Cost classifications and recording, ethics. Western Outfits manufactures and sells clothing items in many countries. Its headquarters is in Seattle, Washington. Most of the clothing is manufactured in China, Pakistan, Philippines, and Thailand. Five years ago it started manufacturing clothing in Hindstan. This country has a highly skilled labor force. Western Outfits is taxed in Hindstan on income earned in that country. To promote greater employment of Hindstan labor, that country's government allows companies operating there a 150% income tax deduction on labor costs if the total labor costs for Hindstan employed nationals exceeds 30% of total manufacturing costs.

Ray Stevens, a Division Controller of Western Outfits has recently been appointed controller for its Hindstan operations. After two months on the job he returns to Seattle to report to the corporate controller. Stevens notes the following in his report.

a. Western Outfits three years ago set up two separate subsidiaries in Hindstan — Hindstan W.O. Manufacturing and Hindstan W.O Inc. Only the Hindstan W.O. Manufacturing company qualifies for the 150% tax deduction on labor costs. Western Outfits charges over 90%

of its Seattle corporate costs that are related to Hindstan operations to the Hindstan W.O.

Inc. subsidiary' despite this subsidiary having less than 20% of the total labor force. Several of the charges to Hindstan W.O. Inc. are for patents and design work that are recorded as manufacturing costs in the other non-Hindstan Asian subsidiaries.

b. The accounting manual that guides worldwide division reporting at Western Outfits classifies fringe benefits paid to direct manufacturing labor (for health, insurance, and the like)

as a manufacturing overhead cost item. Hindstan W.O. Manufacturing (but not Hindstan W.O. Inc.) departs from this policy and records fringe benefits as part of direct manufacturing labor costs

c. Hindstan W.O. Manufacturing has many subcontractors. In all its other subsidiaries world- wide, Western Outfits does not classify these subcontractors as direct labor. In Hindstan W.O. Manufacturing all the subcontractor costs are now classified as direct labor. This situation has created a nightmare" for accounting, and Stevens knows of at least 10 cases where the subcontract price actually covered materials purchased by the subcontractor as well as labor costs of the subcontractor.

Required 1. Stevens wants to ad ere to the "Standards of Ethical Conduct for Management Accountants" (see Exhibit 1-8 on p. 17). What areas in (a), (b), and

(c) should cause him concern?

2. What fits? recommendc." ms should Stevens make to the corporate controller of Western Out 2-35 Distinguish between the general case and a special case of CVP 2-35 Explain the relationship between operating income and net income 2-35 Demonstrate three methods for determining the breakeven point and target operating income 2-35 Describe the assumptions under- lying CVP