system is a management strategy that aligns raw-material orders from suppliers directly with production schedules. This strategy increases efficiency and decrease waste by receiving goods only as they need them for the production process, which reduces inventory costs. This method requires producers to forecast demand accurately.

JIT inventory controls have certain advantages such as production runs remain short, which means manufacturers can move from one product to another easily. This method reduces costs by minimizing warehouse needs. Companies also spend less money on raw materials because they buy just enough resources to make just the ordered products and no more.

In addition the method of costing also needs to be determined in accounting of fixed and variable overheads, which also plays a major role in unit cost.