The year 2008 is concerning for Merrimack Tractors and Mowers due to the company increasing costs and expenses, the company is experiencing financial anxieties. Due to a combination of higher costs in wages, labor, material, and energy as well as the weakening of the dollar, some of the business’ suppliers have has to increase their prices. This, in turn, has led to complications with the company’s inventory costing and the possibility of a strained relationship with president and chief operating officer Rick Martino.
In reference to Table 1, we are able to see some key figures in our income statements that are a cause for concern. As compared to 2007, the productivity of the Merrimack Motors has been affected and 2008 seems to be shaping first year where the increasing earnings trend will cease to exist. Compared to the previous year there was an increase in the raw number of sales of $13,000,000 but due to outer factors there was also an increase of $16,000,000 in the cost of goods sold and the $3,000,000 difference raises concerns. Overall, there is a company response of a $1,950,000 decrease in net income for the year following 2007 would be a breaking point. This $1,950,000 decrease the company would realize a 27.3% decrease in net income compared to 2007. While there are certain factors beyond the company’s control, some stakeholders will definitely worry about the leadership of our president and chief operating officer, Rick Martino. It is his direct responsibility to be able to respond and put forth dynamic leadership in order to mitigate the damage these external factors could produce and with the results that Table 1 exhibits, it is difficult to vouch for his performance.
Referring to Table 2 allows for a more accurate presentation for the LIFO method because it details the amount of units sold per specific quarter. In Quarter 1, selling 5000 units versus 10,000 units would affect the balance sheet by increasing the inventory by $7,000,000. This comes from the difference between the $14,000,000 cost of goods sold of the 10,000 units, and the $7,000,000 cost of goods sold of the 5000 units. If those 5000 units are not sold, then the remaining $7,000,000 stays in inventory. This also states the retained earnings are $7,000,000 higher due to a smaller cost of goods sold, however, the account is also affected by the $10,000,000 decrease in sales. The net retained earnings is $3,000,000 less if 5000 units are sold in the first quarter rather than 10,000 units. The sales reduction is calculated by taking the difference between the 10,000 units sold sales ($20,000,000) from the 5000 units sold sales ($10,000,000). The decrease in sales also decreases the cash and/or accounts receivable balance by $10,000,000.
For Quarter 2, Merrimack Tractors and Mowers sold 20,000 units instead of 10,000 units which causes the inventory on the balance sheet to decrease by $11,500,000. This is calculated through subtracting the $15,000,000 cost of goods sold of the 10,000 units from the $26,500,000 of the 20,000 units. Since the cost of goods sold expense is higher with selling more units, the retained earnings account on the balance sheet will be $11,500,000 less, but $20,000,000 more with higher sales. This creates a $8,500,000 net increase in retained earnings. The $20,000,000 in sales also increases cash and/or accounts receivable.
During Quarter 3, 10,000 units are sold, thus there are no changes to the balance sheet. Inventory, retained earnings, and cash/accounts receivable remain the same.
Quarter 4 has a similar change as in Quarter 1. The inventory increases by $8,500,000 since 5000, instead of 10,000, units are sold. This causes an increase in retained earnings by $8,500,000, but is reduced by $10,000,000 due to the decrease in sales. The net change in retained earnings is $1,500,000 less. This reduction in sales decreases cash and/or accounts receivable by $10,000,000.
Comparing LIFO 2007 to FIFO 2008
If Merrimack adopted FIFO as of January 1, 2008, the income statement and balance sheet would reflect a large increase in net income, which would go from $7,150,000 in 2007 under LIFO, to $12,675,000 in 2008 under FIFO. By making this change from LIFO to FIFO, Merrimack would report an estimated earnings growth rate of 77.3%, rather than a sub-par -27.3% by keeping LIFO. The reason for this is that the costs of goods sold is decreased by the usage of FIFO, which increases gross profit margin and thereby also increasing net income. All of this would reflect positively on retained earnings, and would thus raise stockholders equity on the balance sheet. $2 million more income taxes would be owed however, if Merrimack were to adopt the FIFO method, but regardless of this FIFO would still represent an improvement in net income over LIFO. (See Table 3)
Comparing LIFO 2008 to FIFO 2008
Under the FIFO method, assuming that costs are increasing (inflation), the costs of goods sold would be lower because the first items sold are the most expensive; this results in a $50,500,000 in costs of goods sold under FIFO in 2008 compared to $58,000,000 under LIFO in 2008. As a result, the Gross Margin, the Income before Taxes, and consequently Net Income will all be higher using FIFO as of January 1, 2008, with Net Income in particular being substantially improved from $7,800,000 (under LIFO) to $12,675,000 under FIFO. This has a positive effect on the company’s balance sheet by increasing retained earnings and thereby raising the stockholder’s equity. $2,625,000 more income taxes would be owed if Merrimack were to adopt the FIFO method, but regardless of this FIFO would still improve net income over LIFO. (See Table 3)
If Merrimack changes from LIFO to FIFO in 2008, this would impact its cash flows by lowering the Costs of Goods Sold, increasing tax on Net Income, and therefore producing a higher Net Income. The Cost of Good Sold decreased from 58,000,000, with LIFO to 50,500,000, with FIFO. The Tax Increased from 4,200,000, with LIFO to 6,825,000, with LIFO. The Net Income increased from 7,800,000, with LIFO to 12,675,000, with FIFO.
A switch from LIFO to FIFO is considered mainly due to the fact that we are experiencing a time of great increase in the costs of production. In the last eight years, we have had our costs of shipping almost triple, and simply are too much for us to properly handle without cutting into our bottom line. With the increasing costs and the weakening dollar, we have been unable to maintain a competitive advantage, and thus the decision to switch makes perfect sense. By using the FIFO method, we are expecting the prices to continue rising and our inventory will diminish starting with the oldest ones and moving to the more expensive. Thus, allowing for a greater net profit return. Using the FIFO method instead of LIFO affects the balance sheet by increasing retained earnings due to the higher income from a lower cost of goods sold. The FIFO method would increase inventory because there is less of a cost deducted from the account on the balance sheet. If prices remained stable over time, then Merrimack would likely still be caught up in this dilemma as we could have continued working with similar expenses, however, the weakening dollar entails a possible loss on our net income. Over the time, the only way to adjust and maintain a consistent net income every year would be to gradually increase the prices in order to ensure an adjustment to the changing conditions. Unlike the computer industry, in which prices fall over time due to the advances in technology and the cost of production decreases with more units built, we are unable to take advantage of LIFO in our scenario. With the falling prices in the computer industry and usage of LIFO, the net income gradually increases due to decreasing expenses over time. Switching to FIFO and the decrease in expenses would have a negative effect on our net income and would hurt our bottom line. With the decrease in net income, we would suffer from lower retained earnings which would lead to a great cause for concern.
We have decided to reach the conclusion that the best way to move forward is by switching from LIFO to FIFO methods. While this will entail a couple of changes in the way that we operate as a firm, there are no real disadvantages to switching this formula. We would like to begin by outlining what this change means in this years financial statements. Comparing Table 1 to Table 3 we are able to see the effects that come from switching methods. In the Last in First Out (LIFO) methods, the method we currently use, we receive a Net Income of $5,200,000 and realize a Cost of Goods Sold of $62,000,000. In comparison, the First in First Out (FIFO) methods, the method we will switch to, we receive a Net Income of $12,675,000 and realize a Cost of Goods Sold of $50,500,000. Looking at the raw numbers it seems pointless and illogical not to switch as our bottom line is hurt by the fact that we are maintaining a traditional approach in the times of change.
Certainly this change will not be favorable by everyone at this company due to the fact that there will be underlying considerations existing. While the shift in the Net Income will definitely be beneficial, we cannot solely consider the raw numbers as we will be assuming an Income Taxes Payable liability of around 2 million dollars as soon as we switch. While this may seem like minimal in comparison to the gain in Net Profit we will incur, we must also look at the factor that we have saved over 5 million dollars through the use of LIFO. By changing now, we are able to take advantage of the changing external factors and change based on our decisions as opposed to being forced to having to change due to legislation.
The primary function of our organization is to act upon the best interests of the stakeholders. It is important that the stakeholders in our firm understand what is happening with this switch so we will be disclosing the information for calculating both the LIFO and FIFO in order to have them understand what the switch entails. While some may be upset over the fact that Chief Operations Officer, Rick Martino, was part of the decision to make this transition, the fact is that without said change our company could likely find itself in further woes than just our 2008 slump. Rick Martino’s plan to change the inventory costing is in no way attempting to play with the earnings rather than managing the operations but strategic management on behalf of the company. By changing the way that our inventory costing is processed, we are able to adapt to the changing environment and be able to maintain comparative and competitive results.