Thursday, 24 April 2014

Overstating profits by inflating inventory

All else equal, increasing held inventory will lead to an increase in reported profit, since some fixed costs are moved from the profit statement to the balance sheet. Although not a new finding, this effect is frequently overlooked by shill analysts, wilfully or otherwise. As a result, inventory stuffing has reached ludicrous proportions for many Australian companies.

Let's say Acme Corporation has $10,000 in fixed costs and a variable cost of $1 per unit produced. Assume Acme knows it will sell 4K units in the next year. If Acme produces 4K units, it will have a total cost of goods sold of $14,000. If Acme instead produces 5K units, moving 1K units to inventory, the cost of goods sold will be $12,000, with this lower COGS translating into higher reported profit. This is because $2,000 in fixed costs has been moved to the balance sheet.

Of course, when this inventory is eventually sold, the fixed cost is moved back to the profit statement, leading to a higher COGS and lower profit. Stockpiling inventory can only boost reported profits temporarily. The dollar amount of the temporary reported profit increase is given by:

Increase in reported profit = Increase in inventory * Fixed costs / Total costs

The dollar boost to reported profits caused by inventory stockpiling is equal to the dollar increase in inventory times the proportion of production costs that are fixed. In the example above where 5K units are produced by Acme, inventory increases by $3,000 while the fixed cost proportion is 2/3, leading to a $2,000 increase in profit. Inventory stockpiling is thus more effective for boosting reported profits for capital intensive companies with a relatively high proportion of fixed costs.

In relative terms, the potential boost to reported profit from stockpiling is greater for lower margin companies. The figure below illustrates the relative effect of inventory stockpiling on a company's reported profits, for various initial profit margins and fixed cost proportions. 

The figure illustrates the tremendous potential impact on reported profits from stockpiling, especially in lower margin companies with relatively high fixed costs. For example, a company with a 10% profit margin and a fixed cost ratio of 0.5 can more than double its reported net profit, by stockpiling a fifth of produced units.

Shown below is the historical net profit and inventories of newly ASX-listed Beacon Lighting (BLX.AX), which upon listing was immediately ramped by a cartel including Wilson Asset Management (WAM.AX), creating unrealized profits based upon which the WAM sociopaths will charge very real cash fees.

BLX released its 2011 and 2012 financial reports on the ASX, but uploaded two copies of the same report. Unsurprisingly, nobody even noticed.

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