Problem 11 - Accounting

Question

The following data were extracted from the income statement of Brecca Systems Inc.: $$ \begin{array}{lrr} & \text { Current Year } & \text { Preceding Year } \\ \hline \text { Sales } & \$ 1,139,600 & \$ 1,192,320 \\ \text { Beginning inventories } & 80,000 & 64,000 \\ \text { Cost of goods sold } & 569,800 & 662,400 \\ \text { Ending inventories } & 74,000 & 80,000 \end{array} $$ a. Determine for each year (1) the inventory turnover and (2) the number of days' sales in inventory. Round to nearest dollar and one decimal place. b. What conclusions can be drawn from these data concerning the inventories?

Step-by-Step Solution

Answer

The inventory turnover decreased from 9.2 to 7.4, indicating slower sales. The days' sales in inventory increased from 39.7 to 49.3 days. This suggests that the company is selling inventory more slowly in the current year.

Step 1: Calculate Average Inventory for Each Year

We first compute the average inventory for each year using the formula: \( \text{Average Inventory} = \frac{\text{Beginning Inventory} + \text{Ending Inventory}}{2} \). For the current year: \( \frac{80,000 + 74,000}{2} = 77,000 \). For the preceding year: \( \frac{64,000 + 80,000}{2} = 72,000 \).

Step 2: Calculate Inventory Turnover Ratio

The inventory turnover ratio shows how many times the inventory is sold and replaced over a period. It is calculated as \( \text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} \). For the current year: \( \frac{569,800}{77,000} \approx 7.4 \). For the preceding year: \( \frac{662,400}{72,000} \approx 9.2 \).

Step 3: Calculate Number of Days' Sales in Inventory

This metric estimates how many days it takes to sell the entire inventory. It is given by \( \text{Number of Days' Sales in Inventory} = \frac{365}{\text{Inventory Turnover}} \). For the current year: \( \frac{365}{7.4} \approx 49.3 \). For the preceding year: \( \frac{365}{9.2} \approx 39.7 \).

Step 4: Interpret the Results

Comparing the two years, Brecca Systems Inc. has a lower inventory turnover in the current year (7.4) compared to the preceding year (9.2), indicating a slower movement of inventory. The number of days sales in inventory has increased from 39.7 to 49.3 days, suggesting that inventory is turning into sales less frequently.

Key Concepts

Inventory Turnover

Inventory Turnover is a key metric that reveals how efficiently a company manages its stock. It calculates the number of times the full inventory is sold or used within a certain period. Ideally, a higher inventory turnover ratio indicates better performance because more sales are generated from the same inventory investment.

Here's how it's calculated:

• The formula is: \( \text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} \)
• A higher turnover rate suggests that a company is doing well in selling their inventory quickly, whereas a lower turnover might hint at overstocking or slower sales.

In Brecca Systems Inc.'s data:

• For the current year, the turnover is approximately 7.4
• For the preceding year, it's approximately 9.2

From these figures, we can deduce that the company had slower inventory movement in the current year compared to the preceding one. Ensuring a high inventory turnover can help reduce holding costs and prevent stock obsolescence.

Days' Sales in Inventory

Days' Sales in Inventory (DSI) provides insight into the average time it takes for a company to convert its inventory into sales. In essence, it's the inverse of the inventory turnover ratio and offers a different perspective on inventory performance.

The calculation is straightforward:

• Formula: \( \text{Number of Days' Sales in Inventory} = \frac{365}{\text{Inventory Turnover}} \)
• This tells us how many days, on average, it takes for the inventory to sell.

For Brecca Systems Inc., the calculation results were:

• Approximately 49.3 days for the current year
• Approximately 39.7 days for the preceding year

These numbers show that it takes longer to sell inventory in the current year compared to the previous one.
This increase implies less frequent movement of goods, which may lead to increased storage costs or issues related to inventory aging.

Average Inventory Calculation

Calculating the Average Inventory is crucial for determining other inventory metrics such as turnover and DSI. It represents the middle point of inventory levels over a period and provides a base for further analysis.

The formula to compute it is:

• \( \text{Average Inventory} = \frac{\text{Beginning Inventory} + \text{Ending Inventory}}{2} \)
• This calculation helps smooth out any fluctuations in inventory levels during the period.

In our exercise with Brecca Systems Inc.:

• The average inventory for the current year was calculated to be \( 77,000 \)
• For the preceding year, it was \( 72,000 \)

This average gives a clearer understanding of how much inventory is typically on hand and facilitates more accurate turnover and DSI calculations.