Inventory Warning Signs
Warnings signs are pointing to possible 1Q and 2Q earnings disappointments from higher-than-expected costs
It is not news that inflation has picked up significantly over the last year. Most companies are complaining about the impact of inflation and are seeing their gross margins compress under the weight of higher raw materials and labor costs. However, in our review of 4Q earnings, we have noticed that several companies’ results may have been shielded from the full impact of higher costs by their inventory accounting methods. As these circumstances reverse, this makes these companies more vulnerable to earnings disappointment from higher-than-expected costs. We will highlight five of these companies below.
A Review of the Factors
Readers can visit our archives to see our series on inventory accounting to review how inflation impacts results under the various accounting methods. Essentially, these are the situations that can lead to temporary benefits to reported profits during inflationary periods:
The LIFO (last in, first out) inventory method expenses the cost of the most recently added inventories first. Therefore, higher costs are reflected immediately which will result in lower reported profits during times of inflation when compared to companies using the FIFO (first-in, first-out) or Average Cost methods. However, if a company is selling LIFO inventories faster than it is replenishing them, it will begin expensing older, lower-cost layers in what is known as a “LIFO liquidation.” This scenario will result in temporarily higher profits, but the benefit will reverse when the company again starts to replenish inventories at higher costs.
·The FIFO (first-in, first-out) method expenses older inventories first. During periods of inflation, this will delay the impact of rising costs hitting the income statement and result in higher profits being reported than would have been under the LIFO or Average Cost methods.
Under the Average Cost method, a company calculates the average cost per unit of all units in inventory held during the period which is used to determine the average cost per unit sold during the quarter. This typically results in reported profits that are lower than those reported under FIFO and higher than those reported under LIFO. However, units that are bought during the quarter will impact the average cost calculation regardless of whether they are sold or not. Therefore, a company that delays replenishing inventories during times of inflation can temporarily minimize the impact of rising costs on that period.
With this in mind, we will review six companies that may have delayed the impact of rising costs due to their inventory trends and methods of accounting.