Supply Chain Case StudyAnalysis

PLEASSE FIND THE REFERRED CASE AS ATTACHED Case write-ups: The write-up should not repeat case facts unless they are specifically used to support the arguments. It should provide convincing arguments in order to persuade the reader for your recommendations. Below points can be used to organize your thoughts about a case. As you perform your analysis remain open to the fact that your interpretation of the facts may change and therefore you should constantly revisit your answers. 1. Define the Problem: Describe the type of case and what problem(s) or issue(s) should be the focus for your analysis 2.List any outside concepts that can be applied: Write down any principles, frameworks or theories that can be applied to this case. 3. List relevant qualitative data: evidence related to or based on the quality or character of something. 4.List relevant quantitative data: evidence related to or based on the amount or number of something. 5.Describe the results of your analysis: What evidence have you accumulated that supports one interpretation over another? 6.Describe alternative actions: List and prioritize possible recommendations or actions that come out of your analysis. 7.Describe your preferred action plan: Write a clear statement of what you would recommend including short, medium and long-term steps to be carried out. ________________________________________________________________________________________________________________ Professors William J. Bruns, Jr. (HBS emeritus professor, now at Northeastern University), Sharon M. Bruns (Northeastern University), and Susan Harmeling prepared this case solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffective management. This case is based on general experience. All names and data are fictitious, and any resemblance to actual persons or entities is coincidental. Copyright © 2008 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. WILLIAM E. BRUNS SHARON M. BRUNS SUSAN HARMELING Merrimack Tractors and Mowers, Inc.: LIFO or FIFO? Ricardo “Rick” Martino, president and chief operating officer of Merrimack Tractors and Mowers, Inc., of Nashua, New Hampshire, felt that his job had grown much more complicated during 2007 and 2008. Merrimack was a major regional manufacturer and seller of large commercial grass mowers based on a design developed by his grandfather in the years after World War II. The company’s major competitors were John Deere, The Toro Company, Simplicity, and Husqvarna—much older and larger corporations with extensive lines of lawn care and maintenance equipment. Originally, Merrimack mowers were manufactured and assembled in a workshop and factory in Nashua. However, by 2008 the company was buying all of its tractors and machines, manufactured to its specifications, from a contract manufacturer in China, and it was operating almost exclusively as a machine-and-parts designer and distributor. The company had incorporated in 1980, and an initial public offering was followed by additional offerings of shares over the next decade. By 2008 the company had about 4,000 shareholders, including some mutual funds. About 25% of the outstanding stock was held by members of the Martino family, and shares were traded on NASDAQ. Rick had been elected president after the death of his father late in 1995. Martino’s father had initiated several changes and made decisions that led to the company’s current situation. In the early 1980s, management closed down the last manufacturing operations in Nashua. Labor costs in Japan, and later in China, had historically been well below those in the United States, so it made sense to outsource manufacturing to Japanese and, later, Chinese manufacturers. Even with shipping costs, the mowers’ variable cost was substantially less than it would have been in Nashua. The China arrangements had worked well, and there had been no problems meeting demand in Merrimack’s markets at competitive prices. Through the years, the Martinos had thought about expanding beyond their regional base but, in contrast to their competitors who had developed national and international sales forces, had never done so. However, by 2008 a number of things had changed. Economic development, including activities supporting the 2008 Beijing Olympics Games, had increased wages and labor costs in China, and material and energy costs were also rising. These cost increases were compounded by the ever 3217 DECEMBER 9 , 2 0 0 8 For the exclusive use of F. Baharudin, 2015. This document is authorized for use only by Farah Ainaa Baharudin in Supply Chain Finance Cases taught by Javad Feizabadi, HE OTHER from October 2015 to April 2016. 3217 | Merrimack Tractors and Mowers, Inc.: LIFO or FIFO? 2 BRIEFCASES | HARVARD BUSINESS SCHOOL strengthening value of the Chinese currency (the Yuan or Renminbi) compared with the U.S. Dollar.1 Loyal suppliers had no choice but to raise prices they charged Merrimack for the mowers they manufactured. Rising oil prices had also increased the costs of shipping finished mowers to the United States. The cost of shipping a 40-foot container from Shanghai to the U.S. east coast had risen from $3,000 in 2000 to almost $9,000 by 2008. These trends were in direct contrast to competitors like The Toro Company, which still retained a material U.S. manufacturing presence that was less affected by increasing manufacturing costs in Asia and actually appeared to benefit from the weakening dollar in the export markets in which it competed. As a result, Merrimack’s sales margins on tractors and mowers were under pressure. The projected net income for 2008 was below that of 2007 and earlier years. Outside directors had been pressuring Rick Martino to keep earnings growing or face the possibility that they would replace him with a professional manager who was not a Martino family member. Company management had discussed these trends but dismissed the idea of re-establishing manufacturing operations in Nashua. Seeking another off-shore supplier was a possibility, but there was no way of doing so before the end of 2008 or even 2009 if the company’s profit trends and growth were to be maintained. Only the company controller, James Colburn, had an idea that seemed worth considering to maintain the trend in income growth at Merrimack. Martino did not fully understand the idea, which was based on changing the method of accounting for inventories of tractors, mowers, and parts, but he felt he should carefully consider the idea for the change before rejecting it. He also was a little uncomfortable with the idea of changing the rules of accounting to increase reported income. Colburn tried to reassure Rick that Merrimack would have to make additional disclosures in the notes to its financial statements explaining why it was changing its method for accounting for inventory, and showing retroactive restatements of income, earnings per share, inventory and total assets, retained earnings, and shareholders’ equity for the last several years. Inventory Accounting at Merrimack Mowers In the earliest years at Merrimack, the company controller measured income by matching cash received to the costs required to produce mowers. As a small, unincorporated business run by the founder of the company, cash flow was considered an adequate measure of income, and income taxes were paid by family members and employees who received cash from the company. With the incorporation of the company in 1980, however, new accounting policies needed to be selected and applied. Since that time, inventories had been reported at cost and using an assumption of last-in, first-out (LIFO) flows applied on a periodic basis. LIFO had been selected to save on income tax payments so that the cash saved could be used for investments, and about $2 million had been saved since 1980.2 James Colburn told Rick Martino that if the company changed inventory accounting to a first-in, first-out (FIFO) assumption, Merrimack could report a higher income figure in 2008 than it had reported for 2007 but that this increase was likely to come at the cost of an increase in taxes payable. Martino was surprised a simple change in accounting could increase company profits, but he admitted to Colburn that his understanding of inventory accounting was scanty, and he would need help understanding how a change might work. He was also acutely aware of the Securities and Exchange Commission’s Financial Reporting Release (“FRR”) 36 which requires that a company’s 1 Since the Chinese authorities had allowed greater flexibility in the exchange rate, the CNY:USD rate of 8.3:1, which had applied until mid-2005, had fallen to below 7.0:1 by early 2008. 2 Section 472(c) of the U.S. Internal Revenue Code requires that a taxpayer electing to use the LIFO method for tax purposes must also use the same method for financial reporting. For the exclusive use of F. Baharudin, 2015. This document is authorized for use only by Farah Ainaa Baharudin in Supply Chain Finance Cases taught by Javad Feizabadi, HE OTHER from October 2015 to April 2016. Merrimack Tractors and Mowers, Inc.: LIFO or FIFO? | 3217 HARVARD BUSINESS SCHOOL | BRIEFCASES 3 Management Discussion and Analysis statement filed as part of the annual filings should "give investors an opportunity to look at the [company] through the eyes of management by providing a historical and prospective analysis of the [company]'s financial condition and results of operations, with a particular emphasis on the [company]'s prospects for the future." Colburn agreed to prepare an analysis for Martino to illustrate how a change from LIFO to FIFO inventory accounting might work and why 2008 might be a good year to think about a change to FIFO. He told Martino that International Financial Reporting Standards (“IFRS”) prohibit the use of the LIFO method and that moves in American accounting regulations toward the international standards might require a change away from LIFO in the future anyway, so 2008 might be a good year to make the change. Colburn spent the next day preparing a memo for Martino explaining inventory accounting and two exhibits (based on reel mower units only) showing on a pro-forma basis how income for 2008 might be changed if Merrimack switched from LIFO to FIFO and reported higher income. The memo and pro-forma income statements are shown in Exhibits 1 and 2. As soon as Rick Martino received the memo and exhibits, he began to study them, determined to understand more about how the choice of accounting methods for inventory could have such a dramatic effect on reported income and could potentially solve the company’s problem. For the exclusive use of F. Baharudin, 2015. This document is authorized for use only by Farah Ainaa Baharudin in Supply Chain Finance Cases taught by Javad Feizabadi, HE OTHER from October 2015 to April 2016. 3217 | Merrimack Tractors and Mowers, Inc.: LIFO or FIFO? 4 BRIEFCASES | HARVARD BUSINESS SCHOOL Exhibit 1 An Explanation of Inventory Accounting Methods MEMORANDUM To: Rick Martino, President and COO From: James Colburn, Controller Date: July 28, 2008 Subject: Inventory Accounting Methods Accountants use two different systems of inventory accounting. The first is a “perpetual” system which keeps track continuously of the value of items of inventory and records a cost-of-goods-sold expense when each individual item is sold. Obviously, this method can become extremely cumbersome for companies like ours with many products and high turnover. Like most large companies, we use a “periodic” inventory system where we do not keep track of day to day inventory levels but rather calculate an inventory value and cost of goods sold when we take a physical check of our inventory levels at the end of each fiscal reporting period. The physical count also allows us to verify if there has been any “shrinkage” of inventory (possibly due to damage, obsolescence or fraud). Like all other accounts that we use, the following equation applies for inventory: Opening Balance on the Account + Increases – Decreases = Ending Balance In this case, it translates to: Beginning Inventory + Purchases – Cost of Goods Sold = Ending Inventory which becomes (with a little algebraic manipulation) Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold Three assumptions about the flow of costs through inventory accounts are associated with the most commonly used inventory accounting methods and the inventory valuation method (LIFO, FIFO and Average Cost). If one assumes that the oldest costs are matched with revenues first, the method is identified as first-in, first-out, or FIFO, inventory valuation method. Alternatively, if one assumes that the most recent costs are matched with revenues first, the method is identified as last-in, first-out, or LIFO. Finally, the average cost method is based on the assumption that an “average cost” is matched with revenue and provides results somewhere between LIFO and FIFO. The actual physical flow of items does not need to correspond to the assumed flow of costs and it seldom does. In accounting for produce in a grocery store, for example, an accountant could use a LIFO assumption, even though the grocer would probably want to maintain FIFO physical flow. It is useful to visualize layers of cost built up over time in the inventory account. FIFO always takes the cost from the oldest layer. LIFO always takes the cost from the most recent layer, with the result that the oldest layers may be costs measured well in the past. In the United States, the Internal Revenue (Tax) Code permits companies to use the LIFO assumption in calculating income subject to taxation provided that it is also used for financial reporting purposes. If costs and prices are rising, the expensing of more recently purchased, highpriced inventory increases cost of goods sold, reduces taxable income, and reduces tax payments if the LIFO assumption is used. This was the case in 1980 when we elected to begin using the LIFO method. For the exclusive use of F. Baharudin, 2015. This document is authorized for use only by Farah Ainaa Baharudin in Supply Chain Finance Cases taught by Javad Feizabadi, HE OTHER from October 2015 to April 2016. Merrimack Tractors and Mowers, Inc.: LIFO or FIFO? | 3217 HARVARD BUSINESS SCHOOL | BRIEFCASES 5 At the end of 2007, the difference between the LIFO and FIFO valuation of our inventory (which is equal to the sum of the differences in Cost of Goods Sold between the two accounting methods since 1980) was approximately $5.5 million. As a result, we have not paid about $2 million in taxes which would have been paid had we elected LIFO back in 1980. The real cost of us switching to FIFO is that we will need to restate our historic earnings and realize the increase in inventory value of $5.5 million leading to an instant tax liability of almost $2 million. However, there is probably an ongoing increase in taxes payable as well. This is not really an “additional” tax but just relates to the timing of the payment. The use of LIFO means that the IRS has given us a delay in payment compared to the use of FIFO since 1980. If the company was ever liquidated, we would reduce our inventory to zero and then there would be no difference between the LIFO and FIFO inventory valuations. In such a setting, the cumulative differences in Cost of Goods Sold over the life of the company would also go to zero and so we would end up having to pay the amount anyway. Portions of this memo were adapted from the HBS Note “LIFO or FIFO: That Is the Question” (HBS No. 192-046). For the exclusive use of F. Baharudin, 2015. This document is authorized for use only by Farah Ainaa Baharudin in Supply Chain Finance Cases taught by Javad Feizabadi, HE OTHER from October 2015 to April 2016. 3217 | Merrimack Tractors and Mowers, Inc.: LIFO or FIFO? 6 BRIEFCASES | HARVARD BUSINESS SCHOOL Exhibit 2 Pro-forma Income Statement, 2007 and 2008 for reel mower units if no change in Inventory Accounting 2007 (LIFO) 2008 (LIFO) Units Per Unit Cost ($’000) Units Per Unit Cost ($’000) Beginning Inventory 15,000 900 13,500 15,000 900 13,500 Purchases, Quarter 1 10,000 1,000 10,000 10,000 1,400 14,000 Purchases, Quarter 2 10,000 1,100 11,000 10,000 1,500 15,000 Purchases, Quarter 3 10,000 1,200 12,000 10,000 1,600 16,000 Purchases, Quarter 4 10,000 1,300 13,000 10,000 1,700 17,000 Available for Sale 55,000 59,500 55,000 75,500 Less Sales 40,000 46,000 40,000 Ending Inventory 15,000 13,500 15,000 Footnote to the Pro-forma Accounts 2007 Total Inventories under the first-in, first-out (“FIFO”) method 19,000 Less: Last-in, first-out method (“LIFO”) adjustmenta (5,500) Total Inventory 13,500 Income Statement (thousands of dollars) 2007 (LIFO) Salesb $67,000 Cost of goods sold 46,000 Gross margin $21,000 Selling and admin. exp. 10,000 Income before taxes $11,000 Income taxes (35%) 3,850 Net income $7,150 a This amount is commonly referred to as the LIFO Reserve. b Sales of 40,000 units occurred at a rate of 10,000 units in each quarter during 2007. For the exclusive use of F. Baharudin, 2015. This document is authorized for use only by Farah Ainaa Baharudin in Supply Chain Finance Cases taught by Javad Feizabadi, HE OTHER from October 2015 to April 2016.