Wilmont Company’s executive committee was meeting to select a new vice president of operations. The leading candidate was Howard Kimball, manager of Wilmont’s largest division. Howard had been divisional manager for three years. The president of Wilmont, Larry Olsen, was impressed with the significant improvements in the division’s profits since Howard had assumed command. In the first year of operations, divisional profits had increased by 20%. They had shown significant improvement for the following two years as well. To bolster support for Howard, the company’s president circulated the following divisional income statements (dollars in thousands):
Less: Cost of goods sold 1/
Less: Selling and admin 2/
1/ ? assumes a LIFO inventory flow
2/ ? all costs are fixed
“As you can see,” Larry observed at a meeting, “Howard has increased profits by a factor of four times since 2004. That’s by far the most impressive performance of any divisional manager. We could certainly use someone with that kind of drive. I definitely believe that Howard should be the new vice president.”
“I’m not quite as convinced that Howard’s performance is as impressive as it appears,” responded Bill Peters, the vice president of finance. “I could hardly believe that Howard’s division could show the magnitude of improvement revealed by the income statements. So I asked the divisional controller to supply some additional information. As the data suggest, the profits realized by Howard’s division may be attributable to a concerned effort to produce for inventory. In fact, I believe it can be shown that the division is actually showing a loss each year and that real profits have declined as much as 15% since 2004.” Peters then showed the following information:
Actual (and budgeted) fixed overhead
Fixed overhead rate
Unit variable production costs
1/ ? this represents both expected and actual production.
Fixed overhead rates are computed using expected actual production
1. Explain what Bill Peters meant by “producing for inventory”.
2. Recast the income statements in a variable?costing format. Now, how does the performance of the division appear?
3. Reconcile the differences in the income figures using the two methods for each of the three years.
4. If you were a shareholder, how would you detect income increases that are caused mainly by production for inventory?