- Question: What is the central ethical conflict in this case?
- How would you have responded to the conflict in question?
- What complications or "gray areas" do you identify?
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: BRANDOLINO COMPANY Income Statement For Year 1 Sales (10,000,000 units at $6) $ 60,000,000 Cost of goods sold: Direct costs (material and labor) (10,000,000 at $2) $ 20,000,000 Manufacturing overhead 48.000.000 68,000,000 Gross margin S (8.000.000) Less: Selling and administrative expenses 10,000,000 Operating income (loss) $(18,000,000) The board of directors is upset about the $18 million loss. A consultant approached the board with the following offer: "I agree to become president for no fixed salary. But I insist on a year-end bonus of 10 percent of pre-bonus operating income." 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) S 60.000.000 Manufacturing overhead 48,000,000 $ 108,000,000 Total cost of goods manufactured 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 10,000,000 Operating income before bonus $14.000.000 Bonus 1.400.000 Operating income after bonus $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.) 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: BRANDOLINO COMPANY Income Statement For Year 1 Sales (10,000,000 units at $6) $ 60,000,000 Cost of goods sold: Direct costs (material and labor) (10,000,000 at $2) $ 20,000,000 Manufacturing overhead 48.000.000 68,000,000 Gross margin S (8.000.000) Less: Selling and administrative expenses 10,000,000 Operating income (loss) $(18,000,000) The board of directors is upset about the $18 million loss. A consultant approached the board with the following offer: "I agree to become president for no fixed salary. But I insist on a year-end bonus of 10 percent of pre-bonus operating income." 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) S 60.000.000 Manufacturing overhead 48,000,000 $ 108,000,000 Total cost of goods manufactured 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 10,000,000 Operating income before bonus $14.000.000 Bonus 1.400.000 Operating income after bonus $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.)
