Finance - Intermediate Accounting - Chapter 08 - Valuation of Inventories - A Cost-Basis Approach.pdf

1/6/06 02:15 am Page 367
CHAPTEREIGHT
VALUATION OF INVENTORIES: A COST-BASIS APPROACH
Inventories in A substantial increase in inventory may be a leading indicator of an ing decline in
profit margins. Take the auto industry as an example. Detroit’s inventories have been grow-
ing for several years because the domestic manufacturers like to run the factories at full
the Crystal Ball capacity, even if they are not selling cars as fast as they can make them. The current
arrangement is particularly tough for General Motors. It overproduces and then tries to
push the sales with incentives and month-long “blow-out” sales. GM is hoping that the ever-
growing market will cover the problem until customer demand grows to the point where the
cars are purchased without so many incentives.
But recently, all that was growing was GM inventories. Not too long ago, the average
sticker on a Cadillac DeVille was $54,193, but price after incentives was $42,211.
This meant that the factory was giving up a substantial amount of profit through rebates,
dealer cash, or lease or interest rate subsidies. A similar deal could be had at Ford, which
was selling Explorers for $25,, a 24 percent reduction for various factory incentives.
But inventories at GM and Ford continued to grow, even with these significant
These data concern investors. As one analyst remarked, “When inventory grows faster
than sales, profits drop.” That is, panies face slowing sales and growing inventory,
then markdowns in prices usually result. These markdowns, in turn, lead to lower sales rev-
enue and e, thereby squeezing profit margins on
Research supporting these observations indicates that increases in retailers’ inventory
translate into lower prices and Interestingly, the same research found
that for manufacturers, only increases in finished goods inventory lead to future profit de-
clines. Increases in raw materials and work-in