Case 058Forensic accountingHard

Trevika Apparel's inventory days rose from 110 to 160 while its gross margin rose from 38% to 42%. How can building stock lift the margin, and what does it mean for next year?

The situation

Trevika Apparel makes and sells garments at an average Rs 500 a piece. Last year it made and sold 2.0 crore pieces: revenue Rs 1,000 crore, gross margin 38%, inventory at 110 days of cost of goods sold. Variable cost is Rs 212.5 a piece and fixed factory overhead is Rs 195 crore a year.

This year it sold 2.2 crore pieces, revenue Rs 1,100 crore, but made 2.52 crore. Reported gross margin rose to 42% and inventory to 160 days. The company says the margin reflects better pricing discipline. Costs follow absorption costing, under which fixed factory overhead is spread over every piece produced.

Your task

Explain how producing more than it sold lifted Trevika's margin, split the 4 points into their sources, and say what next year looks like if production comes back into line.

Quick check

Selling price and costs per piece did not change. Why did the margin rise 4 points?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

More than half the margin gain is overhead parked in inventory, not better pricing. Fixed factory cost of Rs 195 crore was spread over 2.52 crore pieces made rather than 2.2 crore sold, so Rs 24.8 crore of it sits in stock on the balance sheet. Selling 10% more explains 1.8 points; the parked overhead explains 2.3. If production drops to clear the stock, margin falls back to about 38%.

Step 1How can making more lift profit when nothing more was sold?

A caterer rents a hall for Rs 20,000 a month and cooks 400 plates in it, so the hall costs Rs 50 a plate. If she cooks 500 plates and freezes 100, the hall now costs Rs 40 a plate, and the 400 she sold look cheaper to make. The frozen plates carry Rs 4,000 of hall rent into next month. Under absorption costingAn accounting method that spreads fixed factory costs over every unit produced, so part of those costs sits in inventory until the unit is sold., fixed overhead is spread over units made, so producing ahead of sales moves part of this year's overhead into inventory and lifts this year's margin. Nothing about the business improved.

Make more than you sell, and part of the factory's cost waits in the warehouseFixed factory overheadRs 195 crorespread over 2.52 crorepieces made= Rs 77.38 a piece2.20 crore pieces sold0.32 unsoldCost of goods sold this yearRs 170.2 crore of overheadInventory on the balance sheetRs 24.8 crore parked
Trevika's Rs 195 crore of fixed overhead is spread over 2.52 crore pieces made, so the 2.2 crore sold take Rs 170.2 crore into cost of goods sold and the 0.32 crore still in stock carry Rs 24.8 crore onto the balance sheet.
Step 2How much of the 4 points is real?

Split it with one counterfactual: what if Trevika had made exactly what it sold? Overhead per piece would be 195 / 2.2, Rs 88.64, cost per piece Rs 301.14 and gross margin 39.8%. So selling 10% more over the same factory is worth 1.8 points, which is real, and the remaining 2.3 points are overhead parked in stock. The company's pricing explanation accounts for none of it, because the price per piece did not change.

Rs crore unless statedYear 1Year 2, as reportedYear 2, make what you sell
Pieces made, crore2.002.522.20
Pieces sold, crore2.002.202.20
Fixed overhead per piece, Rs97.5077.3888.64
Revenue1,0001,1001,100
Cost of goods sold620.0637.7662.5
Gross margin38.0%42.0%39.8%
Inventory186.8279.6186.8
Inventory days110160103
Had Trevika produced only what it sold, year 2 gross margin would have been 39.8% rather than 42.0%; the Rs 24.8 crore gap is fixed overhead carried into inventory, which rose from Rs 187 crore to Rs 280 crore.
Step 3What happens next year?

Suppose sales grow to 2.3 crore pieces and Trevika makes only 1.98 crore to clear the extra 0.32 crore in stock. Overhead per piece jumps to Rs 98.48, and the stocked pieces release their parked overhead as they are sold. Gross margin falls to about 38.4% even though sales grew, because year 2 borrowed margin from year 3. And if the stock is last season's designs, it will sell only at a markdown, which cuts margin further.

The margin borrowed in year 2 is paid back in year 3110 daysYear 1160 daysYear 296 daysYear 338.0%42.0%38.4%made 2.52, sold 2.20made 1.98, sold 2.30made 2.00, sold 2.00inventory daysgross margin
Trevika's gross margin rises from 38.0% to 42.0% as inventory swells from 110 to 160 days, then falls to 38.4% in year 3 when production is cut to clear the stock and inventory returns to about 96 days.

What would you check? Production volume against sales volume, which some companies disclose in the annual report's operating data; the split of inventory between raw material and finished goods; inventory ageing and the markdown provision; and whether the cash flow statement shows operating cash lagging profit. The limitation is that a genuine stock build ahead of a strong season looks identical for a quarter or two. Ask what orders support it.

Where candidates lose it

Candidates see margin up and inventory up as two separate stories, one good and one bad, and never connect them. The interviewer wants the link: the same accounting entry produces both.

The second loss is calling it fraud. Absorption costing is required accounting; the issue is that reported margin overstates the business, and the reversal is predictable.

What the interviewer asks next

  • How would the cash flow statement look in year 2 compared with the income statement?
  • Under what circumstances is building inventory the right decision for an apparel maker?
  • What markdown on the excess stock would take year 3 margin below 35%?

Company names and figures are illustrative.