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Accounting Allah shmoop old school hoarding versus just in time

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inventory Thus smackdown All right people riddle us this If

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we were devious accountants and in a given quarter we

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wanted to make our company look a lot more profitable

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than it actually Wass what would we do Batman So

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let's start by considering the nefarious workings of working capital

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For the uninitiated to the dark side working capital refers

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in this instance toe assets we have in storage almost

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all the time Inventory is worth meaningful E less the

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moment it's owned sort of like Well that new car

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you just drove off the lot You paid twenty eight

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thousand three hundred dollars for it but now with the

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back bumper five feet off the lot it's worth twenty

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six thousand But every now and then an asset appreciates

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III the case of an airline stockpiling fuel and then

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a bomb goes off in Iraq and suddenly oil goes

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from forty bucks a barrel to one hundred gaff In

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that case the market price if the airline wanted to

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just turn around and self would actually generate a profit

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for them But way they aren't in the business of

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oil arbitrage trading there in the business of Flying Joe

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six pack you know around So they likely just leave

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the oil where it is at cost because well they

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plan to use it all up in the next six

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months or so anyway Right so back to pillows Let's

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say that we have been quietly stockpiling inventory of pillowcases

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and chicken feathers And like those things don't wear out

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They have a nuclear half life of like one hundred

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eighty seven years In fact we've stockpiled four million dollars

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worth of chicken feathers and three million dollars worth of

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pillowcases That's at our cost So let's say that in

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the following year we decide to simply work down that

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inventory That is we've spent seven million dollars over time

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when times were good and profits were flowing and cash

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with coming into the coffers to build up excess inventory

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beyond what we normally need to keep on hand run

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factory operations But now as times are leaner or we

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just want to appear to be more cash profitable on

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the cash flow statement there we start reducing this extra

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seven million dollars of inventory without restocking it So our

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expenses go down meaningfully or at least our cash out

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The door goes down and we don't tell anyone what

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we're doing The declining inventories will show up on our

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balance sheet reconciliation but we won't mention the decline on

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the income statement or anywhere else Right Legal Illegal Uh

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well in our model income statement in two thousand nineteen

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we had expenses of nine million dollars for chicken feathers

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and four point five million for pillowcase material If we

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quietly used up the excess inventory of four million and

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three million well couldn't we naturally then reduce the expenses

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of chicken feathers from nine million to five million and

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pillowcase material costs from four point five million to one

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point five million And if we can do that then

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we have just taken seven million dollars of cash expenses

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off of the operational cash costs of our company and

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our pretax well income then sort of Kind of with

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a little bit of accounting Chickie Nery here then would

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go notionally from two point two five million of cash

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profits to nine point two five million Again Legal illegal

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answer Well kind of legal In fact the better optimization

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of inventory was a theme that drove the Japanese automobile

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manufacturers in the eighties to great success because they implemented

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a just in time inventory management system where unlike the

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American auto manufacturers who would keep a year's worth of

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windshield wipers on hand the Japanese manufacturers would on Lee

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keep a few days worth of inventory in implementing their

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system It puts great pressure on the sub pliers of

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windshield wipers to keep the factory currently stocked every few

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days But it also massively reduced breakage losses and the

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over purchasing of windshield wipers for last year's car models

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which no longer fit this year's car models Well it

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might not seem like that big a deal but in

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fact the profit margins had five to ten percent movement

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in this period That's inventory management was simply done better

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All right now let's revisit our famous whole day Well

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example for a minute will normally corporations X Spence marketing

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that is the expenses for marketing are recognized in the

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quarter in which they are committed to be spent and

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then run like you have to commit to spend in

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the marketing money and run it If you do then

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that dough all goes away in that quarter and notice

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our very carefully worded committed to be spent phrase here

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Once a company signs a contract committing them to spending

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marketing dollars on TV ads newspaper inserts and or Web

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banner ads Now the company is generally on the hook

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to spend that money regardless of whether or not they

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sell a lot of pillows underneath it or a well

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subscriptions or whatever So one might think that Gap accounting

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would always require this structure But in the case of

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a well it did not go well was roundly criticized

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by accountants all over the world who had nothing better

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to do with their time for not expensing their marketing

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in the quarter in which it was committed to be

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spent and or spent Has the company done so However

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it would have only shown massive losses which Wall Street

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would've hated and there would've been no sense for whether

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the company would ever in fact be truly profitable or

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not Well in hindsight perhaps the company should have actively

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reported both numbers and eventually they did except that investors

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had a hunt for him in the beginning A well

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was populated by a few million zealots The company had

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massive spend from a concentrated group of activate a well

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surfers who wanted to use the service endlessly And they

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paid three bucks an hour for the pleasure through magical

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accounting in some made up predictions while the company was

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able to divine the magical thirty nine month expected average

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life of a subscriber But there was an asterisk after

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that number Why Well because the number ignored the first

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six months of subscriber life Aye well had an aggressive

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try before you buy offering in which subscribers could sign

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up at a very low price for a few months

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sometimes with a renewal and then a subsequent commit or

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no commit to buying the service for some longer period

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of time So when a well imputed the thirty nine

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months number while they conveniently ignored the first six months

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in essence what they said was that the average life

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of a subscriber after they've served five six months in

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a day is then thirty nine months So what happened

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to the attribution of marketing X Spence is to attract

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users who came on for less than six months in

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a day and never returned Yeah we're still looking for

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the money to Well the analog here is childbirth numbers

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from the seventeenth century The average life of a male

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in those days was in about thirty five years Average

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life thirty five years Think about that But if you

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look past the first two years of widespread child death

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well then the average life span suddenly spiked to something

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in the mid forties like in a forty five ish

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That is if a male survived past his second birthday

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Well then he was likely to live into his mid

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forties Well eh well was able to convince the auditors

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that the same rules basically applied in this case Why

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does all this matter so much Well because in a

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given your ale well might have spent say a billion

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dollars on marketing and keep the numbers around Were they

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required to expense all of that money in one year

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while the three hundred million dollars of theoretical profits would

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have in fact been a loss then of seven hundred

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million but by being able to expense the billion over

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three plus years or advertise it or capitalize it over

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three years Well the company was able to recognise expenses

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of just three hundred million in marketing and claimed to

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Wall Street that they were break even ish And Wall

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Street didn't read a lot of fine print and they

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were happy in the stock was a monster hit at

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least for a while Yeah Welcome to Wall Street people 00:07:16.864 --> [endTime] Come on down and wear a tie

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