Baines Corporation (a fictional company) manufactures fireplace tools and accessories. It has been prosperous since its incorporation, largely due to a small, exceptionally skilled, and highly motivated managerial staff. Baines has been able to attract and retain its excellent management team because of a very attractive managerial incentive plan. The plan allocates 23% of total pre-tax FIFO-absorption cost profits into a pool that is distributed to managers as a year-end bonus. The bonus pool is allocated to individual managers using a point system based on each manager’s performance relative to a budgeted goal. Data relating to 20X1 operations follow:

Beginning inventory	1,500,000 units @ $2.95
Ending inventory	1,500,000 units @ $2.95
Production	4,000,000 units
Sales	4,000,000 units @ $3.50
Variable production costs	$1.45/unit
Fixed production costs	$6,000,000/year

Reported pre-tax profit for 20X1 was:

Early in 20X2, interest rates increased, and the company’s president, Ross Eldred, was concerned about the rising cost of financing the inventory. After a careful study of the situation, he became convinced that inventory levels could be reduced considerably without adversely affecting sales or delivery performance provided certain changes in purchasing, production, and sales procedures were adopted. Accordingly, Eldred called a meeting of the management group in February 20X2 and outlined his multifaceted plan for reducing inventories.

His basic strategy was immediately accepted, and several participants suggested various additional efficiencies and other inventory management improvements. The meeting adjourned with each manager resolving to do all that was possible to decrease inventory levels and thereby reduce interest expense.

As the year progressed, Eldred’s proposals and the refinements suggested by the other managers were put into practice; as a result, inventory levels were significantly reduced by December 31, 20X2. The managers were quite pleased with their successful implementation of the new strategy, and morale was quite high.

Basic facts concerning 20X2 performance were as follows:

Beginning inventory	1,500,000 units @ $2.95
Ending inventory	700,000 units @ $3.325
Production	3,200,000 units
Sales	4,000,000 units @ $3.50
Variable production costs	$1.45/unit
Fixed production costs	$6,000,000/year
Interest expense	$100,000/year

Shortly after the final 20X2 profit figures were reported early in 20X3, a general management meeting was held. As he walked into the room, Eldred was somewhat surprised to see a rather sullen and dispirited group of managers confronting him. One was heard to mumble, “Well, I wonder what this year’s double cross will be!”

Required:

1. What do you think caused the abrupt change in the mood of the management team at Baines Corporation? Cite figures to support your explanation.

2. How might this problem have been prevented? Cite figures to support your explanation.

Transcribed Image Text:

Sales revenues Costs of goods sold Variable production costs Fixed production costs (4,000,000 @ $3.50) $14,000,000 (4,000,000 @ $1.45) (4,000,000 @ $1.50) $5,800,000 6,000,000 11,800,000 Operating profit Interest expense Pre-tax profit 2,200,000 200,000 $ 2,000,000