Inventories under absorption costing 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?

2. What advice would you give to Gordon in responding to Matt’s concern about the present method of profit reporting?

3. Segmented contribution margin analysis Bon Jager Inc. manufactures and sells devices used in cardiovascular surgery. The company has two salespersons, Dean and Martin.

A contribution margin by salesperson report was prepared as follows:

Bon Jager Inc.

Contribution Margin by Salesperson Dean Martin Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000 $480,000 Variable cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184,000 264,000 Manufacturing margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216,000 216,000 Variable promotion expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000 43,200 Variable sales commission expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,000 67,200 128,000 110,400 Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,000 105,600 Manufacturing margin as a percent of sales

(manufacturing margin ratio) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54% 45%

Contribution margin ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22% 22%

Interpret the report, and provide recommendations to the two salespersons for improving profitability.