Reference no: EM13491674

Question (1)Ethical Issues Surrounding Activity-Based Costing

Xavier Auto Parts, Inc. manufactures a wide range of auto parts, which it sells to auto manufacturers, primarily in the United States and Canada.^* The company's Engine Parts Division operated three plants in South Carolina and specialized in engine parts. The division's Charlotte plant manufactured some 6,500 different parts.

Trouble Brewing

Both the Engine Parts Division, as well as the Charlotte plant in particular, had shown satisfactory profitability for the past 20 years. In 2009, however, the Charlotte plant's profitability took a sharp downward turn, in spite of rising sales. The trend continued through the next several years. Management at both the division and plant levels took note of the plant's declining profits and held several strategy meetings as a result.

Division Strategy

The Engine Parts Division had always positioned itself as the industry's full-line producer. If a customer wanted a product, the division would make it. Although occasionally very-low-volume products were discontinued due to lack of consistent orders, the division's product line remained a full line of engine parts. As part of its strategy review, division management did two things. First, an activity-based costing study was initiated in the Charlotte plant in order to give management a better picture of each product line's profitability. Second, a high-level review was undertaken to determine whether the full-line-producer strategy continued to make sense.

Activity-based Costing

An ABC project team was formed, and a successful pilot study was conducted on two of the Charlotte plant's product lines. Then the ABC project was extended to the entire Charlotte operation. Management was astonished to find that fully a quarter of the plant's products were selling at a loss. Moreover, the ABC project highlighted the extent of the product-line proliferation at the Charlotte plant. It turned out that in many instances, unprofitable products had been dropped only to creep back into the product line-up after a customer requested it and a salesperson acquiesced. It became a joke around the plant that the only way to be sure a dropped product was really gone was to burn the engineering drawings and destroy the special tools required to make it.

ABC Team Recommendations

The ABC project team made sweeping recommendations to division management, which suggested that the Charlotte plant's product lines be pruned and that roughly 20 percent of its products be dropped. New emphasis would then be devoted to increasing the profitability of the remaining 80 percent of the Charlotte plant's products. Attention would be given to identifying inefficient processes, and process improvements would be evaluated.

Top management balked at the recommendations of the ABC project team. Some top managers did not believe the ABC results. It just seemed impossible to them that so many of the Charlotte plant's products were losers. Other members of the management team largely accepted the validity of the ABC study, but they, too, hesitated to drop so many products. To do so would most likely have meant massive layoffs and even the possibility of closing the Charlotte plant altogether, while shifting its remaining production to the division's other two plants. Some members of the ABC project team quietly speculated that some of the division's managers were more concerned about their own pay and perks than they were about the well-being of the division. In the final analysis, only a handful of products were dropped, and then only if they were suspected to be unprofitable before the ABC study was undertaken.

Aftermath

The Charlotte plant's profits continued to deteriorate, as did the Engine Parts Division's profitability. Eventually, Xavier's corporate management cut its losses by selling off the Engine Parts Division to a competitor at bargain-basement prices. The division's new owners closed the Charlotte plant and changed the division's focus to be a boutique producer of high-quality engine parts, which was more in line with its own corporate strategy.

Question: What ethical issues do you see in this scenario? How would you resolve them?

Question (2) INCENTIVE TO OVERPRODUCE INVENTORY

 The absorption of fixed overhead costs as part of the cost of inventory on the balance sheet presents ethical challenges because it provides the opportunity to manipulate reported income. This classic case is based on an actual company's experience. *

Brandolino Company uses an actual-cost system to apply all production costs to units produced. The plant has a maximum production capacity of 40 million units but during year 1 it produced and sold only 10 million units. There were no beginning or ending inventories. The company's absorption-costing income statement for year 1 follows:

BRANDOLINO COMPANY

Income Statement: For Year 1

Sales (10,000,000 units at $6)............................. $ 60,000,000

Cost of goods sold:

  Direct costs (material and labor) (10,000,000 at $2) ................... $ 20,000,000

 Manufacturing overhead ............  48,000,000       68,000,000

Gross margin ....................................................... $   (8,000,000)

Less: Selling and administrative expenses..............             10,000,000

Operating income (loss) ........................................ $(18,000,000)

*This scenario is based on the case "I Enjoy Challenges," originally written by Michael W. Maher. It is used here with permission.  The board of directors is upset about the $18 million loss. A consultant approached the board with the following offer: "I agree to become president for no fixed salary. But I insist on a year-end bonus of 10 percent of operating income (before considering the bonus)." The board of directors agreed to these terms and hired the consultant as Brandolino's new president. The new president promptly stepped up production to an annual rate of 30 million units. Sales for year 2 remained at 10 million units. The resulting absorption-costing income statement for year 2 ?s displayed in the right-hand column.

 The day after the year 2 statement was verified, the president took his check for $1,400,000 and resigned to take a job with another corporation. He remarked, "I enjoy challenges. Now that Brandolino Company is in the black, I'd prefer tackling another challenging situation." (His contract with his new employer is similar to the one he had with Brandolino Company.)

Question: What do you think is going on here? How would you evaluate the company's year 2 performance? Using variable costing, what would operating income be for year 1? For year 2? (Assume that all selling and administrative costs are committed and unchanged.) Compare those results with the absorption-costing statements. Comment on the ethical issues in this scenario.

BRANDOLINO COMPANY

Income Statement: For Year 2

Sales (10,000,000 units at $6)  .................................. $60,000,000

Cost of goods sold:

 Costs of goods manufactured:

   Direct costs (material and labor) (30,000,000 at $2)................. $ 60,000,000

  Manufacturing overhead  ..........  48,000,000

   Total cost of goods manufactured  ......................... $108,000,000

Less: Ending inventory:

   Direct costs (material and labor) (20,000,000 at $2)................. $ 40,000,000

   Manufacturing overhead (20/30 3 $48,000,000)  .........  32,000,000

  Total ending inventory costs ...... $ 72,000,000

Cost of goods sold.....................................................    36,000,000

Gross margin.............................................................. $24,000,000

Less: Selling and administrative expenses ...................  10,000,000

Operating income before bonus .................................. $14,000,000

Bonus .......................................................................    1,400,000

Operating income after bonus ..................................... $12,600,000