M.K. Gallant is President of Kranbrack Corporation, a company whose stock is traded on a national exchange. In a meeting with investment analysis at the beginning of the year, Gallant had predicted that the company’s earnings would grow by 20% this year.

Case 1

M.K. Gallant is President of Kranbrack Corporation, a company whose stock is traded on a national exchange.  In a meeting with investment analysis at the beginning of the year, Gallant had predicted that the company’s earnings would grow by 20% this year.  Unfortunately, sales have been less than expected for the year, and Gallant concluded within two weeks of the end of the fiscal year that it would be impossible to ultimately report an increase in earnings as large as predicted unless some drastic action was taken.  Accordingly, Gallant has ordered that whenever possible, expenditures should be postponed to the new-year-including cancelling or postponing orders with suppliers, delaying planned maintenance and training, and cutting back on end-of-year advertising and travel.  Additionally, Gallant ordered the company’s controller to carefully scrutinize all costs that are currently classified as period costs and reclassify as many as possible as product costs.  The company is expected to have substantial inventories at the end of the year.

Required:

1.      Why would reclassifying period costs as product costs increase this period’s reported earnings?

Period Costs are costs that are not necessary in the manufacturing/making of a product. These are expenses made by selling/advertising or for the administrative part of the company. These costs are classified as an expense in the current period on the income statement.

On the other hand, Product Costs are recognized as the company’s direct materials, direct labour and manufacturing overhead in making a product. Product Costs are treated as part of the company's inventory. These costs will be recognized only as an expense when the products are sold. If, for example, a number of unit is not sold, these are considered as company’s current assets on the Balance Sheet.

By reclassifying period costs as product costs, the company will be able to carry some expenses to be current assets on inventories and on the Balance Sheet. He will increase the period's earnings on his report since M.K Gallant will be able to lessen the expenses and increase assets. Changing period costs to product costs, however, improves how a company looks on paper but does nothing for their actual financial position.

2.     Do you believe Gallant’s actions were ethical?  Why or why not?

M.K Gallant, as the president of a corporation, will of course make any action plan available for his business to attract investors, consumers and even competitors. In my point of view, I can argue that his actions and decisions are ethical enough to maintain the company’s profitability.

Cost cutting, which includes postponing and cancelling expenditures & orders, delaying maintenance & trainings and cutting back on travel and advertisement expenses, are reasonable if your business is declining sales and has projected that will not be hitting the year’s target revenues. However, this can be considered risky because 1) advertisements are very crucial on a company’s marketing 2) delaying orders from supplier can cause issues within the company and its suppliers since these are pre-ordered 3) maintenance and training are critical points on a company since it can arise to bigger problems on following years.

Lastly, reclassifying costs is arguable. In this case, stocks are traded therefore we can assume that there will be an audit. The auditors will review the reclassifications and determine if they follow accounting principles (GAAP). M.K Gallant and his controller must have valid reasons in doing a reclassification on the company’s costs.

Case 2

Cheryl Montoya picked up the phone and called her boss, Wes Chan, the vice president of marketing at Piedmont Fasteners Corporation:  “Wes, I’m not sure how to go about answering the questions that came up at the meeting with the president yesterday.”

            “What’s the problem?”

            “The president wanted to know the break-even point for each of the company’s products, but I am having trouble figuring them out.”

            I’m sure you can handle it, Cheryl. And by the way, I need your analysis on my desk tomorrow morning at 8:00am sharp in time for the follow-up meeting at 9:00am.

            Piedmont Fasteners Corporation makes three different clothing fasteners in its manufacturing facility in North Carolina.  Data concerning these products appear below:

	Velcro	Metal	Nylon
Normal annual sales volume	100,000	200,000	400,000
Unit selling price	$1.65	$1.50	$0.85
Variable expense per unit	$1.25	$0.70	$0.25

 

Total fixed expenses are $400,000 per year.

All three products are sold in highly competitive markets, so the company is unable to raise its prices without losing unacceptable numbers of customers.

The company has an extremely effective lean production system, so there are no beginning or ending work in process or finished goods inventories.

Required:

1.      What is the company’s over-all break-even point in dollar sales?

	VELCRO	METAL	NYLON
Selling Price per Unit	$1.65	$1.50	$0.85
Variable Cost per Unit	$1.25	$0.70	$0.25
Contribution Margin Ratio	$0.40	$0.80	$0.60
Sales Mix %	14.29%	28.57%	57.14%
Contribution Margin per Unit	$0.06	$0.23	$0.34
Weighted - Average Contribution Margin Ratio	$0.63

Sales Mix BEP in Units			=		Total Fixed Cost / Weighted Ave CM Ratio
			=		$ 400,000 / $0.63
BEP in Units			=		634, 920.63
				VELCRO		METAL	NYLON
	Sales Mix %			14.29%		28.57%	57.14%
	BEP in Units			634, 920.63		634, 920.63	634, 920.63
	Product units @ BEP			90, 730.16		181, 396.82	362, 793.65
	Selling Price per Unit			$1.65		$1.50	$0.85
	BEP in Dollars			$ 149, 704.76		$272, 095.23	$308, 374.60
	Total Sales Mix BEP in dollars			$ 730, 174.59

*Company’s over-all break-even point in dollar sales is $ 730, 174.59

2.     Of the total fixed expenses of $400,000, $20,000 could be avoided if the Velcro product is dropped, $80,000 if the Metal product is dropped, and $60,000 if the Nylon product is dropped.  The remaining fixed expenses of $240,000 consists of common fixed expenses such as administrative salaries and rent on the factory building that could be avoided only by going out of business entirely.

a.       What is the break-even point in unit sales for each product?

VELCRO BEP			=	TFC / (P-VC)
			=	$ 260, 000 / $0.40
			=	650, 000
METAL BEP			=	TFC / (P-VC)
			=	$ 320, 000 / $ 0.80
			=	400, 000
NYLON BEP			=	TFC / (P-VC)
			=	$ 300, 000 / $ 0.60
			=	500, 000

*Breakeven point in unit for Velcro is 650,000

*Breakeven point in unit for Metal is 400,000

*Breakeven point in unit for Nylon is 500,000

b.     If the company sells exactly the break-even quantity of each product, what would be the overall profit of the company?  Explain the result.

(Formula):

= (BEP of Velcro * Price per Unit) + (BEP of Metal * Price per Unit) + (BEP of Nylon *    Price per Unit)

= (650,000*1.65) + (400,000*1.50) + (500,000*0.85)

            = $ 1,072, 500 + $ 600,000 + $ 425,000

            = $ 2, 097, 5000

*The overall profit of the company at breakeven point of each product is $ 2, 097, 500. The computation for it is stated above.

Case 3

Carlos Cavalas, the Manager of Echo Products Brazilian Division, is trying to set the production schedule for the last quarter of the year.  The Brazilian Division had planned to sell 3,600 units during the year, but by September 30 only the following activity had been reported:

	Units
Inventory, January 1	0
Production	2,400
Sales	2,000
Inventory	400

The division can rent warehouse space to store up to 1,000 units.  The minimum inventory level that the division should carry is 50 units.  Mr. Cavalas is aware that production must be at least 200 units per quarter in order to retain a nucleus of key employees.  Maximum production capacity is 1,500 units per quarter.

Demand has been soft, and the sales forecast for the last quarter in only 600 units.  Due to the nature of the division’s operations, fixed manufacturing overhead is a major element of product cost.

Required:

1.      Assume that the division is using variable costing.  How many units should be scheduled for production during the last quarter of the year? (The basic formula for computing the required production for a period in a company is Expected sales + Desired inventory – Beginning inventory = Required production)  Show computations and explain your answer.  Will the number of units scheduled for production affect the division’s reported income or loss for the year?  Explain.

2.     Assume that the division is using absorption costing and that the divisional manager if given an annual bonus based on divisional operating income.  If Mr Cavalas wants to maximize his division’s operating income for the year, how many units should be scheduled for production during the last quarter? (See the formula in (1) above.)  Explain.

3.     Identify ethical issues involved in the decision Mr Cavalas must make about the level of production for the last quarter of the year.