Sunday, June 17, 2012

Inventory Turnover Accounting Problem

Use the following information to solve this inventory turnover accounting problem:

A golf ball manufacturer reported sales of $10 million and an inventory turnover ratio of 2 during its last accounting period.  The manufacturing company is now adopting a new inventory system to increase efficiency.

The goal of the new inventory system is to reduce the firm’s inventory level and increase the firm’s inventory turnover ratio to 5. At the same time, the company hopes to maintain the same level of sales. Answer how much cash will be freed up by doing this?  

Solution to Accounting Problem:

Yearly Sales                                                    $10,000,000
Inventory Turnover ratio (old)                                   2
Inventory Turnover ratio (new)                                 5

Calculate the level of inventory:

Inventory Equation       =   (Sales/Inventory Turnover)

Calculating Value of old inventory 

Old Inventory                      =       $10,000,000/2 =$5,000,000

Calculating Value of New inventory 

Inventory New            =     $10,000,000/5 = $2,000,000

Amount of Freed up cash by the transition= (Old Inventory – New Inventory)                                                        

=$5,000,000 - $2,000,000= $3,000,000

Correct Accounting Answer = $3,000,000

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