Case 7-20.

Ethics and the Manager; Absorption Costing Income Statements

Case Background Contact Global is a company that produces an advanced global positioning system (GPS) device. After firing the previous CEO by the board of directors due to a series of shady business practices including shipping defective GPS devices to dealers, Guochang Li was hired as chief executive officer (CEO) in late November. The new CEO priority is to restore employees morale that had suffered during the previous CEOs reign. He was particularly anxious to build a sense of trust between himself and the companys employees. His second priority was to prepare the budget for the coming year, which the Board of Directors wanted to review in their December 15 meeting. The Budget appears as follows: Basic budget data Units in beginning inventory......................... Units produced............................................. Units sold..................................................... Units in ending inventory.............................. Variable costs per unit: Direct materials............................................ Direct labor.................................................. Variable manufacturing overhead................. Variable selling and administrative............... Total variable cost per unit...........................

0 400,000.00 400,000.00 0

$57.20 15.00 5.00 10.00 $87.20

Fixed costs: Fixed manufacturing overhead..................... $6,888,000.00 Fixed selling and administrative................... 4,560,000.00 Total fixed costs........................................... $11,448,000.00

Budgeted Income Statement (absorption method) Sales (400,000 units $120 per unit)........... $48,000,000 Less Cost of goods sold: Beginning inventory................................... $ 0 Add cost of goods manufactured 37,768,00 (400,000 units $94.42 per unit)........... 0 Goods available for sale............................. 37,768,000 Less: Ending inventory............................... Gross margin................................................. Less Selling and administrative expenses: Variable selling and administrative (400,000 units $10 per unit)............... Fixed selling and administrative................. Net operating income.................................... 0 37,768,000 10,232,000

4,000,000 4,560,000

8,560,000 $ 1,672,000

The Board of Directors made it clear that this budget is not ambitious as they had hoped. The Board of Directors decided to set a profit goal for the coming year and agreed that if the actual net operating income turned out to be $2,000,000 the BOD will pay bonuses to top managers amounting of $10,000 to $25,000 or otherwise, no bonus would be paid.

Statement of the Problem How to restore employees morale? How to build a sense of trust between management and their employees? How to achieve a profit goal of $2,000,000.00 for the next year? How to determine bonuses in the future?

Objectives: To explain how variable costing differs from absorption costing and compute unit product costs under each method. To prepare Income statements using both variable and absorption costing. To reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. To understand the advantages and disadvantages of both variable and absorption costing Areas of Considerations The Advantages and disadvantages of both variable and absorption costing. Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats fixed manufacturing overhead as a variable cost. This can lead to faulty pricing decisions and keep-or-drop decisions. It also assigns per unit fixed manufacturing overhead costs to production. This can potentially produce positive net operating income even when the number of units sold is less than the breakeven point. The advantages of variable costing and the contribution approach include: The data required for CVP analysis can be taken directly from a contribution format income statement. Profits move in the same direction as sales, assuming other things remain the same. Managers often assume that unit product costs are variable. Under variable costing, this assumption is true. Fixed costs appear explicitly on a contribution format income

statement; thus the impact of fixed costs on profits is emphasized. Variable costing data make it easier to estimate the profitability of products, customers, and other business segments. Variable costing ties in with cost control methods, such as standard costs and flexible budgeting. Variable costing net operating income is closer to net cash flow than absorption costing net operating income.

The Absorption Costing relates to the matching principle. Advocates of absorption costing argue that it better matches costs with revenues. They contend that fixed manufacturing costs are just as essential to manufacturing products as are the variable costs. However, advocates of variable costing view fixed manufacturing costs as capacity costs. They argue that fixed manufacturing costs would be incurred even if no units were produced. Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons: Although direct laborers are paid an hourly wage, many companies have a commitment sometimes enforced by labor contracts or by the law to guarantee workers a minimum number of paid hours. Direct labor is usually not the constraint; therefore, there is no reason to increase the number of direct laborers. TOC emphasizes the role direct laborers play in driving continuous improvement. Since layoffs often devastate morale, managers involved in TOC are extremely reluctant to lay off employees.

Case Analysis (Answers to Guide Questions) Question 1. The units of the GPS device to be sold to meet the net operating income goal of $2,000,000.00. The units of GPS device needed to attain a profit goal of $2,000,000.00 is

410,000 units. The computations are as follows: Selling price..................................... Less variable cost per unit............... Unit contribution margin.................. $120.00 87.20 $ 32.80

Unit sales to achieve = Fixed expenses+ Target net profit target profit Unit contribution margin = $11,448,000+ $2,000,000 $32.80 per unit

= 410,000 units

Question 2. The construction of a revised budget and budgeted absorption costing income statement that yields a net operating income of $2,000,000.00 verification on the above answer. The unit product cost at a production level of 410,000 units would be calculated as follows: Direct materials............................................ Direct labor.................................................. Variable manufacturing overhead................. Fixed manufacturing overhead ($6,888,000 410,000 units)................ Unit product cost.......................................... The Revised Budgeted Income Statement (absorption method) Sales (410,000 units $120 per unit)........... $49,200,000 Less Cost of goods sold: Beginning inventory................................... Add cost of goods manufactured: (410,000 units $94 per unit)................... $ 0 $57.20 15.00 5.00 16.80 $94.00

38,540,000

Goods available for sale............................. Less ending inventory................................ Gross margin................................................. Less selling and administrative expenses: Variable selling and administrative (410,000 units $10 per unit)................... Fixed selling and administrative................. Net operating income....................................

38,540,000 _ 0

38,540,000 10,660,000

4,100,000 4,560,000

8,660,000 $ 2,000,000

Question 3. By increasing production so that it exceeds sales, inventories will be built up. This will have the effect of deferring fixed manufacturing overhead in the ending inventory. How much fixed manufacturing overhead must be deferred in this manner? The managers are suggesting an artificial boost to earnings of $328,000 since at the current rate of sales, profit will only be $1,672,000 and they want to hit the target profit of $2,000,000. The amount of production, Q, required to defer $328,000 can be determined as follows: Units in beginning inventory... Plus units produced................ Units available for sale............ Less units sold........................ Units in ending inventory........ 0 Q Q 400,000 Q 400,000

Fixed manufacturing = $6,888,000 overhead per unit Q

Fixed manufacturing Fixed manufacturing Number of overhead deferred = overhead rate units added in inventory per unit to inventory $6,888,000 $328,000 = (Q - 400,000) Q $328,000 Q = $6,888,000 (Q - 400,000) $328,000 Q = $6,888,000 Q - $6,888,000 400,000 $6,560,000 Q = $6,888,000 400,000 Q = 420,000 units

Question 4. The unit product cost at a production level of 420,000 units would be calculated as follows: Direct materials.......................................................................... Direct labor................................................................................. Variable manufacturing overhead............................................... Fixed manufacturing overhead ($6,888,000 420,000 units).... Unit product cost........................................................................ $57.20 15.00 5.00 16.40 $93.60

The absorption costing income statement would be: Sales (400,000 units $120 per unit)............ Cost of goods sold: Beginning inventory..................................... Add cost of goods manufactured (420,000 units $93.60 per unit)............. Goods available for sale............................... Less ending inventory (20,000 units $93.60 per unit)............... ................................................................. $48,000,000 $ 0

39,312,000 39,312,000

1,872,000

37,440,000

Gross margin.................................................. Less selling and administrative expenses: Variable selling and administrative (400,000 units $10 per unit).................. Fixed selling and administrative.................. Net operating income.....................................

10,560,000

4,000,000 4,560,000

8,560,000 $ 2,000,000

Question 5. Guochang Li guidelines in making decision of approving the plan to build ending inventories in order to attain the target profit for the coming year. The scheme of building inventories in order to increase profits would work. However, the $328,000 in fixed manufacturing overhead is only deferred in inventory. It is an ax hanging over the head of the managers. If the inventories are allowed to fall back to normal levels in the next year, all of that deferred cost will be released to the income statement. In order to keep using inventory buildups as a way of meeting profit goals, inventories must keep growing year after year. Eventually, someone on the Board of Directors is likely to question the wisdom of such large inventories. Inventories tie up capital, take space, result in operating problems, and expose the company to the risk of obsolescence. When inventories are eventually cut due to these problems, all of the deferred costs will flow through to the income statement with a potentially devastating effect on net operating income. Apart from this practical consideration, behavioral and ethical issues should be addressed. Taking the ethical issue first, it is unlikely that building up inventories is the kind of action the Board of Directors had in mind when they set the profit goal. Chances are that the Board of Directors would object to this

kind of manipulation if they were informed of the reason for the buildup of inventories. The company must incur costs in order to build inventories at the end of the year. Does this make any sense when there is no indication that the excess inventories will be needed to meet sales demand? Wouldnt it be better to wait and meet demand out of normal production as needed? Essentially, the managers who approached Guochang are asking him to waste the owners money so as to artificially inflate the reported net operating income so that they can get a bonus. Behaviorally, this is troubling because it suggests that the former CEO left behind an unfortunate legacy in the form of managers who encourage questionable business practices. Guochang needs to set a new moral climate in the company or there will likely be even bigger problems down the road. Guochang should firmly turn down the managers request and let them know why. Having said all of that, it would not be easy for Guochang to turn down a bonus that could be potentially as large as $25,000which is precisely what Guochang would be doing if he were to pass up the opportunity to inflate the companys earnings. And, his refusal to cooperate with the other managers may create a great deal of resentment and bitterness. This is a very difficult position for any manager to be in and many would probably succumb to the temptation. Building up an inventory would decrease the cost of goods manufactured, thus increasing revenues. But please note that the ending inventory will be carried forward to the next year, thereby increasing cost of goods manufactured and decreasing revenues if all others remain constant. Manufacturing companies objective is to decrease ending inventory, as these are additional cost that should have been converted to revenues. Managements objective of increasing profit through inventory build up is all because of personal gain, the $25k bonus. This is like window dressing a financial statement and should not be considered at all.

Question 6. The advice we give to the board of directors concerning how they determine bonuses in the future.

The Board of Directors, with their bonus plan, has unintentionally created a situation that is very difficult for the new CEO. Whenever such a bonus plan is based on absorption costing net operating income, the temptation exists to manipulate net operating income by changing the amount that is produced. This temptation is magnified when an all-or-nothing bonus is awarded based on meeting target profits. When actual profits appear to be within spitting distance of the target profits, the temptation to manipulate net operating income to get the all-or-nothing bonus becomes almost overpowering. Ideally, managers should resist such temptations, but this particular temptation can be easily avoided. Bonuses should be based on variable costing net operating income, which is less subject to manipulation. And, all-or-nothing bonuses should be replaced with bonuses that start out small and slowly grow with net operating income. Bonus should be computed at a certain rate based on net operating income as this would reflect the correct financial performance of the company.

Conclussions and Recommendations The basic difference between absorption and variable costing is due to the handling of fixed manufacturing overhead. Under absorption costing, fixed manufacturing overhead is treated as a product cost and hence is an asset until products are sold. Under variable costing, fixed manufacturing overhead is treated as a period cost and is charged in full against the current periods income. If production exceeds sales, absorption costing will usually show higher net operating income than variable costing. When production exceeds sales, inventories increase and therefore under absorption costing part of the fixed manufacturing overhead cost of the current period will be deferred in inventory to the next period. In contrast, all of the fixed manufacturing overhead cost of the current period will be charged immediately against income as a period cost under variable costing Under absorption costing it is possible to increase net operating income simply by increasing the level of production without any increase in sales. If production exceeds sales, units of product are added to inventory. These units carry a portion of the current periods fixed manufacturing overhead costs into the inventory account, thereby reducing the current periods reported expenses and causing net operating income to increase

Differences in reported net operating income between absorption and variable costing arise because of changing levels of inventory. Under JIT, goods are produced strictly to customers orders. With production geared to sales, inventories are largely (or entirely) eliminated. If inventories are completely eliminated, they cannot change from one period to another and absorption costing and variable costing will report the same net operating income. If the companys current operations have yet to reached its maximum capacity, we suggest to increase the quantity of units manufactured and sold. If we have the same fixed cost, this would result to increase in net operating profit.