Question

3. (20 points) Lance Inc. is experiencing a buildup of inventory on an annual basis. Lance has hired you to help understand why this is happening and how to correct it. Lance believes they have a competent management team that generates excellent results with respect to net income. Lance compensates its management team with both a competitive salary and bonus based on achieving a target net income. Lance Inc. has provided the following data for 2018: Direct materials $10 per unit Direct labor $15 per unit Variable manufacturing overhead $20 per unit Fixed manufacturing overhead $25,000 per year Fixed selling and administrative costs $15,000 per year Sale price $75 per unit Beginning inventory 500 units Units produced 5,000 units Units sold 4,500 units Required: a) What are the possible reasons Lance is experiencing inventory buildup? You must support your answer. b) What suggestion(s) do you have for Lance?

Answer 1

Answer (a):

Given:

Ending inventory = Beginning inventory + Units produced - Units sold = 500 + 5000 - 4500 = 1000 units

This shows that ending inventory of finished goods is double of beginning inventory of 500 units.

Reason why Lance is experiencing inventory buildup:

The primary reason for inventory built up is:

Lance compensates its management team with both a competitive salary and bonus based on achieving a target net income.

As the bonus is based on a target income, the management team is resorting to increase production (higher than what can sell) to increase net income resulting in built up of inventory.

As the companies follows absorption costing, fixed manufacturing overhead is differed based on quantity of finished goods.

Workings to support above answer:

Let us calculate operating income based on absorption costing.

Total variable cost per unit = $10 + $15 + $20 = $45

Hence:

Under absorption costing:

$337,500 Sales Revenue Cost of Goods sold: Variable cost (4500 * 75) Fixed mnaufacturing cost (25000/5000 * 4500) Gross profit Fixed selling and administrative costs Operating Income $202,500 $22,500 $225,000 $112,500 $15,000 $97,500

If we use variable costing:

$337,500 Sales Revenue Cost of Goods sold: Variable cost (4500 * 75) Contribution Fixed manaufacturing cost Fixed selling and administrative costs Operating Income $202,500 $135,000 $25,000 $15,000 $95,000

The reason for difference in operating profit under variable costing and operating profit under absorption costing is higher finished goods. Since units produced is higher than units sold by 500 units, portion of fixed manufacturing overhead (25000/5000 * 500 =) $2,500 has been effectively differed to next year. As such built up of finished goods inventory by 500 units has resulted in increase in operating income by $2,500. This will result in higher net income and higher bonus.

Answer (b):

Lance should change the basis of bonus from net income to residual income. This will effectively address the situation since if the management team tries to produce higher than what they can sell, this may increase net income but will reduce residual income since increase in inventory will increase capital charges and reduce residual income.