CASE SCENARIO

A Case of Decreasing Gross Profit Clayton and Ellison George Larsen will never be accused of having a dynamic presence. The bespectacled accountant spread 145 pounds over a 57 frame and, if you even noticed George, his baby face and full head of short, brown hair gave the look of a college student absorbed with how to survive finals week. But, looks can be deceiving. The 35-year-old son-in-law of the towns wealthiest man is the president and the driving force behind Sturgis Enterprises, one of the nations largest, privately held gift wholesalers.

Certainly, marrying the owner and chairman of the boards daughter didnt hurt Georges ascent through the ranks of Sturgis Enterprises. His ability to quickly grasp numbers and their relationships to the gift business, though, was the overriding reason George became president and chief operating officer (COO); his marriage to Jim Sturgis only daughter was why he achieved his current position at the young age of 29.

Now, as George Larsen met with Jim Sturgis to discuss the owner and chief executive officers (CEO) concerns with the latest financial statements of the company, it became, once again, apparent to George why he needed to break away from his father-in-law and start a business of his own. When Jim Sturgis failed to understand the financials of the company or got a half-baked idea about someone stealing money, George was subjected to tirades of epic proportions. Jim Sturgis knew how to design and sell innovative gift products, but he knew nothing about how to manage corporate financesa fact that he often failed to recognize. This led to hours of listening to the rants and raves about the financial health of the company.

At times, I wonder what my daughter sees in you! Jim Sturgis yelled. Ive spent 30 years building this company. Ive got the two hottest products in the gift market today. Then I look at the preliminary financials that your wonder boy accountant gives me and our profits are pathetic. Can you explain that to me?

With all due respect, Mr. Sturgis, the 2008 figures are only preliminary numbers. Every year there are reclassifications and accrual adjustments that are made by Andy, our wonder boy accountant, as you call him. Afterwards, I review the financials. Youve never looked at the preliminary financials in the past, so I can see why you might be confused. Until these adjustments are completed, lets not jump to the conclusion that our financial results are disappointing. I will admit, though, gross margins have decreased slightly over the past few years.

I dont know how many of these adjustments youre expecting to make, but Id better see a more positive bottom line when you are done! And when you begin your clarification of these numbers, you can first explain why my gross margin appears to be down. I cant go to the bank and ask for a larger credit line with these financials! How do I explain to my ultraconservative banker that Ive increased sales but made less money per sale? Hes been on me to spend money for an outside audit, and if he sees these numbers, Ill have to agree. I dont want to spend money on an audit!

Well, I dont agree with your banker, George responded to Jims tirade. Im not sure an audit is necessary. Okay, then why dont you explain to me about our gross margins and how you are going to fix it so I dont have to spend money on an audit? Thats why I have an accounting department!

Its not quite that simple, George replied to get Jim off the subject of spending money on an audit. Its true that our gross margin as a percentage of sales has declined over the last five years, but the companys net operating income has increased. You are actually making the same amount of money, as a percentage of sales, as you were five years ago.

Thats great, but I still dont get it. What about the gross margin percentage? Obviously, it is declining! Ive negotiated better contracts with our vendors, improved the quality of our product to reduce returns, used fewer outside artists in designing new products, and I am making less per item sold than I did five years ago. How can that happen? Jim demanded.

George laughed to himself. Prior to George coming to work at Sturgis, Jim couldnt tell the difference between gross margin and a gross of pens. Maybe I should have left him in the dark, George thought, as he continued to listen to Jims hysterics.

Again, Jim, I wont have a complete answer until the financials are finalized.

But do YOU understand what Im saying? We have a product that is receiving national publicity and another that is in the top five best sellers at Toys R Us. Because of the volumes for these products, I reduced our costs at the factories in China and Ive been able to avoid deep discounts that are generally given to the major retailers. Even Wal-Mart is getting less than a 20 percent discount on my wholesale price for these items. So, maybe I dont understand the financial statements, as youve pointed out on numerous occasions, but I know Im still getting a good price for my product. Im reducing costs from my vendors, but my gross margins are still going down. That doesnt make sense to me. So are the cost of sales numbers one of your glorious reclassifications or adjustments that need to be made? Jim completed his tirade.

Actually, it could be, George responded. Its always possible that a clerk has set up an account as cost of goods sold instead of a supplies account. Or it could be there is a need for an inventory adjustment. We always have inventory discrepancies between our yearly physical count and the inventory shown in our system. Thats why I need to go over the numbers before we finalize the statements. But, I should also add that when you say we are avoiding deep discounts from major customers, you fail to realize we still are giving a larger discount to these major customers than we did to other customers in the past. Im well aware material costs have been reduced because I approve all purchase orders for the product you buy from China. But, the price you pay for product is just one component of the cost of goods sold. You also have to include shipping costs, tariffs, custom charges, and commissions to our agents to buy the product. These costs have all gone up.

Ignoring Georges reply concerning the cost of goods sold components, Jim spouted, We might have an inventory adjustment?! Good grief, George, Ive spent thousands of dollars in upgrading the inventory software and you tell me we have inventory adjustments. How does that happen?

We still have to take a physical count at year-end to verify our inventory, George replied. As we discussed before, clerks make input errors, counts can be wrong from our vendors that we dont catch, and other administrative errors can cause the physical inventory to vary from the inventory we show in the computer.

Or maybe you recommended the wrong inventory software, Jim said in disgust.

The software is not an issue. If you remember, your high school buddy, Bill, who runs the warehouse, is a self-proclaimed computer whiz. He made the recommendation on the software.

Suddenly, Jims demeanor lightened as he changed the subject. How is Bill doing? Jim inquired about the 25-year warehouse supervisor, Bill Watson.

Oh, I think hes doing as well as anyone could in his position. You know him better than I do, but I dont know how I would handle the loss of my wife, George answered. Yeah, Ive known Bill longer than you, but Im not sure I know him any better. Hes always stayed to himself. He didnt even bother to tell me until last week that his oldest son was studying to be an attorney at some high-powered, high-dollar college. Quite honestly, I didnt think his son was that smart, Jim surmised.

Well, all I know is that Bill missed very little work after his wife died. During that time, I had to get quantities from him to place the product purchase orders and he never missed getting me the information.

Hes old school, George. He takes his work to heart and he does what has to be done. I should stop in on Bill to see how hes doing.

At the risk of reopening a can of worms, are we finished here? George asked as he realized a lecture on the poor work ethic of the younger work force was coming. When Jim mentioned old school, he was warming up to expound upon his beliefs that his generation was the last bastion of the American work ethic that founded this nation.

No, were not finished. Im still disturbed about this gross margin number, Jim jumped back into his dictator role. Cant we finish this after the final financial statements are prepared? George pleaded.

No, we cant. Adjustments or no adjustments, I need to get a better understanding of our inventory control system before we go any farther, Jim continued.

Okay, but I explained all of it to you when we computerized our inventory system over five years ago.

Humor me. Ive trusted you to take care of the business for so long that I think it would be beneficial if I took some time to understand exactly what we are doing around here, came the emphatic reply from the obviously angry owner.

Ill be glad to, responded the agitated president. Let me start by sketching the system to visually show you how we account for inventory and sales. But before I begin explaining, Im reminding you again there are discrepancies between the physical inventory count and the inventory that is shown in the computer. Ive spent hours investigating why there are discrepancies and, aside from actually counting the inventory myself, Ive come to believe that the temporaries I hire to count the inventory are not doing their jobs. If you would give me a larger personnel budget for administrative staffing, I could hire a full-time inventory clerk to monitor the temporaries and check for discrepancies more often than once a year.

How will that make a difference? Jim asked. If I have a full-time inventory clerk, I can take a physical inventory of systematically selected items more often than once a year. In other words, a full-time inventory clerk could take annual physical counts along with counts of selected items on a monthly basis. Plus, I wouldnt have to review inventory counts from the temps to reconcile the ending inventory in our software.

I get the picture, Jim replied as he continued to show signs of being irritated with his son-in- law. Lets get to the inventory system.

George took a pad of paper from Jims desk and proceeded to draw a depiction of the Sturgis Enterprise inventory control system as seen in Figure 1.

As you can see, George began his narrative, upon receiving an order, shipping documents are generated _see Figure 2_. These documents are sent to the warehouse and are used to communicate the items that should be pulled to fill each order. Upon filling the order, the warehouse writes on their copy of the shipping document the quantity of items shipped by item number, and then sends the original shipping document to the customer as the packing slip. A copy is sent to accounting to use for invoicing and, in turn, updating the inventory. When accounting receives the paperwork, the shipping information is entered into the invoicing program, which generates an invoice that is mailed to the customer and automatically adjusts the inventory. This computer count is what has differed periodically from the physical counts. Does that make sense?

Yes, it does make sense. I do have some understanding of our business. George. It appears that you need to get with Bill and come up with some explanations. Ill expect your answer within the next two days, Jim announced as he waved his hand to dismiss his son-in-law.

CASE QUESTIONS

1. Are Jim Sturgis concerns of declining gross margins valid given the increase in sales and steady reported net income over the past five years? In addition to the gross margin and net income percentages that are provided in Table 1, what other performance measures could be calculated to help isolate the problem of declining gross margins?

2. George Larsen suggested to the owner that the 2008 income statement numbers were only preliminary. Is his statement logical? Do companies make routine adjustments of inventory? Explain.

3. Refer to Table 1 and assume you are in the accounting department for Sturgis Enterprises. George has asked you to prepare a memo to the CEO explaining the possible explanations for the decrease in the gross profit percentage over the past several years. Factors to address in your memo include the increase in sales, cost of goods sold, and the impact on cost of goods sold and gross profit due to under- or over-stated ending inventory.

FIGURE 1 Sales Flowchart FIGURE 2 Example Shipping Document TABLE 1 Sturgis Enterprises *2004-2007 are final statements after adjustments. 2008 is before adjustments. FIGURE 1 Sales Flowchart FIGURE 2 Example Shipping Document TABLE 1 Sturgis Enterprises *2004-2007 are final statements after adjustments. 2008 is before adjustments