Module 7: Inventories

Case 7: Dow Chemical

Find the 10-K files of Dow Chemical for the year ended December 31, 2018. Make sure you read Item 1 and Item 7 to get familiar with the business condition of the company. Review the footnote about inventories. Then answer the following questions:

1. What inventory costing method does Dow Chemical use? As of the end of 2018, what is the effect on cumulative pretax income and cash flow of using this inventory costing method (assume a 30% average cumulative tax rate)? What is the effect on the 2018 pretax income and cash flow of using this inventory costing method, assuming a 21% tax rate for this quarter?

2. Compute inventory turnover and average inventory days outstanding for 2018 and 2017 (hint, you need to look for the year 2016's ending inventories to calculate 2017's ratios). Compare the ratios and make comments.

3. Determine FIFO values for inventories for 2018 and 2017 and the cost of goods sold for 2015. Re-compute the two ratios in question 2. Compare the ratios under LIFO and those under FIFO. Which set of ratios would provide more useful analysis?

4. In 2015, Note 7 disclosed the following information. Calculate the effect on net income for the reduction of inventory quantities in 2015.

NOTE7- INVENTORIES

The following table provides a breakdown of inventories:

Inventories at December 31

In millions

2015

2014

Finished goods

$

3,850

$

4,547

Work in process

1,506

1,905

Raw materials

747

797

Supplies

768

852

Total inventories

$

6,871

$

8,101

The reserves reducing inventories from a FIFO basis to a LIFO basis amounted to$8millionatDecember31, 2015and$569millionatDecember31, 2014. Inventories valued on a LIFO basis, principally hydrocarbon and U.S. chemicals and plastics product inventories, represented30 percentof the total inventories atDecember31, 2015and29 percentof total inventories atDecember31, 2014.

A reduction of certain inventories resulted in the liquidation of some of the Company's LIFO inventory layers, increasing pretax income$3millionin2015, decreasing pretax income$23millionin2014and increasing pretax income$55millionin2013.

5. Briefly discuss (1) What inventory recording system do you think fits better for Dow Chemical and why? (2) If some of the inventories were out of date with the market value lower than the cost at the end of the quarter, what are the financial statement effects? (3) What are the financial statement effects of overproduction for a manufacturing firm?

6. Exercise:

Mastrolia manufacturing produces pacifiers. The company uses absorption costing for external reporting, but management prefers variable costing (fixed cost considered as period costs instead of for each unit) for evaluating the profitability of each model. Bonuses, which make up a significant portion of each manager's annual compensation, are based on attaining certain minimum gross margin percentages. Selected data regarding production and sales of the company's popular "Little Eric" model follow:

Selling price per unit

$10

$10

$10

Variable production costs per unit

$4

$4

$4

Fixed production costs per year

$500,000

$500,000

$500,000

Beginning inventory

30,000

LIFO inventory method

@ $8.00 each

Units Produced

125,000

100,000

115,000

Units Sold

100,000

85,000

140,000

Required:

1. Calculate Mastrolia's gross profit percentage each year under generally accepted accounting principles. Briefly explain the reasons for any variations in the annual gross profit percentage.

2.Calculate Mastrolia's gross profit percentage each year under variable costing. Briefly explain the reasons for any variations in the annual gross profit percentage.

3. If you were the manager of the "Little Eric" plant and your annual bonus was based on the plant achieving a gross profit percentage in the excess of 15% each year, which method would you prefer and why? (Assume you can significantly influence annual production schedules.)