Question One (85 Marks)
Gastow Pumps is a manufacturer of commercial and heavy industrial Pumps. The firm's
two product lines are called Directlift and Gravity. The primary raw materials are
flexible steel sheets, and 23cm x 60cm of plastic sheets. Each Directlift pump requires a
2/3 of a meter and a Gravity pump requires a one metre of steel sheet. Allowing for
normal breakage and scrap steel sheet, the company can cut either enough to make four
Directlifts or two Gravity pumps from a single steel sheet. Other raw materials are
costly and treated as indirect materials. Derek Mast, Gastow Pump's accountant has
gathered the following information in preparation for the company's annual budget for
the next year.
• Sales in the fourth quarter of the current year are expected to be 50,000 Directlift
and 40,000 Gravity pumps. The sales manager predicts that, over the next two
years, sales in each product line will grow by 5000 units each quarter over the
previous quarter.
• Gastow's sales history indicates that 60 per cent of all sales are on credit, with the
remainder of the sales in cash. The company's experience shows that 80 per cent of
the credit sales are collected during the quarter in which the sales are made, while
the remaining 20 per cent are collected in the following quarter. There are no bad
debts.
• The Directlift sells for $10 and Gravity for $15. Prices of both products are
expected to increase by 2% in the third quarter of the budget year.
• Gastow's production manager tries to end each quarter with enough finished goods
inventory in each product line to cover 20 per cent of the following quarter's sales.
In addition, an attempt is made to end each quarter with 20 per cent of the plastic
sheets needed for the following quarter's production requirement. Since steel
sheets are purchased locally, Beckett buys them on a just-in-time basis, so
inventory is negligible.
• All of Gastow's direct material purchases are on credit, and 80 per cent of each
quarter's purchases are paid during the same quarter as the purchases are made.
The other 20 per cent is paid in the next quarter.
• Indirect materials are purchased as needed for cash.
• Work in process inventory in negligible.
• Projected manufacturing costs for each product in the budget year are as follows:
Directlift Gravity
Direct material
Steel sheet:
Directlift: 2/3 metre @$3 per metre $2
Gravity: 1 metre @ $3 per metre $3
Plastic sheet:
Directlift: ¼ sheet @$8 per sheet 2
Gravity: ½ sheet @ $8 per sheet 4
Direct labour
0.1 hour @ $20 per hour 2 2

• The following are budgeted manufacturing overhead costs (all these costs except
for the depreciation charges will be paid during the quarter incurred).
o Indirect materials are expected to be $10,200 for quarter 1 & are
expected to increase by $1,000 every quarter.
o Indirect Labour is expected to be $40,800 for quarter 1 & is
expected to increase by $4,000 every quarter
o Other overheads are expected to be $31,000 for quarter 1 &
expected to increase by $5,000 every quarter
o Depreciation is calculated on a straight-line basis at $20,000 per
quarter.
• Gastow pump's quarterly selling and administrative expenses are $100,000 paid
in cash
• Derek Mast anticipates that dividends of $50,000 will be declared and paid in
cash each quarter.
• MOH costs are allocated to each product based on Direct Labour hours.
• Gastow's projected balance sheet as 31 December of the current year is as
follows:
Cash $95000
Accounts receivable 132000
Inventory:
Raw materials 59200
Finished goods 167000
Plant and equipment (net of accumulated depreciation) 8 000 000
Total assets $8 453 200
Accounts payable $99400
Ordinary shares 5 000 000
Retained earnings 3 353 800
Total liabilities and shareholders' equity $8 453 200
Additional information:
• The CEO has decided to invest in purchasing a fully automated electric machine
which is expected to increase production significantly. The acquisition of the new
machine will take place at the start of January next year. The machine will cost
$950,000 and there will be an additional $50,000 of equipment purchase to
allow the machine to operate. The purchase will be financed with a $1,000,000
loan from National Australia Bank. The CEO has negotiated a repayment
schedule of four equal instalments, payable on the last day of each quarter. The
interest rate is 10 per cent per annum and interest is also paid quarterly with
each instalment payment of the principal.

Required:
Prepare Gastow Pump's annual budget for the next year by completing:
? Sales budget (7.5 marks)
? Production budget (6 Marks)
? Direct Material Budget (8.5 marks)
? Direct Labour budget (2 marks)
? Manufacturing Overhead budget (4 marks)
? S & A Budget (1 mark)
? Budgeted cost of goods sold (6 marks)
? Budgeted Income & Expenditure Statement (5 marks)
? Cash receipt budget (7 marks)
? Cash payments budget (7 marks)
? Cash budget (18 marks)
? Budgeted balance sheet as of 31 December of the budget year (13 marks)
Question Two (15 Marks)
Steve Morgan, controller for Newton Industries, was reviewing production cost reports
for the year. One amount in these reports continued to bother him - advertising. During
the year, the company instituted an expensive advertising campaign to sell some of its
slower moving products. It is still too early to tell whether the advertising campaign was
successful.
There had been much internal debate as to how to report advertising costs. The vice
president of finance argued that advertising costs should be reported as a cost of
production, just like direct materials and direct labour. He therefore recommended that
this cost be identified as manufacturing overhead and reported as part of inventory cost
until sold. Others disagree. Morgan believed that this cost should be reported as an
expense of the current period, so as not to overstate net income. Others argue that it
should be reported as prepaid advertising and reported as a current asset, to be
expensed as the advertising results in increased sales.
The president finally had to decide on the issue. He argued that these costs should be
reported as inventory. His arguments were practical ones. He noted that the company
was experiencing financial difficulty and expensing this amount in the current period
might jeopardise a planned bond offering. Also, by reporting the advertising costs as
inventory rather than as prepaid advertising, less attention would be directed to it by
the financial community.

Required
a) What are the ethical issues involved in this situation? (6 marks)
b) What is the effect of treating advertising as either product cost or period cost on
the company's equity? (6 marks)
c) What would you do if you were Steve Morgan? (3 marks)