G Products, Inc., is a manufacturer of mobile devices. Richard is the plant manager at KGs Orrville, Ohio, plant. The Orrville plant manufactures a smartphone, the Zoom, which has sold well for the past six months. Richard is being considered for promotion to manager of the Âentire West Coast division of KG Products. Penny is an accounting supervisor at KG Products and is a good friend of Richards.
Richard and Penny are having lunch in the company cafeteria. There are about six weeks left in the current fiscal year. Richard is concerned that his plant will be showing a loss rather than the healthy profit he had projected for the year. The reason for the shortfall is that demand has radically declined for the Zoom smartphone currently manufactured by Richards plant. New smartphones with more features have been brought to market by KGs competitors. Engineers at KG are currently working on an updated model of the Zoom, but it will not be ready for production in Richard™s plant for another five months. If Richards plant shows a loss this year, Richard will not receive his performance bonus for the year. He also knows that his chance of promotion to the West Coast manager will be greatly reduced.
Penny thinks about Richard’s situation. She then shares with him a strategy that he can use to help increase his profits. She explains that under absorption costing, the more units in ending inventory, the more costs can be deferred. Using her tablet, she makes up a quick example in Excel to show him how he can turn his situation around and show operating income for the year.
Penny’s first spreadsheet assumes that five units are produced and sold in this hypothetical situation:
If five units are produced and sold, the hypothetical company would have a loss of $ 20. Now Penny changes just one fact; instead of producing five units, the company in the example produces ten units. No other facts change the company still sells just five units. Penny shows Richard the revised income statement under the increased production scenario:
Under this second scenario, the operating income would be $ 30, which is quite a bit higher than the original scenario. Penny again emphasizes that the only fact that was different between the two scenarios is that production, and therefore ending inventory, increased in the second scenario.