Question

Heartland Company’s budgeted sales and budgeted cost of goods sold for the coming year are $144,000,000and$99,000,000, respectively. Short-term interest rates are expected to average 10%. If Heartland can increase inventory turnover from its present level of 9 times a year to a level of 12 times per year, compute its expected cost savings for the coming year.

Short answer

The expected cost savings for the coming year is $275,000.

Step-by-step solution

Meaning of Cost of Goods Sold

The direct cost of manufacturing the goods sold by a corporation is known as the cost of goods sold (COGS). This amount directly covers the cost of materials and labor used in manufacturing the final product. When calculating COGS, indirect costs such as advertising and administrative costs are not included.

Computation of expected Cost savings for the coming year

Average inventory (current) $11,000,000

Working Notes:

$$\begin{gathered} \mathrm{Inventory}\mathrm{Turnover}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{inventory}} \\ 9=\frac{\$99,000,000}{\mathrm{Average}\mathrm{inventory}} \\ \mathrm{Average}\mathrm{Inventory}=\frac{\$99,000,000}{9} \\ =\$11,000,000 \end{gathered}$$

Average inventory (new) $8,250,000

$$\begin{gathered} \mathrm{Inventory}\mathrm{Turnover}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{Inventory}} \\ 12=\frac{\$99,000,000}{\mathrm{Average}\mathrm{Inventory}} \\ \mathrm{Average}\mathrm{Inventory}=\frac{\$99,000,000}{12} \\ =\$8,250,000 \end{gathered}$$

Calculation of Cost savings

$$\begin{gathered} \mathrm{Cost}\mathrm{saving}=\left(\mathrm{Average}\mathrm{Inventory}\mathrm{current}-\mathrm{Average}\mathrm{inventory}\mathrm{new}\right)\times \mathrm{Average}\mathrm{rate} \\ =\left(\$11,000,000-\$8,250,000\right)\times 10\% \\ =\$2,750,000\times 10\% \\ =\$275,000 \end{gathered}$$