Lee was hired as chief executive officer (CEO) in late November by the board of direc- tors of Hunter Electronics, a company that produces a state-of-the-art DVD drive for personal computers. The previous CEO was fired by the board due to a series of questionable business practices, including prematurely recording revenues on products that had not yet been shipped to customers.
Lee felt that his first priority on the job was to restore employee morale—which had suffered during the previous CEO’s reign. He was particularly anxious to build a sense of trust between himself and the company’s employees. His second priority was to prepare the budget for the coming year, which the board of directors wanted to review at their December 15 meeting.
After hammering out the details in meetings with key managers, Lee was able to put together a budget that he felt the company could realistically meet during the coming year. That budget appears below:
Units in beginning inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
0
|
Units produced. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
200,000
|
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
200,000
|
Units in ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Variable costs per unit:
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
0
$ 50
|
Direct labour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
40
|
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
20
|
Variable selling and administrative. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
10
|
Total variable costs per unit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
$120
|
Fixed costs:
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
$ 8,400,000
|
Fixed selling and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
3,600,000
|
Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
$12,000,000
|
Sales (200,000 units) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold:
Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
$ 0
|
$40,000,000
|
Add cost of goods manufactured (200,000 × $152 per unit) . . . . . . . .
|
30,400,000
|
Goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
30,400,000
|
Less ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
0
|
30,400,000
|
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
9,600,000
|
Selling and administrative expenses:
|
Variable selling and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
2,000,000
|
Fixed selling and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
3,600,000
|
5,600,000
|
Operating income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
|
$ 4,000,000
|
While the board of directors did not oppose the budget, they made it clear that the budget was not as ambitious as they had hoped. The most influential member of the board said, “Managers should have to really stretch to meet profit goals.” After some discussion, the board decided to set a profit goal of $4,800,000 for the coming year. To provide strong incentives and a win–win situation, the board agreed to pay bonuses to top managers from a bonus pool of
$200,000 if this profit goal was eventually met. Lee’s share of the bonus pool would be $50,000. The bonus would be all-or-nothing: if actual operating income turned out to be $4,800,000 or more, the bonus would be paid; otherwise, no bonus would be allowed.
Required:
1. Assuming that the company does not build up its inventory (i.e., production equals sales) and its selling price and cost structure remain the same, how many units of the DVD drive would have to be sold to meet the target operating income of $4,800,000?
2. Verify your answer to (1) above by constructing a revised budget and budgeted absorption costing income statement that yields an operating income of $4,800,000.
3. Unfortunately, by October of the next year, it became clear that the company would not be able to make the $4,800,000 target profit. In fact, it looked like the company would wind up the year as originally planned, with sales of 200,000 units, no ending inventories, and a profit of $4,000,000.
Several managers who were reluctant to lose their year-end bonuses approached Lee and suggested that the company could still show a profit of $4,800,000. The managers argued that at the current rate of sales, there was enough capacity to produce tens of thou- sands of additional DVD drives for the warehouse. Overtime costs might have to be incurred, but all of this additional cost would be assigned to the DVD drives in ending inventory.