I do not understand how a company can have a negative gross profit. If the inventory cannot be sold in the market for atleast its cost wouldn’t this mean there will be an inventory write down? Is it because this write down will increase COGS above the cost that would make the gross profit zero?
Any help is much appreciated and hopefully I was able to explain my confusion coherently.
Hi Dan,
A negative gross profit means that the revenue generated does not cover the COGS. You would not write down the inventory unless it was not worth the carrying value on the balance sheet. An example might help with this -
Just say Apple launches a new I Phone and I buy a batch at £400 per unit. The next day Samsung brings out a new smart phone which I think will sell way better than the iphone but I have filled up my warehouse with the batch of iphones. I might sell those I phones at £350 a unit because I think that the Samsungs profit will cover this loss and then some, so in the long term I will make a profit. However just say that the day after I do this is the end of my financial year. I will post a negative gross profit of £50 per unit for the iphones. The inventory will not be written down because they are still worth the £400 I paid i.e. they have not become obsolete or their value impared, I have just taken a business decision to take the loss.
I hope I have explained this clearly and it helps.
You can give me any other queries on freecfa@outlook.com or follow me on twitter @freecfa
^ That’s not a good answer. If you start marketing your widget at £300 and you’re carrying it in inventory at £400, it certainly is impaired. In your example the I phones are impaired. IAS 2 states that inventory must not be carried at a higher cost that Net Realisable Value (NRV). This is selling price less selling costs. Often you’d see a negative gross margin followed by an inventory write down in the same period, unless the company quickly overhauled its pricing. Think of homebuilders after a housing price crash. The use of LIFO can also cause some complexities as well (higher cost COGS than what is in inventory).
I don’t want to get into a drawn out discussion about this but I think there is a difference between choosing to sell at less than carrying value and market conditions dictating that you have to sell at less than carrying value, in which case the asset is impaired.
In my example the NRV would be more than cost, so the inventory is carried on the balance sheet at cost as dictated by IAS 2 but the business takes a decision to sell at less than cost in order to take on what it sees as a more profitable product. The product is not obsolete or damaged so can be sold for more than cost but a business decision is taken to sell at less than cost. Although not the same the concept of loss leading in retail runs along these lines ie one product is sold at a loss to attract customers in the hope that they will buy more profitable products. If the strategy fails you may record a gross loss but the ‘loss leader’ product is not impaired because you have chosen to sell at less than cost.
The key here is are you chosing to sell at less than cost or is the market dictating that you have to. In your example of housebuider in a market crash the inventory is rightly impaired, the NRV will be less than what it cost to build the house, it is not the builders choice to sell at this price.
Good luck convincing your auditors that selling iPhones below cost is a loss leader for your Samsung sales. No rational business will sell an iPhone at a £50 loss when they could sell it for a profit. This makes absolutely no sense. In the case of a loss leader, you don’t have negative gross profit because the sale of other stuff (driven by the loss leader) would offset this.
Which is exactly what said in my origianl example.
Other than an iPhone is not a loss leader for a Samsung.
OK, lets forget the IPhone Sumsung thing and agree it is theoretically possible to sell inventory for less than cost without impairing the inventory and therefore possible to have a negative gross profit without an inventory wirte down?