Falling prices and inventories;

              Bulletin HASKINS & SELLS 13
Falling Prices and Inventories
THE firm which owns and occupies a
building and contemplates no addi­tional
construction is little concerned
whether prices rise or fall. The investor
who owns gilt-edge securities has no cause
for alarm even though the securities market
may, so to speak, have gone through the
bottom. But to the concern engaged in
trading, or in manufacturing and selling, a
declining price level is a matter for some
consideration.
As a buyer, a concern of this class
naturally favors a decline in prices. As a
seller, the reverse may be expected to be
true. Theoretically, it should make little
difference either way, since it is usual for a
concern to maintain a selling price which
reflects a fairly uniform percentage of
profit over the cost price. When cost
prices go up sales prices follow. When cost
prices fall sales prices are "expected to come
down. As a matter of fact failure on the
part of the individual concern to anticipate
the market frequently results in a stock of
merchandise acquired at a relatively high
price which must be sold either as such or in
manufactured form, on a declining sales
market.
This is precisely what happened to many
concerns during the year just closed. No
one knew just when the peak of high prices
would be reached. It came about Febru­ary,
1920. Since that time prices have
been steadily declining. Those who carried
over large inventories at December 31,
1919, or bought heavily during the early
part of the year 1920 have had to suffer
the consequences.
The well-settled rule of pricing inven­tories
at "cost or market, whichever is
lower" probably resulted in no losses at the
close of the year 1919. In fact the ma­jority
of concerns probably profited some­what,
if not considerably, by such method,
because of rising costs.
The end of the year following disclosed a
somewhat different situation. The average
net drop in prices during the year was per­haps
25 per cent. In some lines, notably
crude rubber, it was very much greater.
To be consistent market prices had to be
used in pricing the inventories. The
result was a loss equal to the difference
between what the goods cost and the
market at December 31, 1920.
It must not be understood that concerns
in a given industry sustained an inventory
loss last year equal to the decline in prices
in that industry. Such could only be true
of a concern which happened to stock up
at top or near-top prices and was unable
to dispose of such stock before the end of
the year. Concerns with slow moving
stock suffered most. Those with quick
turnovers were able to keep better pace
with the market and consequently to
average their losses.
Few concerns probably use what is
known as the direct method of ascertaining
the cost of goods sold. As a rule the in­direct
or inventory method is used. This
consists in applying against the total of
purchases for a given period the difference
between the inventory at the beginning
and end of the period, respectively. An
increase in inventory decreases the cost of
goods sold. A decrease in inventory in­creases
the cost of goods sold. The
method presumes fairly uniform prices. It
does not allow for extreme fluctuations in
prices.
As a consequence of the decline during
the year 1920, the inventories at the end
of the year, if priced at the market, reflected
not only the usual difference on account of
the physical change in the inventory but a
loss equal to the difference between the cost
of the units in the inventory and the lower
market price at December 31, 1920. This
would throw the loss into the cost of goods