Inventories Under Absorption Costing McCray, Inc manufactures control panels for the electronics industry and has just completed its first year of operations The following discussion took place between the controller, Charles Roehm, and the company president, Michelle Iacovou Michelle I' ve been looking over our first year' s performance by quarters Our earnings have been increasing each quarter, even though our sales have been flat and our prices and costs have not changed Why is this Charles Our actual sales have stayed even throughout the year, but we' ve been increasing the utilization of our factory every quarter By keeping our factory utilization high, we will keep our costs down by allocating the fixed plant costs over a greater number of units Naturally, this causes our cost per unit to be lower than it would be otherwise Michelle Yes, but what good is this if we have been unable to sell everything that we make Our inventory is alsoincreasing Charles This is true However, our unit costs are lower because of the additional production When these lower costs are matched against sales, it has a positive impact on our earnings Michelle Are you saying that we are able to create additional earnings merely by building inventory Can this be true Charles Well, I' ve never thought about it quite that way but I guess so Michelle And another thing What will happen if we begin to reduce our production in order to liquidate the inventory Don' t tell me our earnings will go down even though our production effort drops Charles Well Michelle There must be a better way I' d like our quarterly income statements to reflect what' s really going on I don' t want our income reports to reward building inventory and penalize reducing inventory Charles I' m not sure what I can dowe have to follow generally accepted accounting principles Why does reporting income under generally accepted accounting principles reward building inventory and penalize reducing inventory What advice would you give to Charles in responding to Michelle' s concern about the present method of profit reporting

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Inventories Under Absorption Costing McCray, Inc. manufactures control panels for the electronics industry and has just completed its first year of operations. The following discussion

Inventories Under Absorption Costing

McCray, Inc. manufactures control panels for the electronics industry and has just completed its first year of operations. The following discussion took place between the controller, Charles Roehm, and the company president, Michelle Iacovou:

Michelle: I' ve been looking over our first year' s performance by quarters. Our earnings have been increasing each quarter, even though our sales have been flat and our prices and costs have not changed. Why is this?

Charles: Our actual sales have stayed even throughout the year, but we' ve been increasing the utilization of our factory every quarter. By keeping our factory utilization high, we will keep our costs down by allocating the fixed plant costs over a greater number of units. Naturally, this causes our cost per unit to be lower than it would be otherwise.

Michelle: Yes, but what good is this if we have been unable to sell everything that we make? Our inventory is alsoincreasing.

Charles: This is true. However, our unit costs are lower because of the additional production. When these lower costs are matched against sales, it has a positive impact on our earnings.

Michelle: Are you saying that we are able to create additional earnings merely by building inventory? Can this be true?

Charles: Well, I' ve never thought about it quite that way but I guess so.

Michelle: And another thing. What will happen if we begin to reduce our production in order to liquidate the inventory? Don' t tell me our earnings will go down even though our production effort drops!

Charles: Well

Michelle: There must be a better way. I' d like our quarterly income statements to reflect what' s really going on. I don' t want our income reports to reward building inventory and penalize reducing inventory.

Charles: I' m not sure what I can dowe have to follow generally accepted accounting principles.
1. Why does reporting income under generally accepted accounting principles reward building inventory and penalize reducing inventory?
2. What advice would you give to Charles in responding to Michelle' s concern about the present method of profit reporting?