Why changes in inventories is added in P&L?

Isn't it the changes in inventories is a cost and should be deducted from profit?

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A negative "changes in inventories of finished goods and work in progress" means the closing inventories is less than the opening inventories. This negative amount is deducted from the revenue (in the income statement) because it is part of the cost of goods sold.

A positive "changes in inventories of finished goods and work in progress" means the closing inventories is more than the opening inventories, and why is this positive amount (in the income statement) is added in the revenue?

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By johngroganjga
06th Jul 2017 10:34

Because it's a credit entry.

If you understand why a decrease in stock is an expense, why does it surprise you that an increase is income?

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Replying to johngroganjga:
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By Obcy2017
31st Oct 2017 12:21

Well, it is credit from the accounting POV.

From the investor's or shareholder's POV, it is not revenue but an adjustments to production costs. Sure, if the costs are lower (with positive change in inventories), then EBITDA and Net Profits are higher as well. But only in the current accounting period. One has to analize the sales and production figures (and inventories, of course) in the previous accounting periods to see if the company creates wealth.

One can imagine a company with sales declining, production going to the warehouse instead of the market, and yet the EBITDA/Profits growing, because of that "accounting credit."

Remember, if the company produces but does not sale, it does not generate revenue, no matter what your income statement says.

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Mike Cooper HJS
By mike_uk_1983
06th Jul 2017 10:47

Just to clarify when you say deducted from revenue or added to revenue you mean to arrive at gross profit?

As the proper entry would to be to include in cost of sales so increases or decreases purchases/direct costs and then that total is deducted from revenue to arrive at gross profit.

Movement in inventories shouldn't change the revenue number.

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By Obcy2017
31st Oct 2017 12:34

Be aware: managers often use this real and important adjustment in production costs to boost profits, however temporarily.

A large positive change in finished goods inventory should be viewed as problematic (operational or sales deficiency) and never as "revenue," even though it is true from the accounting point and must be recorded on the P&L as credit leading to more earnings from production in a given period.

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RLI
By lionofludesch
31st Oct 2017 12:35

Showing changes in stocks is a modern fashion.

It can be confusing. I'd rather just adjust it under the bonnet of purchases or whatever,

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Replying to lionofludesch:
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By Obcy2017
01st Nov 2017 16:38

Fashionable, but also potentially misleading.

Imagine Company ABC that reports Earnings or Production (which includes changes in finished product inventory) as $10m in year 2015 and $11m in 2016. Total costs are the same $8m in both years, and therefore, EBITDA is $2m and $3m, respectively - a 50% increase. All that on top of a 10% increase in Production. Great! So great that the managers ask for a bonus for their hard work.

But then you look at the actual Sales figures and discover that, in fact, the company sold $11m in 2015 and $10m in 2016. Sales (or actual Revenue) declined 9%. How come? Well, that is because Production figures used to calculate and report EBITDA included a negative change in inventories (-$1m) in 2015 and a positive change of +$1m in 2016.

Do the managers deserve their bonuses?

Note: a two-year total for both Sales and Production is the same $21m. So are all other relevant numbers. The "lie" - and a very ugly one at that - is in the reported trend. The company EBITDA would have declined 33% not increased 50%, had the level of inventories remained the same.

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paddle steamer
By DJKL
01st Nov 2017 22:38

But there are other metrics that will be considered when determining bonus levels, an increase in inventory with static sales and static margin will for instance mean that stock turnover has reduced.

Yr 1

Sales 10

Op stock 3
Purchases 6
Close stock-4
COS 5
GP 5
50% GP

Closing stock is 4/5 annual sales, previous 3/5 annual sales

YR 2

Sales 10

Op stock 4
Purch 7
Close stock -6
COS 5
GP 5
50% GP still

But closing stock is now 6/5 annual sales

Someone will have noticed so it is hardly a subtle move by management, surely bonuses etc will consider other metrics.

It can be more of a problem with fixed wage costs being absorbed into COS and production deferring /disguising issues, the business in effect possibly being overstaffed, but saying it, standalone is an issue, is wrong, a view of the whole picture is needed.

And re your example, it is not so with variable costs, if
margins had been constant and stock had been static purchases would accordingly likely have been reduced, so costs reduced, it is only where "purchases" include substantial fixed cost absorption that there could be an issue.

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Replying to DJKL:
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By Obcy2017
02nd Nov 2017 13:19

Sure, but not all shareholders have access to all metrics. Some might not understand the complexity of inventory valuation or even the P&L. Managers often decide to pay themselves first, then they justify such actions based on "paper" changes in EBITDA or Net Profits in a given accounting period.

There is some solid research on how managers use inventory change to artificially increase/decrease earnings, depending on what they want to emphasis.

Personally, I'd prefer to see inventory changes under Costs rather than Earnings, because it is an adjustment to costs, not Revenue.

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Replying to DJKL:
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By Obcy2017
02nd Nov 2017 14:02

I can give you a real life example of a company producing plastic containers -- they thermoform PS resin (their raw materials) into margarine/yogurt cups and boxes (finished product).

Last Q they reported an increase in Production or Total Earnings by some $2m, even though Sales declined. The difference was of course, a nearly $3m change in inventories. Or in other words, they produced a few extra thousand tons of boxes for the warehouse. They even had to lease a storage place to keep the new inventory. And, they did not reduce purchases of raw materials because they have long-term contracts with their suppliers; buying less would mean higher prices or losing volume discount, etc. Worse, they had to borrow some money to finance the operations, because they run out of cash, and yet on paper the company was making a decent profit. All because of the accounting practice that can mask the real situation (however temporarily it is and only if one does not check all matrices and ask appropriate questions -- but believe me, some shareholders/owners don't. In this case, the owner of this plastic company even awarded the CEO an extra bonus for the better-than-expected results).

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