Scott Hewitt, the new plant manager of Old World Manufacturing plant Number 7, h

Question

Scott Hewitt, the new plant manager of Old World Manufacturing plant Number 7, has just reviewed a draft of his year-end financial statements. Hewitt receives a year-end bonus of 10% of the plant's operating income before tax. The year-end income statement provided by the plant's controller was disappointing to say the least. After reviewing the numbers, Hewitt demanded that his controller go back and "work the numbers" again. Hewitt insisted that if he didn't see a better operating income the next time he would be forced to look for a new controller. Old World 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. Hewitt 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 Hewitt happy. Required: 1. What are the ethical issues involved? 2. Show numerically how operating income would improve by $325,000 just by classifying the preceding costs as product costs instead of period expense? 3. Is Hewitt correct in his justification that these costs "are definitely related to our product"

Explanation / Answer

1. The ethical issues involved are that:

a. There is violation of the relevant accounting standard pertaining to the valuation of inventories, which categorically disallows treating warehousing and storage costs of finished goods inventories as product costs. They should be treated as period expenses.

b. Treating the warehousing cost as product cost would increase the cost assigned to ending inventory, resulting in overstatement of operating income. Not only will this convey a distorted view to the users of the financial statements, it will also lead to higher tax liability for the company. The only person who stands to gain from the earnings management is the plant manager Scott Hewitt in terms of enhanced bonus and job security.

2. Sales - Cost of Goods Sold = Gross Margin

Cost of Goods Sold = Beginning Inventory of Finished Goods + Cost of Goods Manufactured - Ending Inventory of Finished Goods.

Gross Margin - Period Expenses = Net Operating Income

If the entire warehousing cost is treated as product cost, it becomes a part of cost of goods manufactured. Since 200,000 units were produced, and only 180,000 units sold, the amount of the cost that is treated as an expense for the current period = $ 3,250,000 x 180,000 / 200,000 = $ 2,925,000. The remaining $ 325,000 is deferred to the next accounting period in unsold ending inventory. This results in an understatement of cost of goods sold by $ 325,000, and a commensurate overstatement of operating income.

On the other hand, if the warehousing cost is treated as a period expense, the full $ 3,250,000 will be deducted from gross margin. There would be no scope for deferring any part of the expense to the next accounting period.

In a nutshell:

If the warehousing cost is treated as product cost, the current accounting period bears the brunt to the extent of $ 2,925,000 only.

If the warehousing cost is treated as period expense, the current accounting period bears the brunt of the entire $ 3,250,000.

3. Hewitt is not incorrectin his justification. But these costs are not manufacturing costs. These are post manufacturing costs, and hence are not inventoriable costs.

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