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 2016s ending inventories to calculate 2017s 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.

NOTE 7 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 $8 million at December 31, 2015 and $569 million at December 31, 2014. Inventories valued on a LIFO basis, principally hydrocarbon and U.S. chemicals and plastics product inventories, represented 30 percent of the total inventories at December 31, 2015 and 29 percent of total inventories at December 31, 2014.

A reduction of certain inventories resulted in the liquidation of some of the Companys LIFO inventory layers, increasing pretax income $3 million in 2015, decreasing pretax income $23 million in 2014 and increasing pretax income $55 million in 2013.

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 (2) If some of the inventories were out of date with the market value lower than the cost at the end of the quarter, what are the financial statement effects?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 managers annual compensation, are based on attaining certain minimum gross margin percentages. Selected data regarding production and sales of the companys 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 Mastrolias 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 Mastrolias 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.)