Question 2c d
You have been asked to carry out an investigation by the management of Xzibit Co. One of the company’s subsidiaries, Efex Engineering Co, has been making losses for the past year. Xzibit’s management is concerned about the accuracy of Efex Engineering’s most recent quarter’s management accounts.
The summarised income statements for the last three quarters are as follows:
| quarter to | 30 jun 2006 | 31 mar 2006 | 31 dec 2005 |
| $000 | $000 | $000 | |
| revenue | 429 | 334 | 343 |
| ------- | ------- | ------- | |
| opening inventory | 180 | 163 | 203 |
| materials | 318 | 251 | 200 |
| direct wages | 62 | 54 | 74 |
| ------- | ------- | ------- | |
| 560 | 468 | 477 | |
| ------- | ------- | ------- | |
| less: closing inventory | -162 | -180 | -163 |
| ------- | ------- | ------- | |
| cost of goods sold | 398 | 288 | 314 |
| ------- | ------- | ------- | |
| gross profit | 31 | 46 | 29 |
| less: overheads | -63 | -75 | -82 |
| ------- | ------- | ------- | |
| net loss | -32 | -29 | -53 |
| ------- | ------- | ------- | |
| gross profit (%) | 7.2% | 13.8% | 8.5% |
| materials (% of revenue) | 78.3% | 70.0% | 70.0% |
| labour (% of revenue) | 14.5% | 16.2% | 21.6% |
Xzibit’s management board believes that the high material consumption as a percentage of revenue for the quarter to 30 June 2006 is due to one or more of the following factors:
(1) under-counting or under-valuation of closing inventory;
(2) excessive consumption or wastage of materials;
(3) material being stolen by employees or other individuals.
Efex Engineering has a small number of large customers and manufactures its products to each customer’s specification. The selling price of the product is determined by:
(1) estimating the cost of materials;
(2) estimating the labour cost;
(3) adding a mark-up to cover overheads and provide a normal profit.
The estimated costs are not compared with actual costs. Although it is possible to analyse purchase invoices for materials between customers’ orders this analysis has not been done.
A physical inventory count is carried out at the end of each quarter. Items of inventory are entered on stocksheets and valued manually. The company does not maintain perpetual inventory records and a full physical count is to be carried out at the financial year end, 30 September 2006.
The direct labour cost included in the inventory valuation is small and should be assumed to be constant at the end of each quarter. Historically, the cost of materials consumed has been about 70% of revenue.
The management accounts to 31 March 2006 are to be assumed to be correct.
Required:
(a) (i) Explain the matters you should consider to determine whether closing inventory at 30 June 2006 is undervalued; and
(ii) Describe the tests you should plan to perform to quantify the amount of any undervaluation. (8 marks)
(b) (i) Identify and explain the possible reasons for the apparent high materials consumption in the quarter ended 30 June 2006; and
(ii) Describe the tests you should plan to perform to determine whether materials consumption, as shown in the management accounts, is correct. (7 marks)