It's approaching year-end, and your president has asked you, the management accountant, to visit his office for a heart-to-heart talk. After he closes the door, he tells you that profits for the year will end up below plan and that he's disappointed.
He had just returned from his normal Friday country club lunch with other local manufacturing company executives. He tells you that some of his peers had frankly mentioned the same problem with their companies, and that one of them had whispered the following in his ear:
I learned something new from my management accountant. Before the year started he had us change from a variable costing system to an absorption costing system. Because of that, as we approached this year's end and were a little behind in profitability, we increased our production, even though we didn't have orders. As a result, our profits improved on our reported income statement.
The president asked you to explain all of this to him so together you could decide whether to do the same thing, if needed, at the end of next year to improve profitability.
In a report to him include the following information:
•What exactly is absorption costing vs. variable costing?
•In your opinion, describe whether you think overproducing is an ethical practice and why or why not. Include discussion of which stakeholders might react, and how they would react if they knew about this practice.
•Using the following data, calculate the difference between reported income and unit costs under absorption and variable costing by answering these questions:
1.How many units of production were
■produced?
■shipped?
■left in inventory?
2.What is this firm's predetermined fixed overhead rate?
3.How much of the firms fixed costs stayed in inventory
■under variable costing?
■under absorption costing?
4.Calculate the unit cost
■using variable costing.
■using absorption costing.
5.Based on this firm's predetermined fixed overhead rate, how much of the firms fixed costs ended up on the year's COGS and income statement
■under variable costing?
■under absorption costing?
6.Under which method (variable or absorption costing), will reported profits be higher? Explain why.
To address your query, let's first explain what absorption costing and variable costing are:
Absorption Costing: This method assigns all manufacturing costs, both variable and fixed, to the units produced. It includes direct materials, direct labor, variable overhead, and fixed overhead costs. Under absorption costing, these costs are absorbed into the inventory and not fully recognized until the goods are sold.
Variable Costing: This approach only considers the variable costs of production, such as direct materials, direct labor, and variable overhead. Fixed overhead costs are treated as period expenses and are not allocated to inventory. They are directly deducted as expenses in the period incurred.
Now, let's discuss the ethical implications of overproducing and its potential impact on stakeholders:
Overproducing is generally considered an unethical practice because it can lead to significant negative consequences. It distorts financial statements by artificially inflating reported profits and can mislead stakeholders. Stakeholders, such as investors, creditors, and employees, rely on accurate financial information to make informed decisions. If they were aware of this practice, it could damage their trust and confidence in the company.
It's important to note that stakeholders may react differently based on their positions and interests. For instance:
- Investors might react negatively as the artificially inflated profits could be deceptive, leading to incorrect investment decisions.
- Creditors may become concerned about the company's financial health, leading to possible changes in loan terms or higher interest rates.
- Employees may also be affected as the overproduction may not align with market demand, potentially leading to layoffs or reduced job security.
Now, let's move on to the calculations requested using the given data:
1. The data needed to determine the units produced, shipped, and left in inventory is not provided in the question, so we are unable to provide the precise figures for these quantities.
2. The predetermined fixed overhead rate is also not mentioned, so we cannot calculate it without this information.
3. Similarly, we cannot determine the exact amount of fixed costs that stayed in inventory under variable costing and absorption costing without knowing the predetermined fixed overhead rate and the actual fixed costs incurred.
4. Without the predetermined fixed overhead rate, we cannot calculate the unit cost using either variable costing or absorption costing.
5. Since the predetermined fixed overhead rate is not given, we cannot determine how much of the firm's fixed costs ended up on the year's COGS and income statement under variable costing and absorption costing.
6. Determining which method, variable or absorption costing, would result in higher reported profits depends on several factors, including the relationship between production levels and sales, the difference in fixed costs allocated to inventory, and the timing of recognizing fixed costs in the income statement. Without the specific data required, it is not possible to determine which method would result in higher reported profits in this scenario.
In summary, while we can provide an explanation of absorption and variable costing and discuss the ethical implications of overproduction, we are unable to perform the calculations or answer some of the questions due to missing data.