Chapter 7, Problem 2TIF

Inventory effects under absorption costing

BendOR, 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, Gordon Merrick, and the company president, Matt McCray:

Matt: 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?

Gordon: 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.

Matt: Yes, but what good is this if we are unable to sell everything that we make? Our inventory is also increasing.

Gordon: 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.

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

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

Matt: 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!

Gordon: Well. . .

Matt: 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.

Gordon: I’m not sure what I can do—we have to follow generally accepted accounting principles.

In teams:

1. a. Discuss why reporting income under generally accepted accounting principles “rewards” building inventory and “penalizes” reducing inventory.
2. b. Discuss what advice you would give to Gordon in responding to Matt’s concern about the present method of accounting. Be prepared to discuss your answers in class.