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).

Sales

$1,837,380

Cost of materials

     458,000

Margin

1,379,380

Expenses
Labor

224,000

Overhead

344,288

Depreciation

270,000

Administrative

210,000

Marketing

175,000

Total expenses

1,223,288

Profit before taxes

156,092

Income taxes @ 35%

     54,632

Net Profit

$101,460

Computation of Unit Values
Sales

Flow

Valves

Pumps

Controllers

Total

Units

7,500

12,500

4,000

24,000

Selling Price

$57.78

$81.26

$97.07

$1,837,380

Material cost

16.00

20.00

22.00

458,000

Unit margin

41.78

61.26

75.07

Total margin

$313,350

$765,750

$300,280

$1,379,380

 

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.

Month 1

Flow
Valves Pumps Controllers Total
Unit Sales

7,500

12,500

4,000

24,000

Units Produced

8,500

12,500

4,000

25,000

Ending Inv.

1,000

0

0

1,000

Unit cost

37.75

48.87

100.57

Sales Price

$57.78

$81.26

$97.07

Dollar sales

433,350

1,015,750

388,280

1,837,380

Income Statement
Sales

$1,837,380

Cost of goods sold
Begin inv.

0

Costs added
Materials

474,000

Labor

155,600

Overhead

682,688

Total costs added

1,312,288

Goods available

1,312,288

Ending inv.

1,000

     37,749

Cost of goods sold

1,274,539

Gross Profit

562,841

Administrative

210,000

Marketing

175,000

Total expenses

    385,000

Profit before taxes

177,841

Income taxes @ 35%

      62,244

Net Profit

$115,597

 

 

Month 2

Flow
Valves Pumps Controllers Total
Unit Sales

7,500

12,500

4,000

24,000

Units Produced

6,500

12,500

4,000

23,000

Unit cost

37.75

48.87

100.57

Sales Price

$57.78

$81.26

$97.07

Dollar sales

433,350

1,015,750

388,280

1,837,380

Income Statement
Sales

$1,837,380

Cost of goods sold
Begin inv.

37,749

Costs added
Materials

442,000

Labor

155,600

Overhead

682,688

Total costs added

1,280,288

Goods available

1,318,037

Ending inv.

0

              0

Cost of goods sold

1,318,037

Gross Profit

519,343

Administrative

210,000

Marketing

175,000

Total expenses

   385,000

Profit before taxes

134,343

Income taxes @ 35%

    47,020

Net Profit

$87,323

 

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.

Flow

Valves

Pumps

Controllers

ABC unit cost

$37.75

$48.87

$100.57

Unit variable cost

16.00

20.00

22.00

Fixed cost per unit

21.75

28.87

78.57

Times

x

Inventory change in units

1,000

Equals--Difference in pre tax income

$21,749

Profit before taxes--unit variable costs

$156,092

Profit before taxes--ABC unit costs Month 1

177,841

Difference in profit before taxes

(21,749)

Profit before taxes--unit variable costs

$156,092

Profit before taxes--ABC unit costs Month 2

134,343

Difference in profit before taxes

$21,749

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.