Reference no: EM13339301

Importance of cost classification

Bailey Manufacturing Company (BMC) was started when it acquired $40,000 by issuing common stock. During the first year of operations, the company incurred specifically identifiable product costs (materials, labor, and overhead) amounting to $24,000. BMC also incurred $16,000 of engineering design and planning costs. There was a debate regarding how the design and planning costs should be classified. Advocates of Option 1 believe that the costs should be classified as general, selling, and administrative costs. Advocates of Option 2 believe it is more appropriate to classify the design and planning costs as product costs. During the year, BMC made 4,000 units of product and sold 3,000 units at a price of $14 each. All transactions were cash transactions.

Required

1. Prepare an income statement, balance sheet, and statement of cash flows under each of the two options.
2. Identify the option that results in financial statements that are more likely to leave a favorable impression on investors and creditors.
3. Assume that BMC provides an incentive bonus to the company president equal to 10 percent of net income. Compute the amount of the bonus under each of the two options. Identify the option that provides the president with the higher bonus.
4. Assume a 35 percent income tax rate. Determine the amount of income tax expense under each of the two options. Identify the option that minimizes the amount of the company's income tax expense.
5. Comment on the conflict of interest between the company president as determined in Requirement c and the owners of the company as indicated in Requirement d. Describe an incentive compensation plan that would avoid a conflict of interest between the president and the owners.