COMMUNICATION ACTIVITIES CT6-8 In a discussion of dramatic increases in coffee-b

Question

COMMUNICATION ACTIVITIES CT6-8 In a discussion of dramatic increases in coffee-bean prices, a Wall Street Journal E article noted the following fact about Starbucks. Before this year's bean-price hike, Starbucks added several defenses that analysts say could help it maintain earnings and revenue. The company last year began account- ing for its coffee-bean purchases by taking the average price of all beans in inventory. Prior to this change, the company was using FIFO. Instructions Your client, the CEO of Superior Coffee, Inc., read this article and sent you an e-mail message requesting that you explain why Starbucks might have taken this action. Your response should explain what impact this change in accounting method has on earnings, why the company might want to do this, and any possible disadvantages of such a change.

Explanation / Answer

Starbucks is operating in an inflationary environment in the given scenario as the prices of coffee beans are rising.

When the FIFO method is used in an inflationary environment, the cost of goods include the less expensive items and the ending inventory includes the more expensive items. This leads to higher net income and higher value of inventory.When the weighted average cost method is used, the costs are proportional to the current purchase costs. This results in a lower net income in an inflationary environmement. Thus, change in accouting method from FIFO to weighted average shall lower the earnings.

Since the prices are rising, Starbucks must have switched from FIFO to weighted average to get a better picture of its profitability as using FIFO in a rising price environment would result in higher profits which might not be the actual scenario.

The possible disadvantages of using the weighted average method are as follows:

-If the price of the coffee beans vary too widely between periods, then the pricing of the coffee will not be able to recover the costs of the recent more expensive beans. Averaging would reflect a lower cost of goods sold.

-Since the averge method is retroactive, Starbucks might not be able to understand that it is underpricing till the end of the year.

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