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Accounting Allah shmoop review of margins as they apply to

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inventory management profit margins and inventory Yeah strange bedfellows But

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riddle us this If a company has adopted a quote

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lower of market or book value unquote policy when their

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accounting for inventory what does that mean Yeah that was

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the riddle we were asking you Well recall that companies

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have a choice as to how they value the inventory

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they keep Had Fiji water bottled four million bottles of

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water and a buck each two years ago a buck

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there cost before the drought Well they then have the

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choice of carrying that inventory value at their book value

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of four million dollars Or they could carry them at

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today's prices or market prices for wholesale bottles of water

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of two fifty each or ten million dollars So now

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zoom forward and think about the case where Ray Bans

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has spent a fortune stocking up on safe dark sun

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adjusting glass lenses for sunglasses at fifty bucks each knowing

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that the market prices for them are more like twenty

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bucks if they had to dump them all immediately today

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So the minute they buy the fifty dollar glass lens

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unit and put it in inventory They show a notional

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loss of thirty dollars on that transaction right to cost

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him fifty to make If had to suddenly sell it

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they'd only get thirty Well if they stockpiled say fifty

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million dollars worth of those glass lenses at their cost

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which they're holding van as being worth twenty million today

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But they don't buy any more lenses for six months

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letting inventory dwindle from a million units to Justin one

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hundred thousand What happens to their cash profit margins Well

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from an accounting perspective almost nothing The company used up

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its stockpile of inventory that it had held that a

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static price all along nothing really changed They sold their

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glasses for same eighty dollars a unit and from an

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accounting perspective they made a notional thirty dollars per unit

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as they depleted the inventory But what happened to their

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key cash flow levels Well if no cash she's going

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out the door to restock inventory Wouldn't you think cash

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flow our cash on the books would grow dramatically Of

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course it would Well the question How do you account

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for this relatively sudden change That was the riddle They're

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well just for clarity's sake Essentially what Ray bans will

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have been doing here is plundering the mountain of sunglasses

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in those little cheap leather boxes You could never open

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properly letting the mountain dwindle down to a mole hill

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as they convert all of that value of inventory into

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cash and then have no more mountain to go back

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Teo should there be a massively term run on demand

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for sunglasses from the unholy union of the crack ins

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and the Hydra So that's inventory is a kind of

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well storage shed of cash for a company and it

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applies especially powerful e the products that have no shelf

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life meaning a pair of dark sunglasses Lenses don't go

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bad in two weeks the way a carton of eggs

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does In that case inventory has a very finite value

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that decays the moment that inventory is stocked or a

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laid either in the nest or on the shelves And

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companies then have to shell out an allocation for that

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decline in value or wasted JJ Well regardless tracking the

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purchase price or acquisition price of that inventory then is

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hugely important When you're putting together the forensics of a

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company's reported earnings and marking the period The period change

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in that inventory is a driver of cash balances Is

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Bigas well meaning that it's an awfully low quality cash

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flow or cash earnings quarter when a company's simply grew

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cash flow because they brought down their inventory from being

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worth fifty million box to being worth ten million bucks

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Yeah at some point soon that well runs dry All

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right Yet one more example Ray Bans had five hundred

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million dollars in revenues in the quarter and it showed

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cash earnings of eighty million dollars Unusually high profit margins

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for Ray bans Well what happened Well basically they raided

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their fifty million dollars worth of inventory in glass lenses

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to make the numbers like we've just been saying And

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remember we noted that the moment they bought a glass

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lens for fifty bucks they wrote down its value by

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thirty to be held as being worth only twenty on

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their books So that fifty million dollars worth of dark

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last lenses that they're holding actual cost them something closer

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to one hundred twenty five million dollars Well just to

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be crystal clear the company took an extremely conservative accounting

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view and immediately writing down the value of an individual

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unit of sunglasses glass from its cost to produce a

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fifty bucks to the quote market dumping value unquote ofwhat

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it would receive word Teo put them all on eBay

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and get twenty bucks each So then when Arabia and

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sell the pair of sunglasses for eighty dollars each unit

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appears to be much more profitable on a unit basis

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because the highly aggressive right down of their cost per

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unit then comes off the balance sheet and onto the

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income statement So is this illegal Is it trickery No

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it's just a very conservative style of accounting And adopting

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the lower of market versus book in the manner in

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which they hold the value of those glass lenses on

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their balance sheet as inventory or even a component of

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inventory is what's called a work in process anyway In

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a given period when this company had five hundred million

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dollars in revenues and eighty million dollars in cash earnings

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if they're dark lens sunglass unit inventory declined in value

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by some eighty percent Well they'd have to show those

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declines or at least make it relatively easy for inspectors

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of their filings to understand that they raided the inventory

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on their balance sheet chose not to spend the cash

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to restock it and thus generated a ton of cash

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in the quarter For this reason public companies are required

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to itemize on their balance sheet with the line changes

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in working capital Very important line as well as published

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the value of their inventory each quarter so that if

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a raid like this does happen in the company is

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purposely raising a bunch of cash for whatever reason it's

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clear to investors what's going on and this might not

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be a bad or disguising thing at all Like let's

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say there's a new glass lens technology coming out that

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adjust to eye color automatically and is wired with Bluetooth

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so that the shade density adjust to the level of

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darkness mood wise being played on the customer's iTunes feed

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Well then it makes perfect operational sense to raid the

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inventory for the company to sell off all the old

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lenses that won't be in demand much longer And then

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when the new technology comes out then restocked with the

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cool new stuff that the masses will want to buy

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so think of inventory is a kind of virtual bank

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controlled by the company which gives rise to all kinds 00:06:12.653 --> [endTime] of you know flexible accounting options

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