Question

Wendy Jackson, the new plant manager of Binary Manufacturing has just reviewed a draft of his year-end statements. Wendy receives a year-end bonus of 10% of the plant operating income before tax. The year-end income statement provided by the plant controller was disappointing to say the least. After reviewing the numbers, Wendy demanded that his controller "go back and work the numbers" again. Wendy insisted that if he did not see a better operating income the next time he would be forced to look for a new controller. Binary Manufacturing classifies all costs directly related to the manufacturing of its product as product costs. These costs are inventoried and later expensed as costs of goods sold when the product is sold. All other expenses, including finished goods warehousing costs of $3250000 are classified as period expenses. Wendy had suggested that warehousing costs be included as product costs because they are definitely related to our product" The company produced 200,000 units during the period and sold 180,000 units. As the controller reworked the numbers he discovered that if he included warehousing costs as product costs, he could improve operating income by $325,000. He was also sure that these new numbers would make Wendy happy. Required: 1. Show numerically how operating income would improve by $325,000 just by classifying the preceding costs as product costs instead of period expense? 2. Is Wendy correct in his justification that these costs are definitely related to our product", 3. What should the plant controller do?

Answer 1

a)
If the $3,250,000 is treated as period costs, the entire amount would be expensed during the year as incurred.  If it is treated as a product cost, it would be “unitized” at $16.25 per unit and expensed as each unit of the product is sold.
Warehousing costs per unit = Warehousing costs/ units produced
Warehousing costs per unit = $3,250,000/200,000	$          16.25
if only 180,000 of the 200,000 units are sold, only $2,925,000 ($16.25 per unit × 180,000 units) of the $3,250,000 would be expensed in the current period.
The remaining $3,250,000 – $2,925,000 = $325,000 would be inventoried on the balance sheet until a later period when the units are sold.
The value of finished goods inventory can also be calculated directly to be  ($16.25 per unit × 20,000 units)	$ 325,000.00
b)
No, Wendy is not correct in his justification that these costs are definitely related to our product" because with respect to classifying costs as product or period costs, this determination is made by GAAP.GAAP requires that research and development, as well as all costs related to warehousing and distribution of goods,Operating Expenses, or Selling, General, and Administrative Expenses be classified as period costs and expensed in the period they are incurred.The product  costs are not expensed until the product is sold. Operating Expenses, or Selling, General, and Administrative Expenses
c)
The controller should not reclassify costs as product costs just so the plant can reap short- term benefits, including the increase in Wendy’s personal year-end bonus. Research and development costs, costs related to the shipping of finished goods, and costs related to warehousing finished goods are all period costs under GAAP and must be treated as such.Changing this classification on Binary’s financial statements would violate GAAP and would likely be considered fraudulent.The controller should insist that he must adhere to GAAP so as not to submit fraudulent financial statements to corporate headquarters. If Wendy insists on the reclassification, the controller should raise the issue with the chief financial officer after informing Wendy that he is doing so.If, after taking all these steps, there is continued pressure to modify the numbers, the controller should consider resigning from the company rather than engage in unethical behavior.