Question

INCENTIVE TO OVERPRODUCE INVENTORY

The absorption of fixed overhead costs as part of the cost of inventory on the balance sheet presents ethical challenges because it provides the opportunity to manipulate reported income. This classic case is based on an actual company’s experience.*

Brandolino Company uses an actual-cost system to apply all production costs to units produced. The plant has a maximum production capacity of 40 million units but during year 1 it produced and sold only 10 million units. There were no beginning or ending inventories. The company’s absorption-costing income statement for year 1 follows:

BRANDOLINO COMPANY

Income Statement

For Year 1

Sales (10,000,000 units at $6)

$ 60,000,000   

Cost of goods sold:

Direct costs (material and labor) (10,000,000 at $2)

$ 20,000,000

Manufacturing overhead

48,000,000

68,000,000

Gross margin

$  (8,000,000)

Less: Selling and administrative expenses

10,000,000

Operating income (loss)

$(18,000,000)

The board of directors is upset about the $18 million loss. A consultant approached the board with the following Page 345offer: “I agree to become president for no fixed salary. But I insist on a year-end bonus of 10 percent of operating income (before considering the bonus).” The board of directors agreed to these terms and hired the consultant as Brandolino’s new president. The new president promptly stepped up production to an annual rate of 30 million units. Sales for year 2 remained at 10 million units. Here is the resulting absorption-costing income statement for year 2:

BRANDOLINO COMPANY

Income Statement

For Year 2

Sales (10,000,000 units at $6)

$60,000,000

Cost of goods sold:

Costs of goods manufactured:

Direct costs (material and labor) (30,000,000 at $2)

$ 60,000,000

Manufacturing overhead

 48,000,000

Total cost of goods

manufactured

$108,000,000

Less: Ending inventory:

Direct costs (material and labor) (20,000,000 at $2)

$ 40,000,000

Manufacturing overhead (20/30 × $48,000,000)

 32,000,000

Total ending inventory costs

$ 72,000,000

Cost of goods sold

 36,000,000

Gross margin

$24,000,000

Less: Selling and administrative expenses

 10,000,000

Operating income before bonus

$14,000,000

Bonus

 1,400,000

Operating income after bonus

$12,600,000

The day after the year 2 statement was verified, the president took his check for $1,400,000 and resigned to take a job with another corporation. He remarked, “I enjoy challenges. Now that Brandolino Company is in the black, I’d prefer tackling another challenging situation.” (His contract with his new employer is similar to the one he had with Brandolino Company.)

What do you think is going on here?

How would you evaluate the company’s year 2 performance?

Using variable costing, what would operating income be for year 1? For year 2? (Assume that all selling and administrative costs are committed and unchanged.)

Compare those results with the absorption-costing statements.

Answer 1

1. Here the Manufacturing Expenses plays a vital role as it remain unchanged while changed in production units. Hence, it is consider as fixed cost while evaluating performance of the company. Company’s Performance for 2 year is as under:

Particulars	Amount in $
Sales (10,000,000 X $6)	60,000,000
Less:
Raw Material and Labour Cost (30,000,000 X $2)	60,000,000
Manufacturing Expenses	48,000,000
Add/Less: Stock Adjustment
Add: Closing Stock of WIP [(20,000,000 X $2) + (48,000,000 X 20/40)]	64,000,000
Less: Opening Stock of WIP	--
Gross margin	16,000,000
Less: Selling and administrative expenses	10,000,000
Operating income	6,000,000

2. Operating Profit under operating Costing method:

Particulars	Year-1	Year-2
Sales	60,000,000	60,000,000
Less Variable Cost
Raw Material & labour	20,000,000	20,000,000
Operating Profit	40,000,000	40,000,000

3. Comparison of Absorption Costing and variable Costing

While comparing the operating profit calculated in point 2 with profit of Absorption costing method we can see that there is no increase in operating profit. In year 1 the company has absorbed al the Manufacturing expenses to the produced 10 million units against its installed capacity of 40 million units which leads the company in the operating loss for first year.