Question

Carlos Cavalas, the manager of Echo Products’ Brazilian Division, is trying to set the production schedule for the last quarter of the year. The Brazilian Division had planned to sell 3,600 units during the year, but by September 30 only the following activity had been reported:

	Units
Inventory, January 1	0
Production	2,400
Sales	2,000
Inventory, September 30	400

The division can rent warehouse space to store up to 1,000 units. The minimum inventory level that the division should carry is 50 units. Mr. Cavalas is aware that production must be at least 200 units per quarter in order to retain a nucleus of key employees. Maximum production capacity is 1,500 units per quarter.

Demand has been soft, and the sales forecast for the last quarter is only 600 units. Due to the nature of the division’s operations, fixed manufacturing overhead is a major element of product cost.

Required:

1. Assume that the division is using variable costing. How many units should be scheduled for production during the last quarter of the year? (The basic formula for computing the required production for the quarter is: Required production = Expected sales + Desired ending inventory − Beginning inventory.) Show computations and explain your answer. Will the number of units scheduled for production affect the division’s reported income or loss for the year? Explain.

2. Assume that the division is using absorption costing and that the divisional manager is given an annual bonus based on divisional operating income. If Mr. Cavalas wants to maximize his division’s operating income for the year, how many units should be scheduled for production during the last quarter? [See the formula in (1) above.] Explain.

3. Identify the ethical issues involved in the decision Mr. Cavalas must make about the level of production for the last quarter of the year.

Answer 1

Expected sales for the last quarter of the year	600
Desired minimum inventory	50
Total units needed for sales and desired EI	650
Less: Current inventory on hand -- September 30	400
Desired production for the 4th quarter	250
The number of units scheduled for production will not affect the reported operating income or
loss for the year if variable costing is in use. All fixed MOH costs will be treated as an expense
of the period regardless of the number of units produced. Thus, no fixed MOH cost will be shifted
between periods through the inventory account, and income will be a function of the number of units
sold, rather than a function of the number of units produced and sold.

Answer:2

Expected sales for the last quarter of the year	600
Maximum inventory storage facilities available	1,000
Total units needed for sales and desired EI	1,600
Less: Current inventory on hand -- September 30	400
Desired production for the 4th quarter	1,200
By building inventory to maximum levels, Mr. Carlos Cavalas will be able to defer a portion of the year's fixed
MOH to future years through the inventory account, rather than having all of these costs appear as charges
on the current year's income statement.
Thus, by producing enough units to build inventory to the maximum level that storage facilities will allow,
Mr. Constantinos could relieve the current year of FMOH cost and thereby maximize the current year's net
operating income (and his bonus).

Answer:3

Production options:
1. Production schedule designed to draw down inventory	250
2. Production schedule designed to maximize divisional manager's annual bonus	1,200
By setting a production schedule that will maximize his division's net operating income -- and maximize
his own bonus -- Mr. Carlos Cavalas will be acting against the best interests of the company as a whole.
The extra units aren't needed and will be expensive to carry in inventory. Moreover, there is no indication
that demand will be any better next year than it has been in the current year, so the company may be
required to carry the extra units in inventory a long time before they are ultimately sold.
The company's bonus plan undoubtedly is intended to increase the company's profits by increasing sales
and controlling expenses. If Mr. Carlos Cavalas sets a production schedule as shown in part (2) above, he
will obtain his bonus as a result of sales and production rather than as a result of sales. Moreover, he will
obtain it by creating greater expenses --rather than fewer expenses -- for the company as a whole.
Producing as much as possible so as to maximize the division's net operating income and the manager's
bonus would be unethical because it subverts the goals of the overall organization.