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Can you answer 1 and 2 and explain your reasoning?
BendoR, Inc. manufactures control panels for the electronics industry and has just completed its first year of operations. The following discussion took place between the controller, Gordon Merrick, and the company president, Matt McCray: Matt: I’ve been looking over our first year’s performance by quarters. Our earnings have been increasing each quarter, even though our sales have been flat and our prices and costs have not changed. Why is this? Gordon: Our actual sales have stayed even throughout the year, but we’ve been increasing the utilization of our factory every quarter. By keeping our factory utilization high, we will keep our costs down by allocating the fixed plant costs over a greater number of units. Naturally, this causes our cost per unit to be lower than it would be otherwise. Matt: Yes, but what good is this if we have been unable to sell everything that we make? Our inventory is also increasing. Gordon: This is true. However, our unit costs are lower because of the additional production. When these lower costs are matched against sales, it has a positive impact on our earnings Matt: Are you saying that we are able to create additional earnings merely by building inventory? Can this be true? Gordon: Well, I’ve never thought about it quite that way.. but I guess so Matt: And another thing. What will happen if we begin to reduce our production in order to liquidate the inventory? Don’t tell me our earnings will go down even though our production effort drops! Gordon: Well Matt: There must be a better way. I’d like our quarterly income statements to reflect what’s really going on. I don’t want our income reports to reward building inventory and penalize reducing inventory Gordon: I’m not sure what I can do-we have to follow generally accepted accounting principles 1. Why does reporting income under generally accepted accounting principles “reward” building inventory and “penalize” reducing inventory? What advice would you give to Gordon in responding to Matt’s concern about the present method of profit reporting?
Expert Answer
- Reporting income under generally accepted accounting principles, required allocation of costs to all the units produced. Cost of sales absorbs only the part of fixed costs allocated to the units sold.
Fixed costs are period costs and do not vary with the number of units produced. But as per the reporting requirement, the full fixed costs of the year are not charged to sales, if there is increasing inventory.
The remaining part lies with the finished goods inventory. So, if the finished goods inventory increases during the year profit will be higher . When the finished goods inventory reduces, profit will be lower.
- The better way to measure profits, especially when there are wide variation of inventory is to use variable costing.
Under this method, entire fixed cost is treated as period cost and charged to Income.
The following example will explain:
Direct material & labor=$2 per unit
Fixed overhead=($300/100)=$3 per unit
Number of units produced =100
100 units were produced and 20 units are sold
Total cost per unit=$5
Income Statement:
Sales=$10*20=$200
Cost of goods manufactured=100*5=$500
(Assume beginning inventory=0)
Ending inventory=$5*80=$400
Cost of goods sold=(500-400)=$100
Gross Profit=($200-$100)=$100
Percent of Gross Profit=(50/200)=25%
The profit is increased since a part of fixed cost are in the ending inventory.
If we use variable costing:
Income Statement:
Sales=$10*20=$200
Variable cost=$2*20=$40
Contribution Margin=$160(200-40)
Less:Fixed Overhead=$300
Gross Loss=$140
It will correctly reflect the negative income.
CONCLUSION: The Company should change the method of profit reporting to Variable Costing Method
Building up inventory without anticipated sales should be discouraged, because it increases working capital requirement
