Spencer and Loveland LLP, is a medium-sized, regional accounting firm based in the western part of the United States. A new client of the firm, K\&K, Inc., which manufactures a variety of picture frames, recently contracted with Spencer and Loveland to perform an audit of the company's financial statements for the year ended December 31, 200X. K\&K expects to use the audited financial statements to obtain a more favorable line of credit with their bank.

Spencer and Loveland has a reputation for providing value to their clients above and beyond the high quality auditing services they perform. They successfully look for opportunities to leverage insights obtained during the audit as a basis for offering advice to their clients as a business advisor. \(\mathrm{K} \& \mathrm{~K}\) management is eager to receive Spencer and Loveland's financial advice, given that the company's current accounting personnel primarily have clerical backgrounds. Thus, the audit engagement team has been instructed to generate suggestions that might help improve the growth and profitability of \(\mathrm{K} \& \mathrm{~K}\), which has taken a turn for the worse during the past year.

K\&K's original, labor-intensive custom-frame line appears to be struggling. Given rising costs for skilled labor over the past few years, \(\mathrm{K} \& \mathrm{~K}\) 's production manager has long believed that it was only a matter of time before the company's older custom-frame line would begin to lose the long-term profitability it has enjoyed. He believes the custom line's declining profitability over the past year confirms the decision to expand the company's product line into new areas. At the beginning of last year, \(\mathrm{K} \& \mathrm{~K}\) invested in the RX-1000 system to mass-produce plastic frames. Internal cost accounting reports indicate that the new plastic-frame line has been quite profitable, despite operating at low volume levels relative to its capacity. The production manager recently recommended to K\&K's president that the company consider discontinuing the labor-intensive custom-frame line to focus on expanding the less labor-intensive, higher-volume, higher-margin line of plastic frames.

You are a second-year audit senior at Spencer and Loveland. You and your audit staff are currently auditing the inventory and production costing systems at \(\mathrm{K} \& \mathrm{~K}\). You and the junior staff auditor on the team have performed most of the audit procedures outlined on the audit program and have documented your findings in the audit papers.

As audit senior, you are responsible for reviewing the audit schedules and reporting to the audit engagement manager any areas of concern with respect to the audit. In addition, the manager asked you to analyze the client's inventory and production situation to indicate any areas where you believe the firm can provide value-added constructive suggestions to the client.

BACKGROUND ABOUT K\&K, INC.
K\&K, Inc. was founded 25 years ago when brothers Kent and Kevin Shaw started making custom-made picture frames for local artists using their father's workshop. They soon realized there was profit to be made in building large frames for use by painting and portrait studios. Over the years, \(\mathrm{K} \& \mathrm{~K}\) has become a well-known picture frame manufacturer in the western part of the United States, and has distinguished itself as a company that produces and sells high-quality, made-to-order picture frames. \(\mathrm{K} \& \mathrm{~K}\) manufactures and sells three basic sizes of frames, which are relatively large and ornate. \(\mathrm{K} \& \mathrm{~K}\) sells wholesale to portrait studios, retailers, and other users of large hardwood picture frames.
Due to the nature of the frames produced, the production process for custom frames at \(\mathrm{K} \& \mathrm{~K}\) is labor intensive. Most of the work is done essentially by hand, with the aid of specialized carving and shaping tools. Skilled workers use these tools to craft the wood pieces used in making the picture frames. \(\mathrm{K} \& \mathrm{~K}\) uses a traditional joborder costing system and allocates overhead costs to the frames on the basis of direct labor hours. K\&K's custom frames can be categorized into three basic sizes (small, medium, and large) that use a variety of designs and materials.
\(\mathrm{K} \& \mathrm{~K}\) has grown slowly over the past 25 years, generating reasonable profits along the way. Early last year, management decided to accelerate its growth by entering the market for smaller, mass-produced picture frames of the type sold in most craft and department stores. The company first experimented with inexpensive metal frames. They purchased two used machines to produce these frames, which manufactured a large quantity of metal frames in a relatively short time. However, the frames produced were of varying quality and did not sell well. Thus, the machines remained idle through the second half of last year, and the company does not plan to produce any more of this type of frame.
\(\mathrm{K} \& \mathrm{~K}\) currently produces around 4,000 custom hardwood frames a month, or 48,000 a year. After the failed experiment with mass-produced metal frames, \(\mathrm{K} \& \mathrm{~K}\) invested in new machinery called the RX-1000 system. This new system is capable of producing standard-sized \((5 \times 7,8 \times 10\), and \(11 \times 14\) inch) plastic picture frames at a rate of up to 60,000 frames a month, with little variation in quality. The new machinery fit easily into \(\mathrm{K} \& \mathrm{~K}\) 's existing plant facilities.
Even though the machinery was quite expensive, the plastic frame line is much less labor-intensive to produce than the custom hardwood frame line. Based on the past year's cost data, the production manager is convinced that the new machinery will pay for itself in a matter of two or three years as production and sales volumes for the new frame line increase. Production volumes for the new frames averaged around 24,000 frames a month over the past year, which is close to the production level of \(288,000 \mathrm{~K} \& \mathrm{~K}\) had budgeted.
Sale prices on these mass-produced plastic frames are obviously much lower than those for the custom frames, but management expected to generate a reasonable profit through high-volume production and higher percentage profit margins. So far, \(\mathrm{K} \& \mathrm{~K}\) 's internal data indicates that the new line is far more profitable than had been hoped even at current production volumes, with gross margins just under \(50 \%\). By contrast, the gross margin percentage for the custom frame line dropped from its usual average of \(9 \%\) to \(10 \%\) to an anemic \(5.6 \%\) over the past year. The production foreman prepared a cost summary for the company's two product lines, which is provided on the pages that follow (see Exhibits 1 and 2).
The RX-1000 system consists of three machines integrated into a single system. The first machine mixes appropriate quantities of the resins and other liquid and powder materials needed to produce a molded plastic frame. The second machine injects the mixed raw materials into a large sheet of molds of a particular size, depending on the production run. When the material is cool, the machine breaks the hardened frames free of the molds, and the molds are then manually fed into the third stage. Here, the third machine polishes the frames and inserts a clear, hard plastic sheet, which serves as a picture protector. Workers manually place a glossy paper picture of an attractive young couple behind the clear plastic in each frame (for marketing purposes), and the frames are then packaged for sale and shipment.
The RX-1000 system initially cost \(\$ 380,000\). Management estimates each of the three machines will have a useful life of six years. K\&K depreciates the machinery using the straight-line method. These new machines do not require nearly as much direct labor as the custom frame line, but in addition to the manual labor needed to package the frames, a specially trained employee is required to operate and monitor the system.
The system is also costly to maintain, requiring regular maintenance every two weeks to keep it running effectively. Each regular maintenance cycle requires replacement of parts and lubricants, costing approximately \(\$ 2,450\) a month for labor and parts that must be replaced regularly. A breakdown of expected maintenance and other costs is found in the production foreman's analysis of production costs in the following pages.
Early on, the RX-1000 was so effective at mass-producing defect-free frames that management rented out an additional storage facility to hold the finished inventory produced by the new machinery. Later in the year, production rates had to be scaled back, and the system periodically sat idle until plastic frame inventories shrank to more reasonable levels. Management wants to be in a position to fill orders on a timely basis, and is content to have a considerable amount of both finished goods and raw material inventories on hand.
Inventory costs consist of direct materials, direct labor, and overhead. Overhead continues to be allocated to both product lines from a common, companywide cost pool using direct labor hours as the activity base. Further detail on \(\mathrm{K} \& \mathrm{~K}\) 's production costs are found on the following exhibits.
REQUIREMENTS
1. Briefly list and explain the primary audit risks in the production and inventory segment of the \(\mathrm{K} \& \mathrm{~K}\) audit.
2. Identify any accounting or auditing issues in the way \(\mathrm{K} \& \mathrm{~K}\) handles its product costs, including overhead allocation, that need to be addressed in the current audit.
3. Review the analysis performed by \(\mathrm{K} \& \mathrm{~K}\) on the two product lines. \(\mathrm{K} \& \mathrm{~K}\) 's management is debating the elimination of the manual line given that it is no longer profitable. Should \(\mathrm{K} \& \mathrm{~K}\) discontinue the labor-intensive custom frame product line? Why or why not?
4. Based on your analysis, prepare a memo to the audit manager suggesting areas in K\&K's inventory and production-costing systems where your firm could provide advice and value-added services to the client. In addition, suggest any areas in which your firm might be able to provide consulting services that would be of value to the client.