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 69,190 units during the year, but by September 30 only the following activity had been reported:

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 69,190 units during the year, but by September 30 only the following activity had been reported:

	Units
Inventory, January 1	0
Production	71,800
Sales	62,900
Inventory, September 30	8,900

The division can rent warehouse space to store up to 30,300 units. The minimum inventory level that the division should carry is 1,600 units. Mr. Cavalas is aware that production must be at least 5,340 units per quarter in order to retain a nucleus of key employees. Maximum production capacity is 45,400 units per quarter.

Demand has been soft, and the sales forecast for the last quarter is only 20,900 units. Due to the nature of the division’s operations, fixed manufacturing overhead is a major element of product cost.

Required:

1a. Assume that the division is using variable costing. How many units should be scheduled for production during the last quarter of the year?

1b. Will the number of units scheduled for production affect the division’s reported income or loss for the year?

2. Assume that the division is using absorption costing and that the divisional manager is 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?

 

Explanation

1.

Because of soft demand for the Brazilian Division’s product, the inventory should be drawn down to the minimum level of 1,600 units. Drawing inventory down to the minimum level would require production as follows during the last quarter:

Desired inventory, December 31	1,600	units
Expected sales, last quarter	20,900	units
Total needs	22,500	units
Less inventory, September 30	8,900	units
Required production	13,600	units

This plan would save inventory carrying costs such as storage (rent, insurance), interest, and obsolescence.

The number of units scheduled for production will not affect the reported net operating income or loss for the year if variable costing is in use. All fixed manufacturing overhead cost will be treated as an expense of the period regardless of the number of units produced. Thus, no fixed manufacturing overhead cost would be shifted between periods through the inventory account and income would be a function of the number of units sold, rather than a function of the number of units produced.

2.

To maximize the Brazilian Division’s operating income, Mr. Cavalas could produce as many units as storage facilities will allow. By building inventory to the maximum level, Mr. Cavalas would be able to defer a portion of the year’s fixed manufacturing overhead costs to future years through the inventory account, rather than having all of these costs appear as charges on the current year’s income statement. Building inventory to the maximum level of 30,300 units would require production as follows during the last quarter:

Desired inventory, December 31	30,300	units
Expected sales, last quarter	20,900	units
Total needs	51,200	units
Less inventory, September 30	8,900	units
Required production	42,300	units

Thus, by producing enough units to build inventory to the maximum level that storage facilities would allow, Mr. Cavalas could relieve the current year of fixed manufacturing overhead cost and thereby maximize the current year’s operating income.

Thanks