Inventory Ins and Outs

Inventory may not be the sexiest topic around; I'll grant you that. Maybe in my next column, we'll uncover Victoria's Deep Dark Secrets by looking at The Limited (NYSE: LTD  ) , or some other equally stimulating idea. But for now, let's dive into inventory. It's an important financial statement concept for any investor to understand.

Inventory, schminventory
Why should you care about inventory? For one thing, a glance at an income statement reveals a line labeled "cost of goods sold" as the very first reduction from a company's revenues. Right off the top, we yank out how much it costs a company to sell boats or blankets or baby dolls -- in other words, its inventory.

The inventory account on the balance sheet is tied to cost of goods sold. When a company's ready to calculate how much money it's pocketed, it must determine how much inventory was sold and how much it cost the company. Accounting for inventory can be trickier than you think.

In fact, inventory's tricky characteristics are another reason to pay attention to it. Inventory can be easy to manipulate. By overstating the inventory remaining on a balance sheet, for instance, a company necessarily understates cost of goods sold and overstates net income.

The best-performing stock on the NYSE back in 1996 went down in flames, thanks in part to inventory fraud. Centennial Technologies, which supposedly made PC cards, shot up 451% in 1996 alone. When it was discovered that Centennial had a whole lot of empty warehouses and was booking sales for a product that didn't even exist, the stock crumbled from $55 a share at year's end to $3 in mid-February 1997. Eventually, Centennial was delisted, and a couple of its executives were prosecuted.

I can't promise that you'll soon be equipped to sniff out inventory fraud, but more knowledge certainly never hurt.

Types and valuation of inventory
Yes, inventory's important. There are a couple of different types of it, too. Manufacturing companies make things and hold raw materials, works-in-progress, and finished goods in their inventories. Retail companies sell merchandise, and will usually just have a single inventory category. (Service companies won't have any at all, of course.)

Companies have to keep track of their inventory and the costs associated with it. But this is much more challenging than it seems.

Imagine a firm replenishing its inventory stock with new items that cost more than the old inventory. When it comes time to calculate cost of goods sold, should the company average its costs across all inventory? Should it count the ones it bought earlier and for cheaper? Or maybe it should use the latest inventory for its calculations. This decision is critical and will affect a company's gross margin, net income, and taxes, as well as future inventory valuations.

There are two popular accounting solutions for this problem. You've probably heard of them, as their abbreviations sound vaguely like names of dogs. First-in, first-out (FIFO) and last-in, first-out (LIFO) are the methods most public companies use to allocate costs between inventory and cost of goods sold.

FIFO vs. LIFO
Under FIFO, the goods sold are the oldest produced or purchased by the company. LIFO is simply the opposite -- the goods sold are the most recently produced or purchased.

With both FIFO and LIFO, we are more concerned with cost allocation than the actual flow of goods. We're trying to effectively tie our costs together and may not even know about the inventory's physical flow.

FIFO seems like the most logical method, right? A company would always want to clear out its old inventory before adding to it. Ah, but remember -- we're talking cost allocation here, not actual flow.

LIFO, on the other hand, leads us to believe that companies want to sell their newest inventory, even if they still have old stock sitting around. LIFO's a very American answer to the problem of inventory valuation, because in times of rising prices, it can lower a firm's taxes. LIFO users will report higher cost of goods sold, and hence, less taxable income than if they used FIFO in inflationary times.

However, this perceived LIFO benefit can also create some real weirdness for companies using it. (Not as weird as Crispin Glover in those creepy ads for Willard, but still pretty darn weird.) Inventory values on the balance sheet may not reflect reality under LIFO, as they're likely outdated. A company skimming off its new inventory purchases can end up with an ever-growing pile of inventory on the balance sheet, increasingly old at the core.

U.S. companies and FIFO/LIFO
Removed from accounting, LIFO is unrealistic. That's why most countries outside the U.S. largely reject it as an option for public companies.

U.S. public businesses can't use LIFO for tax purposes and FIFO for financial reporting. They have to be consistent. By peeking into a 10-Q or 10-K, you can quickly discover which firms use LIFO and which use FIFO.

Just to name a few examples, Dell Computer (Nasdaq: DELL  ) uses FIFO. General Electric (NYSE: GE  ) uses LIFO for its U.S. inventory and FIFO for international. Teen retailer Hot Topic (Nasdaq: HOTT  ) uses FIFO. Wal-Mart (NYSE: WMT  ) uses LIFO.

Does it make a difference? Yes, actually, because of the curious nature of LIFO. Companies that use LIFO will usually report a so-called LIFO reserve, which represents the difference between ending inventory under LIFO and under another system (usually FIFO). In certain cases, the difference can be substantial. Also, when comparing two companies, it's helpful to know if they both value their inventories in the same way.

Wal-Mart, for instance, reported in a note to its most recent 10-Q (for the period ended Oct. 31, 2002) that had it used FIFO instead of LIFO, it would have reported $165 million in higher inventory for the quarter. For the corresponding 2001 quarter, its FIFO reported inventory would have been $172 million higher. That hardly makes a dent in Wal-Mart's $29 billion-plus in inventory, but it's still interesting to note.

Inventory, friend-ventory
With that, we'll close our inventory exploration. Hopefully, you have a new friend in inventory, or at least a more familiar one. Inventory is important to companies, both on the balance sheet and as a cost of goods sold. There are a few different types of inventory, and more than one way to allocate its cost. FIFO is the most logical, while LIFO is more popular and, ultimately, a little stranger.

Discussions about inventory don't stop here. We can look at ratios to tell us how efficiently a company manages its inventory. And we can draw conclusions about inventory's relationship to revenue. Plus, we can examine seasonal patterns and inventory.

You'll just have to keep watching and reading to see if our friend-ventory pops up again soon.

LouAnn Lofton doesn't own shares in any of the companies mentioned here. She has no plans to see Willard, either. You can email LouAnn and view her portfolio. The Motley Fool has a really cooldisclosure policy.


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