2. Does Bieler want Delirion to increase or decrease the estimated percentage completion? Explain why — Jason and Nancy are production managers Appliances Division Meester

Jason Bieler and Nancy Delirion are production managers in the Appliances Division of Meester Corporation, which has several dozen plants scattered in locations throughout the world. Delirion manages the plant in Toronto, while Bieler manages the plant in Vancouver. Production managers are paid a salary and get an additional bonus equal to 10% of their base salary if the entire division meets or exceeds its target profits for the year. The bonus is determined in March after the company’s annual report has been prepared and issued to shareholders.

Required:

1. Janovski estimated that the units in ending inventory in the final processing department were 25% complete with respect to the conversion costs of the final processing department. If this estimate of the percentage completion is used, what will be the cost of goods sold for the year?

2. Does Bieler want Delirion to increase or decrease the estimated percentage completion? Explain why.

3. What percentage completion figure would result in increasing the reported operating income by $62,500 over the operating income that would be reported if the 25% figure were used?

4. Do you think Delirion should go along with the request to alter estimates of the percentage completion? Why or why not?

SOLUTION

This case is difficult particularly part 3, which requires analytical skills.

Because there are no beginning inventories, it makes no difference whether the weighted-average or FIFO method is used by the company. You may choose to specify that the FIFO method be used rather than the weighted-average method.

Computation of the Cost of Goods Sold:
	Transferred In	Conversion
Units completed and sold	250,000	250,000
Ending work in process:
Transferred in: 20,000 units × 100% complete	20,000
Conversion: 20,000 units × 25% complete		5,000
Equivalent units of production	270,000	255,000

		Transferred In	Conversion
	Cost of beginning work in process	$ 0	$ 0
	Cost added during the period	49,221,000	16,320,000
	Total cost (a)	$49,221,000	$16,320,000
	Equivalent units of production (b)	270,000	255,000
	Cost per equivalent unit, (a) ÷ (b)	$182.30	$64.00
		Cost of goods sold = 250,000 units × ($182.30 + $64.00) per unit = $61,575,000.
	2.	The estimate of the percentage completion of ending work in process inventories affects the unit costs of finished goods and therefore the cost of goods sold. Jason Bieler would like the estimated percentage completion of the ending work in process to be increased. The higher the percentage of completion of ending work in process, the higher the equivalent units for the period and the lower the unit costs.
3.	Increasing the percentage of completion can increase operating income by reducing the cost of goods sold. To increase operating income by $62,500, the cost of goods sold would have to be decreased by $62,500 from $61,575,000 down to $61,512,500. See the next page for the necessary calculations.

The percentage of completion, X, affects the cost of goods sold by its effect on the unit cost, which can be determined as follows:

Unit cost = $182.30 + $16,320,000/250,000+20,000X

And the cost of goods sold can be computed as follows:

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Cost of goods sold = 250,000 × Unit cost

Since cost of goods sold must be reduced down to $61,512,500, the unit cost must be $246.05 ($61,512,500 ÷ 250,000 units). Thus, the required percentage completion, X, to obtain the $62,500 reduction in cost of goods sold can be found by solving the following equation:

$182.30+$16,320,000/250,000+20,000X =$246.05

$16,320,000/250,000+20,000X =$246.05-$182.30

$16,320,000/250,000+20,000X =$63.75

250,000+20,000X/$16,320,000 =1/$63.75

250,000+20,000X =$16,320,000/$63.75

250,000+20,000X =256,000

20,000X = 256,000 – 250,000

20,000X = 6,000

Thus, changing the percentage completion to 30% will decrease cost of goods sold and increase net operating income by $62,500 as verified on the next page.

X = 6,000/20,000 = 30%

Computation of the Cost of Goods Sold:
	Transferred In	Conversion
Units completed and sold	250,000	250,000
Ending work in process:
Transferred in: 20,000 units × 100% complete	20,000
Conversion: 20,000 units × 30% complete		6,000
Equivalent units of production	270,000	256,000

	Transferred In	Conversion
Cost of beginning work in process	$ 0	$ 0
Cost added during the period	49,221,000	16,320,000
Total cost (a)	$49,221,000	$16,320,000
Equivalent units of production (b)	270,000	256,000
Cost per equivalent unit, (a) ÷ (b)	$182.30	$63.75
	Cost of goods sold = 250,000 units × ($182.30 per unit + $63.75 per unit) = $61,512,500.
4.	Nancy is in a very difficult position. Collaborating with Jason Bieler in subverting the integrity of the accounting system is unethical by almost any standard. To put the situation in its starkest light, Bieler is suggesting that the production managers lie in order to get their bonus. Having said that, the peer pressure to go along in this situation may be intense. It is difficult on a personal level to ignore such peer pressure. Moreover, Nancy probably prefers not to risk alienating people she might need to rely on in the future. On the other hand, Nancy should be careful not to accept at face value Bieler’s assertion that all of the other managers are “doing as much as they can to pull this bonus out of the hat.” Those who engage in unethical or illegal acts often rationalize their own behaviour by exaggerating the extent to which others engage in the same kind of behaviour. Other managers may actually be very uncomfortable “pulling strings” to make the target profit for the year.
	From a broader perspective, if the profit figures reported by the managers in a division cannot be trusted, then the company would be foolish to base bonuses on the net profit figures. A bonus system based on divisional profits presupposes the integrity of the accounting system.

The company should perhaps reconsider how it determines the bonus. It is quite common for companies to pay an “all or nothing” bonus contingent on making a particular target. This inevitably creates powerful incentives to bend the rules when the target has not quite been attained. It might be better to have a bonus without this “all or nothing” feature. For example, managers could be paid a bonus of x% of profits above target profits rather than a bonus that is a preset percentage of their base salary. Under such a policy, the effect of adding that last dollar of profits that just pushes the divisional net profits over the target profit will add a few pennies to the manager’s compensation rather than thousands of dollars. Therefore, the incentives to misstate the operating income are reduced. Why tempt people unnecessarily?