Inventory and COGS

For a retail company, the most important expense on the income statement is cost of goods sold. However, even in a simple situation, a surprisingly difficult question to answer is, how much is cost of goods sold? Consider these transactions for Ramona Rice Company. On March 23rd, she purchased 10 kilograms of rice for $4 per kilo, total cost $40. On November 17th, she purchased 10 kilograms of rice for $9 per kilo, that's total $90. And then finally, on December 31st, she sold 10 kilograms of rice for $10 per kilo, total selling price $100. Let's start with a simple question. What is the operating cash flow for Ramona Rice Company for the year? The computation is easy. Paid $40 for the March 23rd rice purchase, paid $90 for the November 17th rice purchase, and then collected $1000 for the December 31st rice sale. Minus $40, minus $90, plus $100, that's negative $30 in operating cash flow for the year. Now there is no ambiguity about this number. This negative $30 in operating cash flow is an exact objective fact. Okay, now let's tackle this important question. What is Ramona's profit for the year? Hmm, well, she sold 10 kilograms of rice on December 31st, but which kilograms? The rice is probably jumbled together in her storage facility. So we can't be sure exactly which rice grains she sold on December 31st. But Ramona's profit for the year depends on which rice she sold. There are three possibilities. Case one, assume she sold the old rice. Assume that the 10 kilograms of rice sold on December 31st were the old ones, the $4 kilos purchased on March 23rd. Accountants call this a FIFO, or first in-first out assumption. Case two, assume she sold the new rice. Assume that the new rice was sold, the $9 kilos purchased on November 17th. Accountants call this a LIFO, or last in-first out assumption. Case three, assume she sold a mixture of rice. Assume that all the rice is mixed together, resulting in an average cost per kilo of $6.50. $40 plus the $90, that's $130, divided by 20 kilos, $6.5 per kilo. Accountants call this an average cost assumption. The profit in each case is computed like this. Aah, the point of the Ramona Rice example is this. In most cases, there is no feasible way to track exactly which units were sold. Accordingly, in order to compute cost of goods sold, the accountant must make an assumption. Note that this is not a case of tricky accountants trying to manipulate the reported numbers. Instead, this is a case in which income simply cannot be computed unless the accountant uses her or his judgment and makes an assumption. All three of the assumptions described in the example, FIFO, LIFO, and average cost, are acceptable under U.S. accounting rules. According to the international rules, IFRS, LIFO cannot be used. There are very interesting reasons for this international LIFO ban. That's a tale for another day. Now an interesting question is whether a company would randomly choose one of the three acceptable methods or whether the company would make the choice strategically. For example, if Ramona were preparing financial statements to be used to support a bank loan application, which assumption would you suggest that she make? Probably FIFO, in order to report higher profit. On the other hand, if Ramona were computing her income taxes, which assumption would be the best? Probably LIFO, in order to pay lower taxes. Keep in mind how simple this Ramona Rice example is. Two inventory purchase and one inventory sale. But even in this simple setting, computing profit is impossible without making an accounting assumption. When you look at an income statement, remember that many assumptions went into the computation of net income. You can't intelligently interpret that income statement until you understand the impact of those assumptions. So when you are given an income statement, ask this question. What important assumptions were made in the preparation of this income statement?