Problem 4-27 Incentives Created by Absorption Costing; Ethics and the Manager

Carlos Cavalas, the manager of Echo Products Brazilian Division, is trying to set the production schedule for the last quarter of the year. The Brazilian Division had planned to sell 3,600 units during the year, but by September 30 only the following activity had been reported:

	Units
Inventory, January 1	0
Production	2,400
Sales	2,000
Inventory, September 30	400

The division can rent warehouse space to store up to 1,000 units. The minimum inventory level that the division should carry is 50 units. MR. Cavalas is aware that production must be at least 200 units per quarter in order to retain a nucleus of key employees. Maximum production capacity is 1,500 units per quarter.

Demand has been soft, and the sales forecast for the last quarter is only 600 units. Due to the nature of the divisions operations, fixed manufacturing overhead is a major element of product cost.

Required:

1. Assume that the division is using variable costing. How many units should be scheduled for production during the last quarter of the year? (The basic formula for computing the required production for the quarter is: Required production = Expected sales + Desired ending inventory Beginning inventory) Show computations and explain your answer. Will the number of units scheduled for production affect the divisions reported income or loss for the year? Explain.

2. Assume that the division is using absorption costing and that the divisional manager is given an annual bonus based on divisional operating income. If Mr. Cavalas wants to maximize his divisions operating income for the year, how many units should be scheduled for production during the last quarter? Explain

3. Identify the ethical issues involved in the decision Mr. Cavalas must make about the level of production for the last quarter of the year.