Reference no: EM133538147
Case: Parsi Onious is upset. As a manager in the purchasing department, he has just received an ugly surprise, which has brought him to your doorstep.
Parsi manages the team of professional buyers responsible for procuring all of the company's raw materials. This includes hundreds of millions of dollars of metals, chemicals, and plastics each year from around the globe. These materials are used in the manufacture of the company's products, including a new line of refrigerators that was launched just last year. As buyers, Parsi's team is primarily measured on the cost of the materials they purchase. They are expected to work hard to continuously bring down these costs and to help the company stay competitive.
However, Parsi is also personally responsible for producing financial forecasts. Using his inside knowledge of material costs, he is expected to create estimates of how much the company will spend on these materials each month and quarter. These forecasts are used by executives when they communicate with investors. The company sets public earnings targets, so it is critical the forecasts be reliable. Unfortunately, Parsi's forecast for the last quarter was off by a large margin, and now the Vice President of Operations is demanding answers.
When the company purchases raw materials, a debit is recorded against inventory, while a credit is made to accounts payable. Later, after the company manufactures and ships its products to the customer, a credit is made against inventory, recording the consumption of the raw materials. Meanwhile, in accordance with the expense recognition (matching) principle, cost of goods sold is debited. Parsi's team is measured based upon the cost of materials, so this transaction is very important to them. Parsi is forecasting how much cost of goods sold will be expensed each month and quarter.
Finished products contain a certain amount of raw material. Herein lies the problem. The engineering team estimated that each refrigerator contains 11.22 pounds of polyurethane foam, an expensive chemical used for insulation. When the refrigerators are shipped, inventory is credited for 11.22 pounds of polyurethane, while 11.22 pounds is simultaneously debited against cost of goods sold as an expense. However, a physical inventory count conducted at the end of the quarter determined that $350,000 of polyurethane was missing. Apparently much more than 11.22 pounds was being consumed in the manufacture of each refrigerator.
The inventory report triggered the company's accounting department and they made an adjusting journal entry. Since this was unexpected, the adjustment resulted in Parsi's forecast for cost of goods sold to be off by $350,000. As a member of the finance team supporting Parsi, it has now fallen to you to explain the transaction. He doesn't understand why he is being "penalized" for an apparent inventory control problem at the manufacturing plant, and fears being blamed. Parsi wants to be able to defend himself to the Vice President of Operations, which means he needs to know what happened and how it can be prevented in the future.
Question: Provide background and an introduction.
Explain how inventory transactions are related to cost of goods sold and how the process for recording material costs normally works. Show a typical journal entry and T-accounts in your presentation.
An explanation of the adjusting entry that was necessary due to the inventory count and how it would affect cost of goods sold and Parsi's forecast. Show the adjusting journal entry that occurred and the T-accounts.
A couple of suggestions for what changes could be made to avoid this forecasting error in the future.