FIFO, Weighted Average and a Nervous Bank
Zubin Traders began the year with 400 units of a fast-moving item costing BDT 250 each. During the year it purchased 600 units at BDT 280 and 500 units at BDT 320. It sold 1,100 units at BDT 450 each. Operating expenses other than cost of goods sold were BDT 96,000 and the tax rate is 25%. Current assets other than inventory are BDT 210,000 and current liabilities are BDT 200,000. The bank covenant requires a current ratio of at least 1.50. The owner wants to switch from FIFO to weighted average because 'the profit figure looks too high and the tax is heavy', and expects the bank to be pleased by a lower profit. Prices are still rising and replacement cost is now BDT 340 per unit.
1. Compute cost of goods sold, closing inventory and profit after tax under both FIFO and weighted average, and state the tax saved by switching.
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Units available = 400 + 600 + 500 = 1,500; closing stock = 1,500 − 1,100 = 400 units; sales = 1,100 × 450 = BDT 495,000.
FIFO COGS = (400 × 250) + (600 × 280) + (100 × 320) = 100,000 + 168,000 + 32,000 = BDT 300,000. Closing stock = 400 × 320 = BDT 128,000. Gross profit = 195,000; less expenses 96,000 = 99,000; tax at 25% = 24,750; profit after tax = BDT 74,250.
Weighted average Total cost = 100,000 + 168,000 + 160,000 = BDT 428,000; average = 428,000 ÷ 1,500 = BDT 285.33. COGS = 1,100 × 285.33 = BDT 313,867; closing stock = BDT 114,133. Gross profit = 181,133; profit before tax = 85,133; tax = 21,283; profit after tax = BDT 63,850.
The switch saves 24,750 − 21,283 = BDT 3,467 of tax and lowers reported profit by BDT 10,400.
2. Calculate the current ratio under both methods and assess whether the bank will be pleased by the change.
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The covenant needs current assets of at least 1.50 × 200,000 = BDT 300,000.
- FIFO: (210,000 + 128,000) ÷ 200,000 = 1.69, headroom BDT 38,000.
- Weighted average: (210,000 + 114,133) ÷ 200,000 = 1.62, headroom BDT 24,133.
Both pass, so there is no breach - but the cushion shrinks by about 37%. One slow payer or one stock write-down would put the average-cost option much closer to default.
The owner's expectation is wrong. A lender that also lends against stock is not pleased by a lower profit and a smaller inventory figure: inventory is collateral, so reducing its book value by BDT 13,867 reduces the borrowing base. The bank will also ask why a long-standing policy changed in a year of rising prices, and whether the motive was reporting or tax.
3. Is the owner right that profit is 'too high'? Recommend whether to switch, giving reasons beyond the tax figure.
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Partly right, for the wrong reason. With replacement cost at BDT 340 and the last purchase at BDT 320, FIFO matches old costs against current revenue, so reported profit contains a holding gain. On closing stock alone that is 400 × (340 − 320) = BDT 8,000, and more sits inside the units sold. That portion is not distributable: replacing stock costs more than the accounts show. Weighted average smooths the price rise but still lags replacement cost.
But switching to cut tax is weak reasoning here. The saving is BDT 3,467, the change needs disclosure and consistent application, and it costs BDT 13,867 of balance-sheet strength and covenant headroom.
Recommendation: keep FIFO; tackle the real issue by pricing at replacement cost and holding a stock-replacement reserve, so the 'high' profit is not paid out as drawings.