Connection: Inventory Turnover (ADMN 201) ↔ Cost Flow Assumptions (ACC 926)
The Link
ADMN 201 teaches Inventory Turnover = COGS / Average Inventory as a pure activity ratio — the higher the better, benchmark against industry. ACC 926 reveals an inconvenient truth: the COGS figure itself depends on which cost formula was chosen (FIFO vs. weighted average). Two firms with identical physical inventory and identical sales can report different turnover ratios purely because of their cost flow assumption.
graph TD Phys[Physical Reality:<br/>same stock, same sales] Phys --> FIFO[FIFO assumption:<br/>oldest costs to COGS] Phys --> WA[Weighted Avg assumption:<br/>blended cost to COGS] FIFO --> COGSf[Lower COGS<br/>in inflation] WA --> COGSw[Middle COGS] COGSf --> Ratiof[Lower Inventory Turnover<br/>Higher Net Income] COGSw --> Ratiow[Middle Inventory Turnover<br/>Middle Net Income] Ratiof -.same firm, different reports.- Ratiow
(diagram saved)
From ADMN 201
“Inventory Turnover Ratio = COGS / Average Inventory. Times inventory sold and restocked per year; higher = more efficient.” — FinancialRatios
Treats COGS as a given fact. The exam expectation is: plug the numbers into the formula, interpret the result.
From ACC 926
“FIFO assigns oldest costs to COGS; newest costs in ending inventory. Weighted Average = Cost of goods available / Units available. LIFO is NOT permitted under IFRS or ASPE.” — Inventory
In an inflationary environment:
- FIFO → older (cheaper) costs hit COGS → COGS lower → net income higher → ending inventory at newest (higher) prices.
- Weighted Average → blended COGS → middle-of-the-road on every metric.
Same physical inventory. Different reported numbers. Different ratios.
Implications for Ratio Analysis
| Ratio | Affected by FIFO vs. WA? | How |
|---|---|---|
| Inventory Turnover (COGS / Avg Inv) | Yes | FIFO lowers COGS and raises inventory → lower turnover |
| Gross Profit Margin | Yes | FIFO inflates margin in rising-price environments |
| Current Ratio | Yes | FIFO inflates inventory (denominator side OK; this one favours FIFO firms’ liquidity look) |
| Net Profit Margin | Yes (downstream of GPM) |
When comparing firms, check the inventory note first. A firm using FIFO during inflation will look more profitable and slower-turning than an otherwise-identical firm using weighted average. Neither is “right” — they just chose different assumptions.
Why This Matters
The ADMN 201 critical-thinking thread already touches this: a single ratio in isolation tells you little. ACC 926 supplies a specific reason why: the input itself is policy-dependent.
This is also the kind of thing forensic accountants look for: a sudden change in cost flow assumption (allowed under specific conditions) can dramatically change reported numbers without any change in operations.
Inventory Errors Multiply Through Ratios
ACC 926 also documents that inventory errors affect two periods:
- Period 1 ending inventory overstated → COGS understated → Net Income overstated.
- Period 2 beginning inventory overstated → COGS overstated → Net Income understated.
- Two-period cumulative effect = 0, but each period’s reported turnover and profitability are wrong.
ADMN 201 doesn’t address this. ACC 926 makes it Module 8, Section 4.
Related Concepts
- FinancialRatios
- Inventory
- AccountingEquation-FinancialStatements
- DataVisualization-FinancialRatios — PHIL 252’s lens on misleading ratio visualizations applies doubly here