Case 6-3 Morgan Manufacturing

Case 6-3

Question 1:

Westwood’s Gross Margin Percentage is calculated as (sales less cost of goods sold) as a percentage of net sales revenue. For Westwood it’s calculated as follows based on the financial statements (all in millions of dollars):

2010 Gross Margin: (2000-1100) = 900
2010 Sales Revenue = 2000
2010 Gross Margin Percentage = 45%

2009 Gross Margin: (1500 – 800) = 700
2009 Sales Revenue = 1500
2009 Gross Margin Percentage = 46.7%

Westwood’s Pre-Tax Return on Sales is calculated as:

2010 Pre-tax income = 300
2010 Sales = 2000
2010 Pre-tax return on sales = 15%

2009 Pre-tax income = 250
2009 Sales = 1500
2009 Pre-tax return on sales = 16.67%

Westwood’s Pre-tax return on assets is calculated as:

2010 Pre-tax income = 300
2010 Assets = 2240
2010 Pre-tax return on assets = 13.39%

2009 Pre-tax income = 250
2009 Assets = 1875
2009 Pre-tax return on assets = 13.33%

Summary:

Year Gross Margin % Pre-tax ROS Pre-tax ROA
2010 45% 15% 13.39%
2009 46.7% 16.67% 13.33%

Question 2:

The balance sheet accounts that are affected include inventory, which in turn affects total assets. Retained earnings is ultimately impacted because of the different way of accounting for profit.

• Inventory
• Total Assets
• Retained Earnings

The ratios and measurements affected include:

• Cost of Goods Sold
• Gross Margin
• Gross Margin percentage of Sales
• Income Before Taxes
• Income Tax Expense
• Pre-tax return on sales, and pre-tax return on assets

Using LIFO vs. FIFO affects the ability to directly compare results because of the impact on gross margin and profit. Assuming merchandise costs are rising over time, accounting under LIFO will understate the net income (profit) for the current period by assigning the revenue to the highest cost merchandise.

Assuming two companies had similar merchandise costs and revenue for the period, the use of different inventory costing methods complicates