“The surest way not to fail is to determine to succeed.” Richard Brinsley Sheridan
ABC Retailing Co. prices its products by adding 30% to its cost. ABC anticipates sales of $715,000 in March, $728,000 in April, and $624,000 in May. ABC’s policy is to have on hand enough inventory at the end of the month to cover 25% of the next month’s sales. What will be the cost of the inventory that ABC should budget for purchases in April?
You will see many of these type of questions in your exam. It’ll provide you with a certain type of forecast but will ask you to calculate something different. In this case, we have sales forecast for three months but we are being asked to calculate the budget for purchases, not sales. It’s very important that you pay attention to this type of questions and only calculate what you are being specifically asked.
In order to come up with the budget for purchases in April, first we need to know the budget for purchases in March and May. We are told that ABC prices its products by adding 30% to its cost. This means that we can covert the sales forecast of each month into the purchase budget by using the following formula:
Cost of Inventory = Sales Price / 1.3
March Cost of Inventory: $715,000 / 1.3 = $550,000
April Cost of Inventory: $728,000 / 1.3 = $560,000
May Cost of Inventory: $624,000 / 1.3 = $480,000
Now that we have the cost of inventory for each month, it is a lot easier to calculate the budget for purchases in April. We do that by using the Inventory Equation:
Ending Inventory = Beginning Inventory + Purchases – Cost of Good Sold (COGS)
Let’s now take this formula and plug in the figures related to the month of April, since this is what we are being asked to do. We are told that ABC keeps 25% of next month’s inventory needs on hand at the end of each month. This means that the ending inventory in April should be 25% of May’s cost of inventory: $480,000 x 25% = $120,000. Now for beginning inventory, it should be 25% of the cost of sales in April: $560,000 x 25% = $140,000. Let’s plug those two figures into the formula:
$120,000 = $140,000 + Purchases – Cost of Good Sold (COGS)
Purchases in April is what we are trying to calculate and because this is still unknown, let’s use an X to represent it. COGS is the cost of inventory in April which we know it to be $560,000. Let’s plug this into the formula as well:
$120,000 = $140,000 + X – $560,000
Now we simply need to solve for X by re-arranging the formula in the following manner:
$120,000 + $560,000 – $140,000 = X
$540,000 = X
Based on our analysis above, we conclude that this is the correct answer.
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