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November 4, 2005

Confused Americans for Truth - The Curse of Inventory Profits

by Ferdinand T Cat

Obscene oil profits are back in the news. Currently, they're taking a back seat to the whole Iraq war intelligence thing, but that can't last forever.

Because profits are generally a small portion of revenue, a small change in revenue can cause a big percentage change in profits. Nonetheless, there are more factors at work. Though prices have been rising for some time, the windfall profits don't kick in until disaster strikes. This is due to a little-discussed economic principle called The Curse of Inventory Profits. Since a picture is worth a thousand words (and you have not really experienced how painful a thousand words can be until you've heard Bruce try to explain something), we've decided to present this principle in the form of a Flash animation. The pictures begin below the fold.

Respectfully submitted,

Ferdinand T. Cat

Trackposted to Big Dog's Weblog, Blue State Conservatives, Cao's Blog, Euphoric Reality, NIF, Stuck on Stupid, The Political Teen, Jo's Cafe, Basil's Blog, Mudville Gazette, bRIght and Early, and the three guys who took the last train to the coast the day the music died.

# At Fri 12:50 AM | Permalink | Trackback URI | Comments (2) | More Confused Americans for Truth

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Comments

This makes no sense. Selling from inventory does not create windfall accounting profits like this animation summarizes. When you sell from inventory, two different entries are made into the Journal. The first is a debit to Cash of $50 and a corresponding credit to Sales. The second is a credit to inventory of $45, and a debit to inventory expense of $45. This leaves a net profit of $5 immediately, and does not depend on buying another of barrel of oil which may or may not be available.


Posted by: Ankur at November 8, 2005 5:50 PM

What you say is true, but you are looking at a single transaction in isolation. I'm talking about the effect of buying multiple barrels of oil at different prices and then selling them.

The profit from the $45 barrel you bought last week is less than the profit from the $40 barrel you bought the previous week. It is the failure to buy another $45 barrel that causes that $40 barrel to be pulled from inventory, and when it does get pulled, you get a $10 profit instead of a $5 one. When you replace that $40 barrel with a new $45 one, the transaction results in net profit of 0, but the profit potential of your inventory has just dropped by $5.

Furthermore, this process only occurs because of the practice of last-in-first-out inventory accounting. If you do first-in-first-out accounting, you get a completely different profit picture. Computing profits on a LIFO basis is supposed to make your profit picture match your cash flow, so that you do not end up in the dreaded tax-rich/cash-poor squeeze. Unfortunately, if your inventory starts moving too fast, it produces screwy results.


Posted by: Ferdy [TypeKey Profile Page] at January 29, 2007 8:15 AM

HTML is not allowed in comments; however, if you put in a raw URL (http://www.somewhere.com/page.html) it will automatically be converted to a link.. Also, it is likely your comment will not appear unless you refresh the page manually after posting it.

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