Guochang Li was hired as chief executive officer (CEO) in late November by the board of directors of ContactGlobal, a company that produces an advanced global positioning system (GPS) device. The previous CEO had been fired by the board of directors due to a series of shady business practices including shipping defective GPS devices to dealers. Guochang felt that his first priority was to restore employee morale—which had suffered during the previous CEO’s tenure. He was particularly anxious to build a sense of trust between himself and the company’s employees. His second priority was to prepare the budget for the coming year, which the board of directors wanted to review in their December 15 meeting. After hammering out the details in meetings with key managers, Guochang was able to put together a budget that he felt the company could realistically meet during the coming year. That budget appears below:
The board of directors made it clear that this budget was not as ambitious as they had hoped. The most influential member of the board stated that ?omanagers should have to stretch to meet profit goals.?? After some discussion, the board decided to set a profit goal of $2,000,000 for the coming year. To provide strong incentives, the board agreed to pay out very substantial bonuses to top managers of $10,000 to $25,000 each if this profit goal was eventually met. The bonus would be all-or-nothing. If actual net operating income turned out to be $2,000,000 or more, the bonus would be paid. Otherwise, no bonus would be paid.
Required:
1. Assuming that the company does not build up its inventory (i.e., production equals sales) and its selling price and cost structure remain the same, how many units of the GPS device would have to be sold to meet the net operating income goal of $2,000,000?
2. Verify your answer to (1) above by constructing a revised budget and budgeted absorption costing income statement that yields a net operating income of $2,000,000.
3. Unfortunately, by October of the next year it had become clear that the company would not be able to make the $2,000,000 target profit. In fact, it looked like the company would wind up the year as originally planned, with sales of 400,000 units, no ending inventories, and a profit of $1,672,000.
Several managers who were reluctant to lose their year-end bonuses approached Guochang and suggested that the company could still show a profit of $2,000,000. The managers pointed out that at the present rate of sales, there was enough capacity to produce tens of thousands of additional GPS devices for the warehouse and thereby shift fixed manufacturing overhead costs to another year. If sales are 400,000 units for the year and the selling price and cost structure remain the same, how many units would have to be produced in order to show a profit of at least $2,000,000 under absorption costing?
4. Verify your answer to (3) above by constructing an absorption costing income statement.
5. Do you think Guochang Li should approve the plan to build ending inventories in order to attain the target profit?
6. What advice would you give to the board of directors concerning how they determine bonuses in thefuture?
[url=]View less »[/url]
1 Approved Answer
Kumud D answered on January 25, 2021
5 Ratings,(9 Votes)
[color=rgb(51, 51, 51) !important]Solution: 1) Units of the GPS device to be sold = (Fixed cost + Desired profit) / (Sales price - Variable cost) = (11448000 + 2000000) / (120 - 87.20) = 410,000 units
2) Revised budget under absorption costing income statement that yields a net operating income of $2,000,000: | Sales units | 410000 | | Production units | 410000 | | Sales value | 492,00,000 | | Cost of goods sold | 385,40,000 | | Gross profit | 106,60,000 | | Less: Selling and administrative expense | | | Variable | 41,00,000 | | Fixed | 45,60,000 | | Net operating income | 20,00,000 |
3) Additional profit required to meet the target = 2000000 - 1672000 = 328000 Fixed manufacturing overhead charge should be reduced by 328000 to meet the target therefore charge to COGS should be = 6888,000 - 328000 = 6560,000. Therefore setting up the below equation to get the the no of units to be produced: 6888000*400000 / x = 6560000 X = 420,000 Accordingly, 420000 units would have to be produced in order to show a profit of at least $2,000,000 under absorption costing.
4) Verification ofanswer to (3) above by constructing an absorption costing income statement as per below: | Sales units | 400000 | | Production units | 420000 | | Sales value | 480,00,000 | | Cost of goods sold | 374,40,000 | | Gross profit | 105,60,000 | | Less: Selling and administrative expense | | | Variable | 40,00,000 | | Fxed | 45,60,000 | | Net operating income | 20,00,000 |
5. Guochang Li should not approve the plan to build ending inventories to attain the target profit. Because build up of inventory will not be a good idea unless stock build up is justified as a matter of tactical planning for higher sales forecast for next year. Attempt to reduce this year COGS by producing more units will reverse in next year as in next year production has to bring down as company can not always produce more than salesand therefore next year COGS will be much higher and it will be difficult for Guochang Li to explain the loss or deteioration in profit. Accordingly it is advised toGuochang Li to be more business improvement driven and not to allow the over production.
6. Board of directors should close this loop hole by suitably amneding their bonus policies. One alternative is that bonus should be calculated using variable costing profitability. So production units has no impact on bonus calculation and bonus will depend on sales and operating efficiencies. Another alternative is to fix the inventory limits if company follows absorption costing system. So people will not have any room to interplay with inventory build up to claim the bonus.
|
|
