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Medieval Image
Author(s):
Young, David W.
Functional Area(s):
   Financial Accounting
Setting(s):
   For Profit
Difficulty Level: Beginner
Pages: 2
Teaching Note: Available. 
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First Page and the Assignment Questions:

Following the receipt of his MBA in spring 2004, Joshua Billings accepted his first job as director of the Mail Order Department of Medieval Image (MI). MI had a large mail order business in which it sold a variety of home accessories, jewelry, electronic devices, and clothing. Everything the Mail Order Department sold was characterized by its medieval look, including its line of tee-shirts, which had a pattern much like the mail of a suit of armor.

Mr. Billings was particularly interested in the tee shirts because they did not appear to have been selling particularly well. Each year for the past three years (2002-2004), the previous director had purchased and sold 3,000 tee shirts, but the inventory remained at 10,000—its level at the beginning of 2002. The new tee shirts always had been ordered during January, and no sales typically had taken place until April, when the spring catalog was sent out.

There was another problem as well. Each year the shirts cost a bit more than in the prior year. Mr. Billings' predecessor had been using a FIFO inventory accounting system, which Billings had learned in his MBA Program typically gave rise to higher before-tax income in periods of inflation than a LIFO system, and hence higher taxes. He thus thought it might make sense to shift the inventory accounting system to LIFO to lower taxes. However, he decided to stay with the FIFO system for the remainder of 2004, and then do an analysis to compare the results.

As 2004 came to a close, sales once again totaled only 3,000 tee shirts. Mr. Billings gathered together data on inventory levels and gross margins for the past three years. He then recalculated the gross margin amounts for those years using a LIFO approach, and was delighted to see that the LIFO approach would have produced significantly lower amounts, and therefore would have meant much lower taxes had it been in use. The results of his calculations are shown in Exhibit 1.

Armed with this information, Mr. Billings met with the store's accounting staff, and convinced them to shift the inventory accounting system to LIFO beginning in 2001. He also featured the tee shirts more prominently in the 2001 catalog in the hope that they would sell better. Finally, he decided to suspend purchases of new tee shirts during 2001 and to sell the shirts out of the existing inventory of 10,000.

2001 was a very successful year. All 10,000 tee shirts in inventory sold. Mr. Billings was extremely dismayed, however, when the accountants presented him with information for 2001 showing that the gross margin was $60,000 under the LIFO system, and that it would have been only $42,000 under the FIFO system.

“How can that be?” he asked the accountants. “We have been operating in an inflationary environment for the past three years, and a LIFO system produces lower profits under inflation. There must be some mistake.” . . .

Assignment

  1. Work through the calculations that underlie the figures contained in Exhibit 1. Be sure you understand how the gross margin and inventory amounts were calculated under both FIFO and LIFO.
  2. Using sales of 10,000 tee shirts in 2001, calculate the gross margin under both FIFO and LIFO. Why do these figure differ?
  3. Did Mr. Billings learn the wrong lesson in his MBA Program? Explain why or why not. If you believe he learned the wrong lesson, what is the right lesson?