Updatd:  January 27, 1999

A Note on the Impact of Inventory Levels on Net Income

Fluctuations in inventory levels can cause profit variations when inventory is valued according to GAAP standards. GAAP standards require that all manufacturing costs must be capitalized in inventory regardless of whether the costs are variable or fixed.

The inclusion of fixed costs in the unit cost causes profits to rise as inventory levels rise because the fixed cost in inventory is stored on the balance sheet instead of being carried over to the income statement. When the inventory level falls, this fixed cost that has been stored on the balance sheet is moved over to the income statement thereby causing net profit to fall.

To illustrate this phenomenon I first present a one month income statement constructed using only variable costs in inventory (in this case, materials only).

Next I show two income statements for two months with the identical sales as in the first income statement that uses only variable costs in inventory. However, in these two income statements the inventory levels change; in the Month 1 statement the inventory of Valves rises by 1,000 units, and in the Month 2 statement Valve inventory falls by 1,000 units.

Notice how the net incomes changed from one month to the next even though sales remained the same. This example used activity based costs for costing the units of product, but any costing method that assigns fixed costs to units will give the same result.

To more clearly show why the incomes differ, consider the following table that shows variable unit costs and the unit fixed costs assigned to the units by the ABC costing system.

The difference between the net income before taxes for the income statement with variable costs and the one with the ABC costs is always explained by the unit change in inventory multiplied by the fixed overhead per unit.