In this workout, we've been told that a company has produced 100 units of inventory during the year, and that direct costs for the inventory production are three per unit and production overheads are 200. We've been asked to calculate the cost of goods sold for the year and the inventory balance at the end of the year if 80 of the units have been sold by the end of the year. Now the information from the question has been included here in these cells, and we can use that to calculate the information we need to calculate cost of goods sold and the inventory balance. We first need to calculate the cost per unit of each inventory item, and in particular, we need to think about how fixed production overheads are allocated to inventory. Now, there are different approaches for this, but the most common approach is to use activity-based costing, sometimes abbreviated to ABC. This approach allocates fixed costs using the number of units produced in each period. So the cost per unit of inventory is going be calculated as the direct cost per unit, plus the fixed costs per unit giving a total cost per unit. So let's take the direct costs of three and then calculate the overhead cost per unit. That's 200 of overheads divided by the anticipated production level of 100, giving two per unit. And then we can sum these together to give our total cost per unit of five. Now we can use this information to calculate the cost of goods sold. If we know that 80 units have been sold, we simply need to multiply that by the total cost per unit of five to give our cost of goods sold of 400. And for our inventory, we know that if we've sold 80, there must be 20 left over. So let's just calculate that we've got the 100 produced minus the 80 that have been sold, multiplied by the cost per unit of five, leaving us with 100 of inventory at the end of the year. Where this becomes more interesting is what happens if I increase the level of inventory production? Let's say I increase the inventory production to 150.

What we can see here is that the cost of goods sold actually reduces below the 400 that we originally had if we increase the amount of units produced. And then clearly as you'd expect, the inventory balance increases. Now why is this? Well, by increasing inventory production, we've lowered the fixed cost per unit. So more of the fixed costs are sitting in inventory and less of the fixed costs are sitting in cost of goods sold. And this highlights a major risk associated with fixed cost absorption and inventory. It's really dependent on production levels. If management increases production, it reduces the cost of goods sold, recognized in earnings and boosts profitability.

So how can we spot if management on manipulating inventory valuation by increasing production? Well, as you can see here, this increases inventory levels, and we will see this in a couple of places. Firstly, we'll see increased working capital outflows in the cash flow statement where profits are reconciled to operating cash flows. And secondly, we'll see increased inventory balances in current assets.

Also, if this is an ongoing issue, we'll see regular inventory writedowns as this will eventually result in inventory balances that are so inflated. The inventory costs exceed that ultimate selling price.