8:33 PM Thu Jun 4 50% FOCUS ON ETHICS INCENTIVE TO OVERPRODUCE INVENTORY The absorption of fixed overhead costs as part of the cost of inventory on the balance sheet presents ethical challenges because it provides the opportunity to manipulate reported income. This classic case is based on an actual company's experience." Brandolino Company uses an actual-cost system to apply all production costs to units produced. The plant has a maximum production capacity of 40 million units but during year 1 it produced and sold only 10 million units. There were no beginning or ending inventories. The company's absorption-costing income statement for year 1 follows: $ 60,000,000 BRANDOLINO COMPANY Income Statement For Year 1 Sales (10,000,000 units at $6) Cost of goods sold: Direct costs (material and labor) (10,000,000 at $2) $ 20,000,000 Manufacturing overhead 48,000,000 Gross margin Less: Selling and administrative expenses Operating income (loss) 68,000,000 $ (8,000,000) 10,000,000 $(18,000,000) The board of directors is upset about the $18 million loss. A consultant approached the board with the following offer: Page 345 I agree to become president for no fixed salary. But I insist on a year-end bonus of 10 percent of operating income (before considering the bonus). The board of directors agreed to these terms and hired the consultant as Brandolino's new president. The new president promptly stepped up production to an annual rate of e 50% 50% 8:33 PM Thu Jun 4 Less: Selling and administrative expenses Operating income (loss) 10,000,000 $(18,000,000) The board of directors is upset about the $18 million loss. A consultant approached the board with the following offer: Page 345 "I agree to become president for no fixed salary. But I insist on a year-end bonus of 10 percent of operating income (before considering the bonus)." The board of directors agreed to these terms and hired the consultant as Brandolino's new president. The new president promptly stepped up production to an annual rate of 30 million units. Sales for year 2 remained at 10 million units. Here is the resulting absorption-costing income statement for year 2: BRANDOLINO COMPANY Income Statement For Year 2 Sales (10,000,000 units at $6) $60,000,000 Cost of goods sold: Costs of goods manufactured: Direct costs (material and labor) (30,000,000 at $2) $ 60,000,000 Manufacturing overhead 48,000,000 Total cost of goods manufactured $108,000,000 Less: Ending inventory: Direct costs (material and labor) (20,000,000 at $2) $ 40,000,000 Manufacturing overhead (20/30 x $48,000,000) 32,000,000 Total ending inventory costs $ 72,000,000 Cost of goods sold 36,000,000 Gross margin $24,000,000 Less: Selling and administrative expenses 10,000,000 Operating income before bonus $14,000,000 Bonus 1,400,000 Operating income after bonus $12,600,000 manufactured $108,000,000 50%. $ 40,000,000 8:33 PM Thu Jun 4 Less: Ending inventory: Direct costs (material and labor) (20,000,000 at $2) Manufacturing overhead (20/30 x $48,000,000) Total ending inventory costs Cost of goods sold Gross margin Less: Selling and administrative expenses Operating income before bonus Bonus Operating income after bonus 32,000,000 $ 72,000,000 36,000,000 $24,000,000 10,000,000 $14,000,000 1,400,000 $12,600,000 The day after the year 2 statement was verified, the president took his check for $1,400,000 and resigned to take a job with another corporation. He remarked, I enjoy challenges. Now that Brandolino Company is in the black, I'd prefer tackling another challenging situation. (His contract with his new employer is similar to the one he had with Brandolino Company.) What do you think is going on here? How would you evaluate the company's year 2 performance? Using variable costing, what would operating income be for year 1? For year 2? (Assume that all selling and administrative costs are committed and unchanged.) Compare those results with the absorption-costing statements. Comment on the ethical issues in this scenario. *This scenario is based on the case "I Enjoy Challenges," originally written by Michael W. Maher. It is used here with permission