Question

Dean Williams, the manager of Bond Moldings’ European division, is working on putting together the production schedule for the last three months of the year. The European division had planned to sell 200,000 units during the year. However most recent projections indicate sales will only be 180,000 units. By the end of September, the following activity had been reported:

• Beginning Inventory, January 1 -0-
• Production 60,000 units
• Sales 50,000 units
• Ending Inventory, September 30 10,000 units

Demand has been weak so far and the sales forecast for the last quarter is only 10,000 units.

The European division has the option of renting outside warehouse space to store up to a maximum of 25,000 units. The division has a policy that it needs to maintain a minimum inventory level of 2,500 units to ensure that customer orders will potentially not have be cancelled or shorted.

Mr. Williams is aware that production must be at least 10,000 per quarter in order to justify continuing to pay a small core of production workers. Maximum production capacity is 50,000 units.

Further, fixed manufacturing overhead is a significant portion of the divisions’ product cost.

Question

Identify and comment on the ethical issues centered on the decision Mr. Williams must make about the level of production for the last quarter of the year.

Answer 1

The ethical issue centered around is whether closing stock should be built to achieve the net operating income target for the year. There is shortage of 20,000 units of sales target and further lower forecast of sales is expected in last quarter. These lower sales will lead to lower net income. The lower net income can be achieved by building closing inventory.

In Absorption costing the product cost includes variable manufacturing cost (direct material, direct labor, variable manufacturing overheads) and fixed manufacturing overheads. The product cost per unit will higher in the given case due to higher portion of division fixed cost. The closing stock valued at product cost in absorption costing will be higher and it will lead to deferment of fixed manufacturing overhead incurred rather than expensing it to income statement. The higher amount of closing stock will lead to higher net profit reported for the year. But since the sales forecast are not good it will lead t inventory build up which is not good for the firm. The higher inventory build up will have risk of obsolescence and it may be non-moving also if sales do not pick up.

The higher production to building inventory and achieve net profit target is not an ethical action on part of the manager of Bond Moldings’ European division. The profitability target should be achieved with sales only and not through build up of closing inventory.