Question

Case 2: (C2, D3)

Ahamed Ali, the new plant manager of Ahlia Manufacturing Plant Number 12, has just reviewed a draft of his year-end financial statements. Hand receives a year-end bonus of 8% of the plant’s operating income before tax. The year-end income statement provided by the plant’s controller was disappointing to say the least. After reviewing the numbers, Ahamed demanded that his controller go back and “work the numbers” again. Ahamed insisted that if he didn’t see a better operating income number the next time around, he would be forced to look for a new controller.

Ahlia Manufacturing classifies all costs directly related to the manufacturing of its product as product costs. These costs are inventoried and later expensed as costs of goods sold when the product is sold. All other expenses, including finished goods warehousing costs of $3,570,000, are classified as period expenses. Ahamed had suggested that warehousing costs be included as product costs because they are “definitely related to our product.” The company produced 210,000 units during the period and sold 190,000 units.

As the controller reworked the numbers, he discovered that if he included warehousing costs as product costs, he could improve operating income by $340,000. He was also sure these new numbers would make Ahamed happy.

Instructions:

1. Show numerically how operating income would improve by $340,000 just by classifying the preceding costs as product costs instead of period expenses.
2. Is Ahamed correct in his justification that these costs are “definitely related to our product”?
3. By how much will Hand profit personally if the controller makes the adjustments in requirement 1?
4. What should the plant controller do?

Answer 1

Finished goods warehousing cost per unit = $3570000/210000 units = $17 per unit

If these costs are classified as product costs instead of period expenses, only the costs pertaining to 190000 units would be charged to expense as cost of goods sold while those pertaining to 210000 - 190000 = 20000 units would be carried in inventory.

Thus, operating income would increase to the extent of the costs inventorized which is 20000 units x $17 = $340000.

No, Ahamed is not correct in his justification. Only costs incurred in the manufacture of a product are considered to be product costs. The finished goods warehousing cost is a cost incurred subsequent to the manufacture of a product and are hence not product costs.

If the controller makes the adjustment, the amount of personal profit would be to the extent of the additional year-end bonus which would be 8% x $340000 = $27200.

The plant controller should not make the adjustment since it would be in violation of GAAP and unethical to do so.