# Inventory Methods

Essay by shy12University, Bachelor'sA+, February 2006

Scenario

A retail company begins operations late in 2000 by purchasing \$600,000 of merchandise. There are no sales in 2000. During 2001 additional merchandise of \$3,000,000 is purchased. Operating expenses (excluding management bonuses) are \$400,000, and sales are \$6,000,000. The management compensation agreement provides for incentive bonuses totaling 1% of after-tax income (before bonuses). Taxes are 25%, and accounting a taxable income will be the same.

The company is undecided about the selection of the LIFO or FIFO inventory methods. For the year ended 2001, ending inventory would be \$700,000 and \$1,000,000 respectively under LIFO and FIFO.

Required:

* How are accounting numbers used to monitor this agency contract between owns and managers?

* Evaluate management's incentives to choose FIFO.

* Evaluate management's incentives to choose LIFO.

* Assuming an efficient capital market, what effect should the alternative policies have on security prices and shareholder wealth?

* Why is the management compensation agreement potentially counter-productive as an agency-monitoring mechanism?

* Devise an alternative bonus system to avoid the problem in the existing plan.

Before we get into the more theoretical parts of this assignment we will use the numbers in our example to calculate and demonstrate the difference between the LIFO and FIFO inventory method.

We will have to calculate our after-tax income twice: once without bonuses to establish the basis for the bonuses, and once we calculated bonuses we have to determine the actual net income after taxes including bonuses. First have to determine cost of sales which equals beginning inventory minus ending inventory. This would result in the following:

Exhibit 1

Based on these results we can determine the basis for our bonus calculation

Exhibit 2

Bonuses are to be calculated at 1% of after-tax income (before bonuses) which would result in \$20,250 and \$22,500 under...