IMA EDUCATIONAL Case Case Journal Study ima Fair and Square? Ethical Dilemmas at Bexley Box Company Susan F. Weiss, PhD CMA CFM CPA CGMA CSCA Assistant Professor Rhode Island College The Association of Accountants and Financial Professionals in Business ISSN 1940-204X Bexley Box Company, Inc., a privately held firm in Dearborn, Mich., was a supplier of corrugated shipping boxes to the automotive parts manufacturing sector. The company serviced many producers that were primary parts suppliers to the largest automobile companies headquartered in the United States. Over the past three decades, Bexley Box Company's volume dwindled significantly in correlation with plummeting demand for domestic vehicles by U.S. consumers. The company thus faced a mounting overcapacity issue. In response, the company's chief executive officer (CEO), John Easton, sought other opportunities to engage the company's underutilized capacity and endeavored to become a regional supplier of shipping boxes to a large internet U.S.-based retailer that established local distribution centers in the Detroit metropolitan area and the Midwest. Bexley Box Company was required to perform some reengineering, upgrading, and retooling of its equipment in preparation for the new customer's requirements. To accomplish this, the company's in-house engineers performed equipment adaptations over the course of several months and completed testing, while there was lackluster productivity because of decreasing sales orders from the company's traditional customer base. The production, engineering, and operations managers then tested the equipment concurrently to ensure the new production schedule for shipping corrugated boxes could be accommodated. As a result, Bexley Box Company's sales executives successfully presented a supplier proposal to SmileNow Distributors, the foremost internet retailer excelling in U.S. market share. SmileNow had recently marketed a popular program with the objective of minimizing shipping costs for its loyal customers who ordered frequently. The SmileNow! program offered expedited delivery at a reduced annual flat fee. The anticipated increase in sales volume based on projections by SmileNow's executive team was staggering, representing nearly 400 million corrugated boxes annually. Hence, Bexley Box Company's sales managers were committed to consummating a deal on the proposal and elevating the company's capacity to regain status as a sector leader by becoming one of SmileNow's leading suppliers. Though Bexley Box Company would not be SmileNow's sole supplier initially, the potential existed that the company could eventually achieve this coveted position with its client given a proven success record indicated by quality, performance, and customer satisfaction surveys. Bexley Box Company's independent board of directors was thrilled at the news of this opportunity and commended the executive team, particularly the CEO. Bexley Box Company's managers and executives were fully determined to augment the strategic potential of the SmileNow opportunity. The company's controller, Harry March, CMA, reported to John Easton. Harry had emphasized the importance of the value chain in providing a methodology to production, engineering, operations, and marketing managers that would allow these business partners to identify critical segments in the maintenance of the customer relationship for the sustainable future. Managers appreciated the introduction of the value chain theory and often referred to its premises when proposing revisions in the engineering and production processes, specifically. Harry was prepared to provide an extensive and timely feedback loop that would detail usage, efficiency, spending, and production volume variances and result in management behavioral changes, if necessary, to optimize manufacturing. It was Harry's belief that managers should be incentivized toward achievement and continuous improvement-and guided ethically as well. Harry knew that economies of scale were important in realizing profitability through enhanced capacity utilization. He was also aware that increases in production volume had the potential to incentivize managers to overproduce to achieve operating profit targets, leaving a company with a deluge of unsold stock. Harry was a seasoned professional who networked frequently with his IMA (Institute of Management Accountants) colleagues at local chapter continuing professional education (CPE) session meetings in the area. Many controllers who worked in the automobile industry supply chain manufacturing plants in the Detroit area were members of the local IMA chapter and shared relevant news regarding financial opportunities in the area. Harry learned via email from his IMA colleague Tom Sheridan that the State of Michigan was offering property tax relief credits on behalf of manufacturing plants in Wayne County for repurposing facilities formerly dedicated to the automotive and related industries. Harry shared this information with John Easton, and together they contacted the state treasurer regarding eligibility requirements. The company was potentially eligible for a 60% property tax credit that would reduce its payments: the state would require Bexley Box Company to pay 40% of the funding for the regular property tax bill and pay the city of Dearborn directly for the remainder. Considering Bexley Box Company's annual property tax bill was US$6 million, it was critical that the fledgling company secure the state support. The state requirement stipulated that the company hire at least 500 permanent full-time workers to be eligible for the subsidy that would be paid and amortized monthly. Though Harry's overhead calculations excluded the subsidy initially, John assured Harry that the company would realize the effects of it by year-end vs. the standard cost of SmileNow's boxes (see Table 1). John was convinced he would be able to increase the current head count of 1,500 by 500 employees to result in the 2,000 employees required to realize the tax relief. Table 1. Bexley Box Company's Monthly Fixed Overhead Pool Utilities Property Taxes Depreciation Insurance Total Monthly Fixed Overhead $1,000,000.00 500.000.00 3,000,000.00 1,500,000.00 $6,000,000.00 Normal Monthly Volume: 30,000,000 boxes; overhead is applied based on units produced Note: All monetary values are represented in US dollars The Bexley Box Company management team was convinced that SmileNow would provide the opportunity for growth and was committed to surpassing standard costs (see Table 2). By doing so, the company would not only realize additional profitability but also accumulate resources to augment capacity over time. This would be particularly advantageous since complementary growth alongside SmileNow would ultimately require expansion and capital expenditures, which would be realized after a short time if the standards were successively bested. Timely reporting thus became a distinct priority for Bexley Box Company's accounting staff. Staff meetings were held with the production area each week to reprise the outcomes of the most recently completed variance analysis reports from completed production runs and to discuss potential process enhancements that would result in incremental efficiency. Since the production runs were lengthy, a possibility existed that a significant amount of production time would clapse without monitoring and variance calculation; the window of opportunity for profitability was thus closed if unfavorable direct manufacturing variances were experienced. The operations and administrative staff convened and agreed that calculation and dissemination of weekly direct manufacturing variances would be desirable to address any inefficiency with alacrity. Accordingly, production and engineering would work to eliminate and rectify any problematic manufacturing issues that resulted in underperformance. Table 2. SmileNow Box Standard Cost Per Unit Material Labor Variable Overhead Fixed Overhead Total $0.10 0.18 0.02 0.20 0.50 Box sell price to SmileNow $0.75 ea. Note: All monetary values are represented in U.S. dollars Stan Kirby, Bexley Box Company's dedicated and valued production manager, was a close colleague of Harry; together they had weathered the storm resulting from the economic downturn and dearth of demand that affected Bexley Box Company's former sector and, unfortunately, culminated in several layoffs of middle management in prior years. Stan had discreetly revealed to Harry that he was considering leaving the company, since he could "hardly afford the mortgage payment, let alone save for my kids' education and my own retirement if I don't make my annual 20% bonus." Yet, Stan was very excited about the potential to meet budgeted operating income totals for the first time in years and once again be eligible for incentive pay. the John Easton was aware of the opportunity to provide an extra incentive for managers because of procurement of the SmileNow business. A stretch target was established that would provide for an extra 10% bonus for managers if actual operating income exceeded budgeted operating income of US$10 million by 10%. Though Harry was somewhat reticent to agree to this initially, as he was keenly aware of the potential to achieve this objective solely through the realization of favorable manufacturing variances, John convinced him that it would be advantageous to incentivize the staff and further enhance morale. As production meetings commenced and regular variance analysis reporting for materials and labor were reviewed for potential improvement, Bexley Box Company's employees became acclimated to the idiosyncrasies of manufacturing the new product line. Since there was significant automation in the manufacturing process, material and labor efficiency variances, in particular, were minimal. Labor consisted of removing and strapping die cut and finished units of cardboard from stacking units. These processes were automatically timed and controlled. Supplier prices for raw materials were predictable, resulting in negligible, if any, material purchase price variances. By the fourth quarter in October, processes were running smoothly, and the challenging learning curve was beaten. Incremental but immaterial favorable variances to standard continued to emerge periodically, as Bexley Box Company adhered to SmileNow's exacting standards for quality. Two months later, Harry and Stan were having lunch with Richard Girard, Bexley Box Company's top salesperson who had negotiated the contract between the company and SmileNow. Harry inquired of Richard, "What has Smile Now's reaction been to the new product? Have they been pleased with the quality?" Richard replied, "Absolutely! In fact, we are in discussions to potentially add volume in the form of other size boxes to our product line that we manufacture for SmileNow. Talks are in the beginning stages, naturally, but engineering is working on a model and developing a design presently." Stan chimed in, "That is terrific! I am so pleased that we finally have the opportunity to flourish as a plant again!" Richard agreed: "I believe we all must feel the same way!" Harry nodded in agreement. Harry spent the next week at an IMA regional conference to complete his yearly CPE requirements to maintain his CMA designation, where he once again greeted Tom Sheridan. Tom asked whether Harry had been able to apply and realize the tax relief offered through the Wayne County manufacturers' subsidy. Harry indicated that the company was working to increase volume through the new designs, and it was likely that Bexley Box Company would be able to take advantage of it. Harry thanked Tom for the information, as it was critical in incentivizing the staff. The following week was December month-end, and it was time for Harry and his staff to calculate the monthly variances for fixed overhead. Harry rationalized calculating fixed overhead variances once a month since it was difficult to approximate the applied overhead total and compare it to the fixed overhead components for spending that had been booked either through standard entries for depreciation or estimated monthly utility costs, as invoices often arrived late. But something caught his attention this time: the fixed overhead spending and production volume variances. He wondered what happened in the past week, while he was at the conference. As Harry looked at the production volume over the past two weeks, he noted that the SmileNow production runs' consistent output of 7.5 million boxes per week had increased to 10 million each week over that time. This resulted in millions of additional boxes manufactured for the month and within weeks of yearend. In disbelief, Harry went to the finished goods warehouse and found hundreds of pallets of corrugated SmileNow boxes waiting to be shipped. He called Richard and asked whether SmileNow had ordered an increased volume yet as he discussed. Richard replied, "No, we are still in talks. It would really not be the boxes that we are making presently that would be of interest-we are responsible for all of that volume, and demand is steady and regulated according to their needs. Any incremental volume would be of another size." Harry's next inquiry was directed to Stan, who immediately offered this explanation: "Yes, after our lunch conversation with Richard, I spoke to John Easton immediately. He agreed that it looked so promising that we could manufacture incremental volume. In fact, I am having my crews work three shifts to keep up with the volume. We even hired college students on a temporary basis to optimize the schedule." Harry said, "Stan, I just spoke to Richard, and SmileNow is not interested in purchasing more volume of the box we manufacture presently. They are looking to add volume in other sizes. We will have a serious cash flow problem now that the manufacturing schedule has bloated!" Stan became adamant: "Harry, we've all waited years to get a bonus again-including you! Most of all, John realizes this and wants us to have a great yearend. That's why he told me to proceed!" Because of the conversation with Stan, Harry then began reviewing the payroll expense for the last two weeks of December. Harry approached Alicia Monroe, Bexley Box Company's human resource manager, for more information. Alicia indicated that it was difficult to source employees for hire based on a piecework rate that mirrored the standard. Alicia was finally able to contract with an agency that employed 500 local college students who were on semester break for the last two weeks of December. These students were willing to work on the night shift temporarily at the negotiated all-inclusive rate of US$20/hour for a standard work week of 40 hours to manufacture the incremental volume. Harry walked into his office, locked the door behind him, and collapsed in his chair, pondering his course of action. As he viewed the paperwork that had accumulated on his desk, while he was at the IMA conference, he discovered a note from his payroll manager saying: "Provided the head count of 2,000 employees to State of Michigan for year end as requested per John Easton." Harry was greatly concerned regarding the production levels achieved and communications regarding the growth in production headcount to the state, while he was away from the office. He turns to you to help calculate the dollar impact of these events and to address directions from John Easton while abiding by the IMA Statement of Ethical Professional Practice. ABOUT IMA (INSTITUTE OF MANAGEMENT ACCOUNTANTS) IMA, the association of accountants and financial professionals in business, is a global professional association focused exclusively on advancing the management accounting profession. IMA supports the profession through research, teaching cases, the CMA (Certified Management Accountant) program, continuing education, networking and advocacy of the highest ethical business practices. IMA has a global network of more than 140,000 members in 140 countries and 300 professional and student chapters. For more information, please visit www.imanet.org. The memo should discuss the potential ethical (conflict of interest issues) associated with the overproduction of inventory at year end. In your discussion you should refer to the IMA Statement of Ethical Professional Practice (see chapter 1, Exhibit 1-7), consider the implications for the year-end audit, the impact on the performance bonus and tax credit. You should support your discussion with quantitative data as well as the proper reference to any authoritative source, if appropriate. The case materials provide both quantitative and qualitative information that you should use to produce the memo. Assumptions and clarifications for the information in the case: o Use the information in Table I to produce an estimate of the actual fixed overhead for December. Assume the only change will come from the amount of the tax credit. o Use the information in Table 2 and the information regarding the student employees to calculate the actual labor cost for the temporary worker by themselves. Items that you should be able to analyze as part of the exercise. The information in the case is enough to calculate FOH Variances (i.e., spending and volume) for the month of December. The information in the case is enough to calculate the effect on direct labor variances for the time the student-employees worked (i.e., last two weeks of December). You should be able to calculate the impact on the company's pre-tax profit of each of the variances calculated.. o You should be able to consider the effects of the overproduction associated with the use of absorption costing and the amount of FOH that might be deferred to future periods as part of the inventory. Your memo should include a discussion on: o Whether or not the effect of any variances in December help in achieving the stretch target. o There may be issues with the financial audit. There may be issues with the taxing authority regarding the tax credit. Harry's ethical and professional responsibility and his duty to all the stakeholders involved. At a minimum you should present Exhibits showing: o The calculation of FOH variances o DL variances and their potential impact on the company's profit. o Any other exhibits you may consider useful in driving your point. The body of the memo should not exceed one single spaced page with a 10 to 12-point font. Note that the exhibits should be attached to the memo and not be embedded in the one page write up. You are expected to reference the appropriate exhibits and data to support your conclusions. Exhibits should be attached to the memo and numbered in the order that are referenced in the memo. The submission should be done in one single document where you include the memo and the exhibits. Do not submit separate documents for the memo and the exhibits. Everything should be included in the same document. You may post questions regarding the case in the Ask Dr. Carlos page of Module 11. See the Rubric (below) for more guidance regarding the criteria that will be use to evaluate your work