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Merrimack Tractors and Mowers, Inc.

Group 1
WECProject
24-Oct-2012

Submitted to: Dr. Payal Mehra

Submitted by:Mukesh Kumar (PGP28284) Atul Bhatia (PGP28318) Utkarsh Gupta (ABM09037) ShrishtiShrivastava (ABM09036) AshwathiUplakkal (PGP28312) Abhishek Sharma (PGP28309)

Contents
I. II. A. B. C. D. E. III. A. B. IV. A. a. b. c. Abstract ........................................................................................................................................... 3 Introduction .................................................................................................................................... 4 Problem Statement ..................................................................................................................... 4 Reasons ....................................................................................................................................... 4 Timelines ..................................................................................................................................... 4 Area of Operation ....................................................................................................................... 4 Alternatives ................................................................................................................................. 4 Methods ...................................................................................................................................... 5 Current Scenario ............................................................................................................................. 5 Analysis methods ............................................................................................................................ 5 Analysis ....................................................................................................................................... 6 LIFO to FIFO ..................................................................................................................................... 6 LIFO ............................................................................................................................................. 6 FIFO ............................................................................................................................................. 6 Average Cost Method ................................................................................................................. 6

Advantages of changing from LIFO to FIFO......................................................................................... 6 Disadvantages of changing from LIFO to FIFO .................................................................................... 6 B. a. b. c. d. V. A. B. VI. A. B. C. VII. Alternative Strategies ..................................................................................................................... 7 Study of vendors in China ........................................................................................................... 7 Frequency of Purchase................................................................................................................ 7 JIT ................................................................................................................................................ 7 Outsource to other countries ..................................................................................................... 7 Recommendations .......................................................................................................................... 8 Short Term Recommendations ........................................................ Error! Bookmark not defined. Long Term Recommendations ......................................................... Error! Bookmark not defined. Implementation .......................................................................................................................... 9 Retrospective change of accounting statements ........................................................................... 9 Calculation of Taxes payable........................................................................................................... 9 Payment of Taxes payable .............................................................................................................. 9 References ................................................................................................................................ 10

I.

Abstract
In this case, Ricardo Martino, President and CEO of Merrimack Tractors and Mowers, Inc. faced an issue of declining sales margin on mowers. The projected net income for 2008 was lower than that of 2007 and he faced pressure from the directors to keep the earnings growing. One of the major reasons for this decline in net income was the rise in cost of importing tractors from China due to a appreciating Chinese currency and rising oil prices, which directly affected the shipping costs. The company management dismissed the idea of reopening the Nashua plant. Inventory accounting method from LIFO to FIFO was analysed in order to increase net income. However, this would result in an increase in tax payments. Hence at best it could only serve as a temporary solution. So we have further analysed other plausible long term solutions to the problem and provided our recommendations.

II. Introduction
A. ProblemStatement
The main concern presented in the case revolves around improving the financial condition of Merrimack Tractors and Mowers. Declining profits coupled with fierce competition is the main crux of the problem. Inability to expand to their base to a national scale was yet another problem.

B.

Reasons
Several developments in 2008 such as the Beijing Olympics were reshaping the business environment in China leading to rising labour rates, material and energy costs. Strengthening Yuan and rising oil prices compounded the problems for the company and resulted in a 200% increase in the prices.

C.

Timelines
Historically the mowers were manufactured and assembled in house in the factory at Nashua in the United States of America. By 2008 the company had completely contracted manufacturing division to China in order to leverage the low labour rates there. Even after factoring the shipping costs they found the China arrangement extremely lucrative. Within a span of 2 years the company had to return to its profitable ways to stay in the run.

D.

Area of Operation
The company was initially a family owned enterprise. It built itself a strong regional presence. However the company was unable to extend its dominance on a national level unlike many of its competitors like The Toro Company.

E.

Alternatives
The company has several alternatives in front of them. The alternatives were evaluated on the basis of merits and demerits. Based on the evaluations we have concluded that the most optimum solution is changing the method of inventory valuation.

III. Methods
A. Current Scenario
Merrimack Tractors and Mowers, Inc. has been ailing with incremental costs owing to increasing wages and labour costs in China from where it sourced all its manufacturing and assembling operations. Company pondered over various ideas - re-establishing manufacturing operations in Nashua or sourcing from vendors other than Chinese. But the only feasible idea that could enable them post income growth any further is changing from LIFO method of inventory cost recognition to FIFO method of inventory cost recognition.

B.

Analysis methods
Through this report we will analyse the companys decision to change its accounting policy on the grounds of various permitted methods of inventory valuation. We will try to demystify various asset valuations, income and tax regulations in US and the international standard that is coming to the scene. The analysis will also throw some light on how spending more on income tax will ultimately let them post more profits. We will be using namely two methods for the case analysis. Accounting policy analysis, where we will analyse the LIFO method of inventory costing and how it is different from FIFO method of inventory costing. In this analysis we will also try to recommend which of the method should be used and how and why should anyone of them be used. Income tax analysis, where we analyse the many of the taxing regulations which could be used by the company to increase or decrease deferred tax. The emphasis will also be on retrospective effect of changing the policy from LIFO to FIFO method of inventory costing leading to increase in the amount of deferred tax payable.

IV. Analysis
A. LIFO to FIFO
One of the solutions proposed in the case was to shift the inventory accounting method from LIFO to FIFO.

a. LIFO
In the LIFO method of inventory accounting one assumes that the most recent costs are matched with revenues first. LIFO leads to a lower revenue and lower tax that needs to be paid.

b. FIFO
In the FIFO method of inventory accounting one assumes that the oldest costs are matched with revenues. FIFO leads to higher revenue and a higher income tax to be paid.

c.

Average Cost Method


A third method of inventory accounting is the average cost method which is based in the assumption of matching an average cost with revenue. This method provides results somewhere between those provided by the LLIFO and FIFO method of inventory accounting.

Advantages of changing from LIFO to FIFO


There were numerous advantages that Merrimack Tractors and Movers would gain by switching their inventory accounting method. Some of these are as follows: 1. 2. 3. Increase in the profit of Merrimack Tractors and Movers Improved image of company Future change to FIFO may be made mandatory by IFRS

Disadvantages of changing from LIFO to FIFO


Change of the inventory accounting method is only a temporary solution. It may prove profitable in the short run but in the long term Merrimack would have to

look for alternative means to improve their profitability and image in the eyes of their shareholders Moreover, changing the inventory accounting method may seem suspicious to investors and shareholders as well. This would tarnish the image of the company. If the cost rise in the future, then a change to FIFO would be unprofitable. The company would incur higher taxes.

B.

Alternative Strategies
a. Study of vendors in China
Number of vendors that Merrimack employs in China needs to be analysed. If the number of vendors is large in number, it is recommended that the number of vendors be reduced. This would enable the company to purchase in bulk from a few vendors. Purchasing in bulk reduce the cost of procurement.

b. Frequency of Purchase
If the procurement cycle is very large, it would lead to higher inventory holding costs, larger amount of maintenance costs and a larger space for storage. Hence, Merrimack should purchase more frequently.

c.

JIT
A strategy that can be adopted by Merrimack is Just in Time manufacturing. This would lead to: 1. 2. 3. Flow of goods improves Minimization of storage space needed Smaller chance of inventory breaking/expiry

d. Outsource to other countries


A long term solution that can be adopted by Merrimack is to outsource the production to other countries in Asia-Pacific like Indonesia, Thailand, Vietnam, etc. Moving away from China and establishing a production facility in one of these countries can lead to a reduction in production costs and once again improve the market share of Merrimack.

V. Recommendations A.
Short Term Recommendations
The organization should shift to FIFO method of inventory accounting. It should be done in a systematic manner by making retrospective changes in the financial statements. Extensive shareholders sessions should be conducted to justify this shift from FIFO to LIFO by stressing on the point that this shift was inevitable considering the onset of IFRS. FIFO method will lead to higher earnings being posted for the present fiscal year. Positive impacts of this recommendation are the ability to post higher net income which would result into greater confidence of shareholders in the stocks. This would also ease down the pressure exerted by the external directors and avert management transition, eventually providing an additional year to Rick Martino to implement changes which will be sustainable in the longer term. On the flip side, this may lead to higher income tax payable which is inevitable in case the company is liquidated.

B.
1.

Long Term Recommendations


Backward Integration/ Alternate Sourcing: Suppliers outside of China should be explored. Countries like Indonesia, Philippines, and India can be chosen as outsourcing destinations. This might lead to some cost cutting.

2.

Expand beyond the region: Merrimack has been a regional player for years unlike its competitors who have expanded both nationally and internationally. Merrimack should expand in two phase manner, first nationally and then internationally. This would lead to economies of scale and provide more bargaining power against suppliers.

3.

Marketing Activities: Merrimack should aggressively market its product across the regions of its operations. This would create greater brand recognition and would lead to more sales.

VI. Implementation A.
Retrospective change of accounting statements

Merrimack Tractors and Mowers Inc. have been posting financial statements with LIFO inventory costing. To be able to use FIFO inventory costing company has to change all the financial statements retrospectively. Its need in the present scenario is paramount as all the prospective COGS would depend on the previous values of inventory.

B.

Calculation of Taxes payable

Changing of inventory costing method would lead to change in taxes payable. This particular change from LIFO to FIFO would lead to increase in taxes payable by two million dollars. So tax accounting is absolutely vital in calculation of federal taxes payable.

C.

Payment of Taxes payable

The increased tax liability by the amount of two million dollars would also need to be met by additional cash. The company is making losses so egging out extra cash would be difficult on its own by the company. So company needs to arrange extra cash to tackle increased federal taxes liabilities.

VII. References
1. Wikipedia- FIFO and LIFO accounting 2. http://www.accountingtools.com/fifo-vs-lifo-accounting