According to the Management Discussion and Analysis section of Frankfurt Supply Company’s annual report, Frankfurt recently decreased the sales prices of its products in order to increase market share. In addition, Frankfurt recently lowered its requirements for credit customers and increased the credit limits of some customers. What is the most likely impact on Frankfurt’s accounts receivable turnover and inventory turnover as a result of these changes? Accounts receivable turnover Inventory turnover A) Decrease Decrease B) Decrease Increase C) Increase Increase D) Increase Decrease Your answer: B was correct! Accounts receivable turnover will likely decrease as a result of offering credit to customers with weak credit histories. Collections will likely slow down and bad debt expense will likely increase. Iinventory turnover is likely to increase as sales of Frankfurt’s products increase from more liberal credit terms and the decrease in price. OK I understand the effect on receivables turnover. But, Inventory Turnover = COGS/inv. COGS will definitely go up because of more sales. But wouldn’t inventory go up as well to accomodate those extra sales? How do you know that the overall ratio will go up (the increase in COGS is greater than the increase in inventory)?
In my opinion, if company has to reduce its sales price and increase its credit limits of some customer, the company is getting some difficulties of competitive or sales activities. In that case, the inventory level maybe kept constant or be increased with very small number. I mean we cannot load high inventory in the warehouse when sales activities getting difficult. That the reason why inventory turnover decrease.
This is a very difficult question to answer when they don’t give exact numbers to work with. I see your point about the inventory, but I guess since nothing is said about a inventory we assume there is no or little change. In my opinion it is equally difficult to know whether or not receivables turnover went up or down. Sales will obviously increase, but then so will accounts receivable. Without specific numbers it is difficult to tell which will increase by more.
So AR increases - because more credit is offered to customers. Sales increases, and since Credit offered is a percentage of the Sales, Sales increase would be more than the AR Increase. So AR Ratio decreases. COGS increases – because Sales Increased. This automatically means that End Inv. would reduce. So COGS/Inv would increase. Hence choice B. CP
Cpk123, I understand your point but actually inventory level can increase during the reported period. Your conclusion is correct when inventory level unchanged AND inventory cost unchanged. If company apply FIFO method in rising price period the problem get different.
If you decrease Sales price, but are paying a higher price for Inventory new purchases – your bottom line is taking a hit. If you are decreasing Sales price to increase market share, I believe you are pretty much in a “monopolist” industry (could be wrong about the “economic” type of classification). Also when you are comparing companies based on the Inv. Turnover – the consistency requirements make sure you use either LIFO or FIFO cogs and Inventory consistently. I would surmise – Sales price reduction would mean you are able to convince your suppliers to also reduce the Input price on the inventory – that way revenue goes down, so does your cost – so your profit margins are not eaten into. I may have written things above that do not apply in all conditions. But given the above problem – I would have analysed it 9 times out of 10 like I did, when I solved it above. CP
Inventory Turnover ratio = COGS/Avg. Inventory. There is nothing given about COGS so lets assume it remains constant. If company is trying to increase sale, they are trying to get rid of inventory. So avg. Inventory goes down. for eg. if intial cast is ITR = 10/10 = 1 now if Avg inventory decreases assuming COGS constant then ITR = 10/5 = 2 (an incresae).
jdoshi, COGS will increase because sales increase…
Here’s my thinking: Yes, receivables turnover would most likely decrease because of the numerator effect on sales (from decreasing prices of the merchandise would stunt the growth or even reduce sales temporarily) and denominator effect from loose trade credit (increase in average accounts receivable). The denominator is the smaller value of the two, so every $1 increase is greater in percentage terms in the denominator than the numerator. Of course, if we were wearing our economics hat and assumed that this firm was changing the price along the elastic portion of the demand curve, then our conclusion might be different. But let’s not get carried away with outside assumptions, i.e. whether the firm uses LIFO, FIFO, etc. To the part of the inventory turnover: COGS (the numerator) will increase because of the attempt to increase market share (lower prices would increase quantity demanded, and looser credit would increase demand in general). Inventory will be sold at a much faster pace. It’s true the question doesn’t state which has the greater effect: numerator or denominator? Think about it for a second: why would your inventory turnover decrease when your sales and output increase? This can result from fixing poor inventory management, going from having little merchandise in stock to handle orders to having sufficient quantities to meet demand–but then that means your sales (and COGS) go up even higher since you have less backorders! Is that what a firm that’s trying to increase market share runs into? I doubt it. Again the question is weakly stated, but if I had to choose an answer, then B would be the one.
I would give supplementary opinion of the greater effect on numerator or denominator. My idea is explained base on the management decision point view. The denominator is smaller than numerator for the reason as follow. In period of targeting market share development, the company would accept sales price down and offer more credit to customer with weakly credit histories but they also pay attention to the risk of inventory level in case of market share not increase as they expected. So, the inventory volume would be limited less than normal by board of management temporally. If market share strongly increase as board of management targeted, mass production will be put in progress and inventory will be kept higher. I wonder if company can satisfy the big sales contract when inventory is too low. But i’d rather thinking of growth company when its board of management trying to increase market share.
I see your point. I wish the people who write these test questions could respond to this thread. But remember that as your selling the denominator decreases as the numerator increases. Even though you’re replenishing inventory, that merchandise will eventually be sold, thus diminishing that very inventory. On average, the growth of inventory will be stunted by the sale of that very inventory. That very increase in sale translates into an increase in COGS, which can be restrained by market demand or limited inventory to meet that demand. There’s really no indication about the company’s inventory management strategy. It can go either way. I guess the test writers were just expecting a simple textbook definition from the end user.