Corporate Inventory Analysis and Costing Methods

For Home Depot (HD) and many other corporations, inventory represents one of the single largest items on the balance sheet. For 2008, inventory represented 25.9% of Home Depot's total assets. Furthermore, inventory turns over many times throughout the course of the year, feeding into the firm's income statement through cost of goods sold (COGS). In order to understand inventories, you first need to be aware of the three major inventory costing methods.

When the concept of inventory costing methods was first presented to me, I wasn't sure what exactly there was to talk about; if a company buys a widget for cost X, it would make sense that upon the sale of that widget, X dollars would flow to cost of goods sold. Furthermore, if you had to place a value on your inventory in it's entirety, it would make the most sense to simply report the sum of the cost of all items in inventory. Unfortunately, the accountant powers- that- be didn't design inventory costing in such a straightforward manner. As a corporation, you basically have three choices in terms of inventory costing: first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost. In FIFO, the oldest price stored in inventory is assigned to cost of goods sold. With FIFO, the most recently recorded price is attached to the good and flows to COGS. Average cost, as the name implies, assigns the average cost of the inventory item. During inflationary times, the FIFO costing method is the most profit-advantageous because yesterday's cost is being booked as today's expense. The opposite would of course apply during times of falling prices. Because of the profit implications, the IRS requires corporations to remain consistent with their costing method. From what I've been told, the IRS will allow you to switch methods - but only once. Below is a quick example showing how different inventory costing methods can result in completely different COGS (and subsequently gross profit margins) - for the same transaction.
In this simplified example, I'm assuming that Company A is purchasing hammers from the manufacturer/distributor, holding them in inventory, and subsequently selling them at its retail locations. I'm also assuming some severe inflation in the hammer supply industry, but it was done to help clarify the point. As is evident though, FIFO leads to significantly lower cost of goods sold, gross profit margins, and ultimately net income. You should check the footnotes that accompany the firm's financial statements to determine which method is being used. This is important due to a profit-boosting phenomenon known as LIFO Liquidations, which usually occurs during times like now when corporations are allowing their inventories to dwindle lower and lower without replacement. The result is that new sales begin to cut through years of (assumedly lower) price layers, lowering COGS and boosting net income. This could result in a temporary profit windfall, however it's unlikely to repeat itself, and should almost be considered an extraordinary aspect of income (in my humble opinion).

Now that you have a cursory grasp of inventory costing, I'll move on to two ratios that will help to assess a given company's inventory situation: Inventory Turnover and Average Inventory Days Outstanding.

Inventory Turnover measures the number of times that a firm's inventory has "turned over" during the year. It's calculated as follows:

Inventory Turnover = Cost of Goods Sold / ( (Starting Inventory + Ending Inventory) / 2 )
Home Depot's Inventory Turnover
= $47,298M / ( ( $10,673M + $11,731M) / 2 )
= $47,298M / ($22,404M / 2)
= $47,298M / $11,202M
= 4.22

The implication here is that Home Depot's inventory turned over 4.22 times during its 2008 fiscal year.

Some sources provide a several step process for determining the next ratio, Average Inventory Days Outstanding. The shortcut though is to just 365 and divide it by Inventory Turnover. For Home Depot:

Average Inventory Days Outstanding = 365 / (Inventory Turnover)
=365 / 4.22
=86.49

This means that, during 2008, the average item spent 86.49 days in Home Depot's inventory. This ratio should be compared across several years to determine trends in the firm's inventory. As an example, during 2007, Home Depot's average inventory days outstanding was 87.25. This means that Home Depot actually improved its turnover from 2007 to 2008, which is contrary to what I would expect during a recession. This year-over-year comparison is probably most indicative of efficient inventory controls at the company. My expectation though is that when Home Depot reports fiscal 2009 results (towards the beginning of February 2010) we'll be able to observe an increase in the average inventory days outstanding. I may be wrong though, and HD could have conceivably scaled down its inventory to meet sales demand in an efficient manner that will allow it to remain consistent with its ~86 day turnover rate. It's items like these that should allow investors to discern between market leaders and laggards coming out of this recession (and into the new normal?)

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