It is December 15 and Jane Jones, the plant manager at Acme Electric Fan Co., faces a difficult decision. The operation has been running steadily over the last 11 months. During that time, Jane worked with the production engineers to tweak the production machinery just enough to allow for a small increase in available capacity. The plant produced 18,000 fans between January and the end of November and is scheduled to produce 2,000 fans in the month of December. The sales manager indicates that all 20,000 fans will be sold by the end of the year. Jane realizes the extra investment in engineering costs will allow the plant to produce an extra 500 fans in December. Cost and pricing information are provided below:
Inventory holding costs are negligible, and customers have been known to place unexpected special orders that are typically difficult to fill. Jane figures a small safety stock of 500 fans would provide a cushion against future special orders. Even so, Jane is torn about the decision to produce the 500 additional fans. Her performance is evaluated mainly by the profit generated by the plant. In addition, her year-end bonus is based on profitability of the plant Jane is worried that incurring the extra costs will have a negative effect on plant profitability.
Required:
Take on the role of the plant accountant and provide Jane with the analysis she needs to make an informed decision. Assuming the company utilizes absorption costing, analyze the effect of producing the additional 500 fans on plant profitability and on Jane’s bonus, and recommend a course of action?
🔒
Unlock the complete assignment
You are viewing the free preview. Purchase this assignment once to reveal the complete resource.
$9.99 USD
Secure checkout is completed by Stripe.
SOLUTION
Memo
To: Ms. Jane Jones, Plant Manager
From: Plant Accountant, Acme Electric Fan Co.
RE: Production beyond the planned 20,000 fans this year
I have prepared this memo in response to your question concerning the effect of producing an extra 500 fans this year. As indicated at our recent meeting, the obvious issue when producing units beyond what can be sold is the cost of holding the extra units in inventory. We have determined that the extra inventory holding costs related to the 500 fans would be negligible so let’s move on to the effect of incurring the extra production costs without also realizing sales revenues related to these units before the end of the year. You expressed concern that this decision might have a negative effect on plant profitability. To help you to make this decision, I provide the following analysis:
Assume you decided to make the extra 500 fans:
Sales (20,000 units x $12)
$240,000
Cost of goods sold:
Beginning inventory
-0-
Add cost of goods manufactured:
20,500 units x ($3+2+1+ 3*)
184,500
Less: Ending inventory (500 x $9)
(4,500)
Cost of goods sold
180,000
Gross margin
60,000
Less Variable selling costs
($1 x 20,000)
20,000
Net income
$40,000
*$3 = $61,500 fixed costs ÷ 20,500 units produced
Without the additional 500 fans, net income would be as follows:
Sales (20,000 units x $12)
$240,000
Cost of goods sold:
Beginning inventory
-0-
Add cost of goods manufactured:
Variable manufacturing costs: 20,000 units x ($3+2+1)
$120,000
Fixed manufacturing costs
61,500
Less: Ending inventory
-0-
Cost of goods sold
181,500
Gross margin
58,500
Less Variable selling costs
($1 x 20,000)
20,000
Net income
$38,500
* Note the $61,500 fixed costs are spread over fewer units in this scenario so that the cost per unit increases to $3.08 ($61,500 ÷ 20,000 units produced)
As you can see from this analysis, profits are actually higher when the extra 500 fans are produced. This can be explained by our use of an absorption costing system. This system is designed to match costs with revenues generated; therefore, the $1500 in fixed costs related to producing the extra fans is held back in the Ending Inventory account (an asset on the Balance Sheet) until next period when the fans are sold. At that point, the costs will move out of ending inventory and will be included in cost of goods sold.
Based on my analysis of the effect on profits, the fact that holding costs are negligible and that unexpected orders that would otherwise upset the production schedule are sometimes issued by customers, I would recommend that you produce and hold in inventory the additional 500 fans.