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incentive to overproduce inventory the absorption of fixed overhead costs as part of 3732634

INCENTIVE TO OVERPRODUCE INVENTORY

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

Brandolino Company uses an actual-cost system to apply allproduction costs to units produced. The plant has a maximumproduction capacity of 40 million units but during year 1 itproduced and sold only 10 million units. There were no beginning orending inventories. The company’s absorption-costing incomestatement for year 1 follows:

BRANDOLINO COMPANYIncome StatementFor 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. Aconsultant approached the board with the following Page 345offer:“I agree to become president for no fixed salary. But I insist on ayear-end bonus of 10 percent of operating income (beforeconsidering the bonus).” The board of directors agreed to theseterms and hired the consultant as Brandolino’s new president. Thenew president promptly stepped up production to an annual rate of30 million units. Sales for year 2 remained at 10 million units.Here is the resulting absorption-costing income statement for year2:

BRANDOLINO COMPANYIncome StatementFor 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 goodsmanufactured

$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 presidenttook his check for $1,400,000 and resigned to take a job withanother corporation. He remarked, “I enjoy challenges. Now thatBrandolino Company is in the black, I’d prefer tackling anotherchallenging situation.” (His contract with his new employer issimilar 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 foryear 1? For year 2? (Assume that all selling and administrativecosts are committed and unchanged.)Compare those results with the absorption-costingstatements.Comment on the ethical issues in this scenario.

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