Proportionate consol. - adjusting COGS

Q-bank question #89494 Can someone explain to me why the answer to this question is to add both COGS and then subtract the proportionate share of *sales* to company X? Why wouldn’t you subtract the proporationate share of COGS? I just can’t seem to wrap my head around this one but maybe I’m missing something here. ________________________________________________________________________ Company X owns 40% of company S and currently accounts for the investment using the equity method. Below are the 2002 balance sheets and income statements for companies X and S, in thousands of dollars. Company S X Sales 200 1,000 Cost of goods sold (COGS) 140 700 Operating expenses 20 100 Income from investment in S 0 12 Earnings before taxes (EBT) 40 188 Taxes 10 47 Net income 30 141 Company X purchases 25% of the output of company S, and $4,000 of the receivables of company S are from company X. If the investment is treated using the proportionate consolidation method, the COGS for company X will be: A) $742,000. B) $756,000. C) $736,000. Your answer: A was incorrect. The correct answer was C) $736,000. COGS will be increased by the proportionate share of the COGS of company S, less the proportionate share of sales of S made to company X, which means COGS is equal to 700,000 + (0.4 × 140,000) - (0.4 × 0.25 × 200,000) = 736,000.

Company S has sold back stuff to X and on the Balance sheet of X it has already been Proportionally consolidated. For proportionate Consolidation -> COGS Consolidated = COGS X + 40% COGS S = 700 + 40% * 140 = 756 Now S has sold 25% to X. So 25% of 40% Sales is to be removed. so remove .25 * .4 * 200 = (20) This is the Upstream Sale condition. Remove the portion of unrealized profits like operation we do in the text book in the Equity method section. X has accounted for 40% sales of S in the Prop. Consolidation process - now 25% is kind of being returned. so 25% of 40% must be removed. You would not remove COGS – because COGS is only Inventory… It is the final Sales that was made by S to X. Hope this explains…

700,000 COGS of S +0.4 * 140,000 [Include proportionate share of COGS of X] We have to remove the effect of intercompany transactions. .25 (Sales of X) ==> output of X that S purchased, factored by 40% So we would be double counting 40% of [.25*Sales of X] So we need to subtract that… I’m not sure if that is very clear…explanation.