Executive Summary
Merrimack Inc. is a company that has its roots back in the year in the aftermath of World War II. My father founded this company in the belief in certain business values and having faith that it is going to succeed in its market. In fact, up until now the company has succeeded in having a comfortable market position. In order to remain competitive and top market we decided years ago to move our production capabilities in foreign countries, first Japan and then China. This was done because of the low costs available there and so the company could benefit more.
Unfortunately, this days it seems the fortune has turned the back to us. Due to economic growth and other factors the costs of manufacturing and transportation are rising fast. These are affecting negatively our company’s revenues and profits. Since we cannot affect the global conditions but are affected by them, this paper proposes to use what tools are still available to us to make our company remain at the current level of revenues and profits.
The tool I am proposing is to change our accounting policies from LIFO standard (last-in, first-out) to FIFO standard (first-in, first-out). Below I will try to explain the benefits and costs of this transformation and why I believe this is the correct thing to do.
Report
Future predictions
For the coming year, 2008, we assume that will sell the same 40,000 units, as in 2007, starting with $2000 per unit. In that case our balance sheet would change as shown in “Exhibit 1” at the end of the paper. There are two basic predictions we can make here. If we are to sell the same as 2007, or 10,000 units per quarter, using LIFO the net income (or the profits) will increase to $8,450. That is a $1,300 increase from the past year. As we have mentioned before, the difference between LIFO and FIFO is about $5,500. By the current prediction with LIFO for 2008 the taxes should be $4,550. If FIFO is used we would have to pay a higher amount of money in taxes but this we should not forget that this amount is going to be paid some day. It is just accumulating along the years. It is like having a debt on our company waiting to be paid. The problem is that the time may come in a moment when our company would really need that money. And that could even mean bankruptcy.
Thus, by changing to FIFO we would increase our taxes and reduce short term profit, but would certainly, at least, stabilize the long term profitability of the company. This revenues stabilization would guarantee us cover from future shocks of the market or rising costs. In “Exhibit 2” we have assumed what will happen if the sales were not 10,000 per quarter but 5,000 in the first and last quarter, 20,000 in the second and 10,000 in the third. As you can see in the tables the costs and revenues would change, the flow of cash would be diverse than that of previous options.
If we use LIFO we would miss this positive change in the flow of cash, a miss that FIFO would eliminate. This is because LIFO takes into account only the last layers, the most recent. Instead FIFO takes into account the oldest layer, the very first of cash flow and includes all the coming layers up until the most recent one. This way you have a clearer picture of how your flow of cash has gone throughout all the year that passed and lets you take appropriate decisions for the future year to come.
Possible Options
The rising costs of production in China and the rising costs of transportation due to fuel prices, has led our company into a stand-by position. By seeing the dynamics of the world markets and world economy surely we are heading to difficult times. This is why fast and correct action and measures are needed. The first thing to consider is the possibility whether we can change the manufacturing place and cut the ties with the Chinese manufacturers. But the possibility of re-opening the production units for mowers in Nashua is not an option. This is because the manufacturing costs will have a sharp increase way over what we are experiencing right now. The fact of the rising cost of transportation from $3,000 in the year 2000 to $9,000 in 2009 is a definite argument on the need to take measures as soon as we can to safeguard the future of the company.
We can certainly search for other manufacturing options such as searching for other off-shore suppliers that offer cheaper costs than the current ones. Unfortunately, there is no way of doing so before the end of 2008 or even 2009 if the company’s profit trends and growth were to be maintained.
So, one applicable solution that will be of great help is the changing on our accounting policies from LIFO to FIFO. This will benefit the company in retaining the same level of profits for the next year and increase them in the years to come. Below I will briefly explain the difference between the two.
LIFO and FIFO
In inventory control and accounting policy, these two term show the possible ways how you handle your merchandise. In a joking way we can say if you restock the shelves by pushing the old items back to make room for new items of the same kind? Then the last items stocked will be the first items sold, or LIFO. This would be a typical stocking method for items that have no ‘sell-by’ date associated with them, or at least one that is in the distant future, such as canned good. Perishable items such as milk and eggs are restocked from the back, so that the old items are pushed to the front and are the first selected by shoppers; this is a FIFO restocking method. This is why most convenience stores have walk-in coolers behind their cold displays, so that they can stock from the rear (“Wise Geek” 2009).
When we measure our flow of cash in the company if we match the last cost we had (the latest one, the most recent) with the first revenues we have used the last-in, first-out method (otherwise known as LIFO). This is the actual accounting method that we use to measure the flow of cash and balances of our company.
The other method in use around the world today is FIFO, or first-in, first-out method. The difference with LIFO is that FIFO takes into account the oldest costs in a company (the very first costs) and matches them with the first revenues to have been made. This method is in fact the method used widely around the world and, in fact, the compliance with it is a requirement of the International Financial Reporting Standards. Being so, our company in a future time will have to comply with it by law and we will be force anyway to change our accounting policies and methodology from LIFO to FIFO.
Benefits and reasons to change from LIFO to FIFO
Since prices generally rise over time because of inflation, by using the last-in, first-out method (LIFO), a company records the sale of the most expensive inventory first and compares it to the oldest revenues to have been made, the first ones.
In doing so, the usage of this method shows a decreased profit and has a reducing effect on taxes. And this is exactly why in the late 1980’s, when the company was incorporated, the managing team decided to implement this type of accounting policies. The reason is that by paying a smaller amount in taxes per year the company could manage to save during all these years a total sum of around $2 millions. The intention back those years has been to save this money in order to use them for investments in the future.
However, this method rarely reflects the physical flow of indistinguishable items and it does not mean that we will not have to pay the tax money we managed to save. In fact, the use of LIFO means that the IRS (Internal Revenue Service of the United States) has given us a delay in the payment of these taxes in comparison if we had chosen back in 1980 the use of FIFO.
The IRS is clear in it that LIFO policies and methodology is permitted in the belief that an ongoing business does not realize an economic profit solely from inflation. When prices are increasing, they must replace inventory currently being sold with higher priced goods. And it is LIFO whom better matches current costs against current revenues. It also defers paying taxes on a “phantom income” basis arising only from inflation. These are the main benefits we had from applying LIFO standard policies and methodology during the past almost three decades.
On the other hand we have FIFO. It is a common method for recording the value of inventory. It is appropriate where there are many different batches of similar products. The method presumes that the next item to be sold will be the oldest of that type in the warehouse. In practice, this usually reflects the underlying commercial substance of the transaction, since many companies rotate their inventory (especially of goods that are perishable). This is still not in contrast to LIFO because FIFO and LIFO are cost flow assumptions not product flow assumptions (Gibson 2002, p. 1).
The LIFO costing method contrasts with the first in, first out (FIFO) inventory method, which assumes that the cost of items sold in a period reflects the oldest cost in inventory just before sale. As a consequence, remaining inventory valued at FIFO more closely represents current or replacement cost.
In a business world of ever increasing costs (due to different world wide factors), it is becoming more and more common for companies to use FIFO for reporting the value of merchandise to bolster their balance sheet. As the older and cheaper goods are sold, the newer and more expensive goods remain as assets on the company’s books.
Having the higher valued inventory and the lower cost of goods sold on the company’s financial statements may increase the chances of getting a loan. However, as it prospers the company may switch to LIFO to reduce the amount of taxes it pays to the government (Gibson, 2002, p. 2).
This is the main benefit we can have from FIFO methodology and policy. Again, I state that LIFO was attractive for our company in that it delays a major detrimental effect of inflation, namely higher taxes. However, in a very long run, we will have to pay that tax money. In a certain way the IRS is allowing us an “extension” on the time of paying but eventually we will have to pay that money.
Let us take a look at our balance sheet to better understand this. For 2007 we had 40,000 items sold with a total Cost of Goods Sold of $46,000. The total Sales inventory was of $67,000. That gives us a Gross Margin of about $21,000. From this Gross Margin we have to subtract the various sales and administrative costs. That is the profit before taxes. Since the administrative and sale costs are fixed at $10,000 for 2007 the profit before taxes (or income before taxes) will be $11,000. Taking into account the 35% rate of taxes the net profit for the company was $7,150.
Now, that is using the LIFO accounting principles. In it we have assumed an initial cost, a Beginning Inventory cost, of about $13,500. If we had used the FIFO methodology we would have had a $19,000 on beginning inventory cost. The difference between the two is $5,500.
If we take into account the 35% of the tax burden we can now understand the amount of money the company managed to avoid paying in taxes during these years. Well, everything seems perfect with this methodology. The problem is that we still will have to pay that money in the near future. That is the real cost of us switching to FIFO. We will need to restate our historic earnings and realize the increase in inventory value of $5.5 million leading to an instant tax liability of almost $2 million. However, there is probably an ongoing increase in taxes payable as well.
Again, we must keep in mind that this is not really an “additional” tax but just relates to the timing of the payment. The use of LIFO means that the IRS has given us a delay in payment compared to the use of FIFO since 1980.
Examples
Let me take some meaningful examples. If the company was ever liquidated, we would reduce our inventory to zero and then there would be no difference between the LIFO and FIFO inventory valuations. In such a setting, the cumulative differences in Cost of Goods Sold over the life of the company would also go to zero and so we would end up having to pay the amount anyway.
Exhibit 1
This Pro-forma income statement is for 2008 assuming 10,000 units per quarter at $2000 per unit with the same costs as in 2007.
- Total Inventories under the first-in, first-out (“FIFO”) method 19,000
- Less: Last-in, first-out method (“LIFO”) adjustment (5,500)
- Total Inventory 13,500
- Income Statement (thousands of dollars) 2007 (LIFO)
- Sales $67,000
- Cost of goods sold 90,000
- Gross margin $23,000
- Selling and admin. exp. 10,000
- Income before taxes $13,000
- Income taxes (35%) $4,550
- Net income $8,450
Exhibit 2
- Total Inventories under the first-in, first-out (“FIFO”) method 19,000
- Less: Last-in, first-out method (“LIFO”) adjustment (5,500)
- Total Inventory 13,500
- Income Statement (thousands of dollars) 2007 (LIFO)
- Sales $67,000
- Cost of goods sold 103,000
- Gross margin $36,000
- Selling and admin. exp. 10,000
- Income before taxes $26,000
- Income taxes (35%) $9,100
- Net income $16,900
References
LIFO and FIFO accounting, 2009. The Wise Geek Website. Web.
Gibson, S. C. (2002). LIFO vs. FIFO: a return to the basics. The RMA Journal Online.