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The next step is to compute the ratio of cost of goods manufactured during the year to the selling price thereof, in order to reduce the inventory of finished goods from selling price to cost.

SCHEDULE 6 COMPUTATION OF Ratio OF PRODUCTION Cost to SELLING PRICE EACH YEAR

Cost price Selling price Ratio of cost to
(Schedule 4) (Schedule 5) selling price
330,000.00
660,000.00

50%
352,000.00
640,000.00

55%
348,000.00
600,000.00

58% The cost value of the inventories of finished goods may now be computed by multiplying the selling price of the inventories by the rate per cent. representing the ratio of manufacturing cost to selling price applicable to each year.

SCHEDULE 7

1st year 2nd year 3rd year

COMPUTATION OF Cost OF FINISHED GOODS INVENTORIES

% of cost

Selling price to selling price Cost First yearbeginning inventory 54,900.00 X

50%

27,450.00 First yearending inventory 76,500.00 x 50%

38,250.00 Second yearending inventory 114,000.00 X 55%

62,700.00 Third yearending inventory 150,000.00 Х 58%

87,000.00 While the apparent operating profits are shown in schedule 3, these profits are erroneously computed by reason of the overvaluation of the finished goods inventories. Overvaluing the opening inventory understates the profit, while overvaluing the closing inventory overstates the profit. The adjustment from apparent operating profits to true operating profits may be shown as follows:

SCHEDULE 8
STATEMENT SHOWING ADJUSTMENT OF OPERATING PROFITS
BY REDUCTION OF FINISHED GOODS INVENTORY VALUATIONS

FROM SELLING PRICE TO Cost

1st year

2nd year

3rd year

90,700.00

Apparent operating profit-schedule 3 181,500.00

181,500.00 138,350.00 Adjustment of inventory-beginning

of year: Selling price

54,900.00 Cost-50%

27,450.00

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This statement of adjusted operating profits should be verified by the preparation of revenue statements for the three years.

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The goodwill, computed on the basis of three years' profits, would be determined as follows:

SCHEDULE 10
COMPUTATION OF GOODWILL
First year's profit-schedule 9

170,700
Second year's profit-schedule 9

125,300 Third year's profit-schedule 9

79,000

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This computation of the goodwill is subject to certain qualifications.

The problem says that the production expense includes depreciation. It may be that the depreciation has been overstated and hence the operating profits understated. This may easily have occurred if the company has used even a fair rate of depreciation, because it is carrying its construction and real estate at a figure which includes the profits. If the company has applied a fair depreciation rate to this overvaluation, it has charged operations with an excessive depreciation and hence understated the profits.

It might be preferable to base the goodwill on the profits before taking interest into consideration. The question, however, does not limit the profits to the net results before excluding the interest. It might be better to adopt some other number of years' purchase and base the calculation on the net profit on sales on the theory that the purchaser might have ample capital to carry on the business and thus avoid the interest charges. Problem 2:

Does the basis of three years' profits for arriving at the goodwill outlined in the previous question appear to you to be reasonable upon the facts disclosed to you? If not, what advice would you offer upon the question if A or B were your client? Solution, Problem 2:

The basis of three years' profits for arriving at the goodwill does not seem a reasonable basis. The prospective seller of the business, however, does not seem to be in need of advice, as the sale of the goodwill for $375,000 in the circumstances which become apparent on making an analysis appears to be at a value far in excess of the real worth.

If A were my client I should investigate the interest charges. If I found that this interest was an allowance on capital I should call his attention to the fact that such interest is in reality profit and that he was understating his profit by the amount of the interest thus deducted.

Attention has also been called to the fact that the profits may be understated by reason of excessive depreciation charges, but it seems that from A's point of view the less attention is called to the overvaluation of the real estate and construction the better.

If B seriously considers purchasing a goodwill based on three years' profits, even after eliminating the unrealized profit on construction and real estate and the extraneous profit on the sale of stock and after reducing the inventories to cost, he is in serious need of advice.

It is a fundamental rule that goodwill cannot be fairly predicated upon declining profits. Where profits are reasonably uniform or are increasing and where they are sufficiently in excess of the normal return on the investment, three years' profit is not an exorbitant price. But the profits of this business have decreased from $170,700 to $125,300 and finally to $79,000, and goodwill cannot wisely be based upon profits which are declining with such regularity and rapidity. Even if it could be conclusively shown that the profits will remain at $79,000, the payment of $375,000 for the goodwill would be virtually a purchase of five years' profits.

The prospective purchaser should also give consideration to the fact that the sales are decreasing annually, the sales of the second year being only 94.4% of those of the first year, and the sales of the third being only 88.3% of those of the first year as shown in the following schedule.

SCHEDULE 1

SCHEDULE SHOWING DECREASE IN SALES

Year
1st
2nd
3rd

Sales 638,400.00 602,500.00 564,000.00

Per cent.
100.00
94.4
88.3

At the same time, the inventory has been increasing by leaps and bounds. The following schedule shows the inventories at the various dates, the rates per cent. being based upon the inventory at the beginning of the first year. It is significant, in the decline of sales, to note that the final inventory of production material is 207.4% of the initial raw material inventory, while the final inventory of finished goods is 316.9% of the initial finished goods inventory. A should certainly be asked to explain this increase.

SCHEDULE 2
SCHEDULE SHOWING INCREASE IN INVENTORIES
Date

Raw material Per cent. Finished goods Per cent. Beginning first year 51,400.00 100.0 27,450.00 100.00 End first year

72,000.00 140.1 38,250.00 139.3 End second year

103,100.00 200.6 62,700.00 228.4 End third year

106,600.00 207.4 87,000.00 316.9 Attention has already been called, in the solution to the first problem, to the fact that the cost of production has increased from 50% of the selling price the first year to 55% thereof the second year and 58% thereof the third year. Declining sales with rising costs of production do not offer an inviting prospect for a purchaser.

The rise in selling expenses should also give a prospective purchaser pause. The following schedule shows the increase in selling expenses during the second and third years. The selling expenses the second year were 106% and the selling expenses the third year were 119.6% of the selling expenses of the first year. Expressed in another way, the selling expenses were 8.2% of the sales of the first year, 9.2% of the sales of the second year and 11.1% of the sales of the third year.

SCHEDULE 3 SCHEDULE SHOWING INCREASE IN SELLING EXPENSE

Increase over first

year

Per cent.

first
year's
expense

Year
1
2
3

Selling
expense
52,500
55,650
62,800

Per cent. of

selling expense to sales of the year

8.2 9.2 11.1

3,150.00
10,300.00

106.0
119.6

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