Booker Jones Case Study

#1

a) 20,000 Additional Barrels needed in 1961 at a cost of $31.50 per barrel. Expenses (Costs of Barrels Used) would be reduced by $630,000. Pretax loss was ($407,000) so by reducing expenses by $630,000, a pretax profit of $223,000 would be generated.

b)
1) There were 172,000 barrels in inventory at 6/30/60. If costs of the barrels were added to inventory, it would increase inventory by $5,418,000 (172,000 x $31.50). Inventory would be valued at $9,924,000. That would be the only change on the balance sheet as cash would remain unchanged due to the switch.

2) On 6/30/61, there were 192,000 barrels on hand. Using the same math as in part 1 we get an increase of $6,048,000 for a final inventory value of $11,078,000. Again that would be the only change to the balance sheet.

3) There would no net effect on the operating statement in 1960 because the costs that were actually incurred that year were the barrel costs as Costs of Barrels Used. Since production volume and costs haven’t changed since prior to 1957, the costs of the barrels will come out of inventory and be expenses as Cost of Goods Sold for the same amount as would have been expensed as Costs of Barrels Used.

#2) I do not see Jones as going from a profit to a loss. I believe they made an investment to bolster future earnings, or rather attempt to do so. It seems very reasonable to me that costs of the barrels could and should be capitalized. In fact, while I don’t have a mastery of GAAP rules and the barrels have a one time use, since their use is for such a long period of time, I’d contend they could be capitalized as PP&E and depreciated annually by $7.75 per barrel [($31.50 cost - $0.50 salvage value)/4 years]. Having said all of that, they are taking a tremendous cash hit.

#3) I would recommend making the switch and capitalizing the cost