You are the manager of a public company that produces a variety of kitchenware. Demand is decreasing and it appears that earnings expectations will not be met this quarter which could lead to the selection of the share price of the company and you risk losing your job. One employee from the marketing department suggested to offer more discount to customers to increase the sales. You realize that rather than help the bottom line, more discount could lead to even lower income. The accountant suggested to simply increase the production despite the fall in demand to increase the reported profit as storage capacity is unutilized.
Does the accountant’s suggestion make sense? Why?
This post was part of TyroCity discussion forum
Question asked by ganesh_shrestha
Oldest comments (4)
Yes the accountant’s suggestion makes sense. What the accountant suggests is that with the increase in the production the cost of goods sold will decrease as fixed manufacturing cost will be same for whatever amount you produce. Let us take an example.
For example a company’s fixed manufacturing cost is Rs. 500,000. So whether you produce 100,000 unit or 200,000 units the fixed cost will still remain as Rs. 500,000. But with 100,000 unit the cost of goods sold will be Rs. 5 per unit (Rs. 500,000 divided by 100,000 units) while the cost of goods sold for 200,000 units will be only Rs. 2.5 per unit.
So let us assume that your sales will remain at 100,000 units and you sale it for Rs. 10 per unit. Then in the first case you will sale 100,000 units (total production) at Rs. 10 earning Rs. 10,00,000. Similarly in the second case, out of 200,000 units produced you will sale 100,000 units for Rs. 10 and earn the same amount of Rs. 10,00,000 but the cost of production will only be 250,000 earning you a profit of Rs. 750,000 where as in the first case with production cost of Rs. 5 you will only be earning Rs. 500,000. In addition, in the second case with production of 200,000 units you will also have an inventory shown in the balance sheet for 100,000 units at Rs. 2.5 equalling to Rs. 250,000.
"As innovation and mechanization continue in manufacturing operations, fixed costs become a larger proportion of product costs. Higher fixed manufacturing costs can produce larger differences between absorption costing and direct costing net incomes. (Baxendale & Foster, 2010)” However absorption costing is considered to have two major weaknesses. One it allows the chances for manipulation of the net income with the scale of production. It also does not clarify on the amount of variable and fixed cost. (Sopariwala, 2009)
Baxendale, S., & Foster, B. (2010, Sept/Oct). ABC ABSORPTION AND DIRECT COSTING INCOME STATEMENTS. Cost Management; Boston , pp. 5-14.
Sopariwala, P. R. (2009, Nov/Dec). THE ABSORPTION VS. DIRECT COSTING DEBATE: A COMPROMISE SOLUTION. Cost Management; Boston , pp. 41-46.
In general, people understand costs in terms of monetary prices or the amount of expenditure incurred on goods and services (Szilagyi, 2016). But accountant understand the cost as the sacrifice made in order to obtain a good or a service. In some cases the expenditure incurred on a good or service may be good indicator of the sacrifice made to obtain the same but there are situations where it is not. For example: - in some situations resources used do not have monetary value. - Some resources do have monetary value but they cannot be exactly measured. Costs can be classified in different ways depending on the purpose for which it is required. But in general costs can be classified broadly into fixed and variable costs, direct and indirect costs, and capital and recurrent costs. But in this case accountant suggest me on the basic of variable cost. In variable cost Variable costs are items of costs that vary directly and proportionately with production volume. If the total amount of costs increases as volume increases, the item is a variable cost. The percentage of cost increase or decrease that results in proportionate to the percentage change in the volume of production or the services provided. So in this case the production and cost directly proportional. As per accountant suggestion increasing the production means not only increase the product no only it also increase the other cost. Cost is the sacrifice made in order to obtain a good or service. There are mainly three elements of costs, such as material, labor and expenses. All indirect costs are called overheads. Costs can be classified into variable and fixed costs, direct and indirect costs, and capital and recurrent costs. Each classification has its own significance in management decisions (Wudhikarn, 2012). In manufacturing company have various types of cost these are cost of labor charge, material cost, store cost, human capital cost and other cost. So logically I think that it would not be a good solution for me so I personally say that, the accountant’s suggestion doesn’t make a sense. In the present day competitive economy, importance of product cost cannot be undermined. It is rather a key to success. Managers want product costs for guiding their decisions regarding pricing, inventory valuation and income determination. If we cannot measure product cost we cannot manage it.
Szilagyi, P. (2016). corporate executives buying and selling goods and services. Journal of Multinational Financial Management .
Wudhikarn, R. R. (2012). Improving Overall Equipment Cost Loss Adding Cost of Quality. International Journal of Production Research, 50(12) .
The suggestion of the accountant to increase the production despite the fall in demand to increase the reported profit is sensible to some extent as it will prevent the share price from declining and the risk of losing the job is also eliminated for the time being. If the company is practicing absorption costing in preparing the financial statements, this could be the suitable measure for showing increased profit by simply increasing the production even if the sales remain constant. In absorption costing, the fixed cost associated with the production of goods is attributable to cost of goods sold and inventory. Even if we fail to increase the sales, the large amount of fixed costs is associated with inventory that reduces the actual expenses reported in the income statement.
A company is producing 10,000 units of products with fixed costs of Rs.100,000. The fixed cost per unit will be Rs.10 and variable costs of Rs.12 per unit. If the selling price per unit is Rs. 25, the gross profit of the company can be calculated as:
Sales Revenue(25*10,000) =250,000
Less: Fixed Costs (10*10,000 ) =100,000
Less: Variable Costs (12*10,000) =120,000
Gross Profit =30,000
If the company decides to utilize its full capacity and produce 15,000 units though the sales is 10,000, the fixed cost per unit will reduce to Rs.6.67 per unit and the gross profit will change as:
Sales Revenue(25*10,000) =250,000
Less: Fixed Costs (6.67*10,000 ) = 66,700
Less: Variable Costs (12*10,000) = 120,000
Gross Profit =63,300
We can see that as per the accountant’s advice, the cost of goods sold is lowered increasing the value of inventory. This results in increased gross profit that will eventually lead to higher net income. However, the income statement is fabricated and the reduced/slowed sales will be viewed as lower costs and higher profit(Ozyasar, 2018). It will give the hint that company is doing well when it is not being able to pick up the sales.
Despite some of these ethical issues, I will go with the accountant’s suggestion. It will also provide me with the time to think about the new ways to increase sales. As suggested by the marketing manager, offering discounts may not lead to increased sales and the increase in discount will also decrease the net profit as it is treated as expenses. Along with implementing the accountant’s suggestion, I will invest my time in finding the reasons for lowered demand and looking for ways to reduce operational costs, build personal relationship with customers, make distribution more effective and incorporate the suggestions from customers to increase the profit by increasing sales in long run (Edmunds, 2018).
Edmunds, S. A. (2018, June 26). How to Increase Sales & Revenue: 5 Essential Strategies. Retrieved from Chron: smallbusiness.chron.com/increase-s...
Ozyasar, H. (2018, September). The Influence of Inventory Changes on Gross Profit. Retrieved from Chron: smallbusiness.chron.com/influence-...
The suggestion of the accountant makes sense to some extent but it doesn’t either depending on what perceptive you look things at from. The situation of the company is that it’s losing out in making sales/conversions and failing behind from their target. In a very negative note, considering that the suggestion of the accountant is taken into consideration and the production is amplified despite the fall in demand, it will certainly help bring down the development cost of the product and produce more products at the same overall price point (Chenhall, 1996). As we can see companies producing goods in mass can manufacture them at huge numbers compared to ones crafting one at a time and is thus a lot of cost saving as well. But what if those produced goods aren’t wanted at all by the customer? What to do next? With the maximum budget spent in producing new goods rather than selling the current inventory would lower the cash that the business has and thus have to depend on further sales or injection of funds from other sources to fund any other product or product exposures. It will create more desperation to clear the inventory and thus eventually with the demands of the goods on a low number force the company to lower the price. That goes around the same recommendation as suggested by the marketing department member and doesn’t make much sense.
On the bright note, on a shorter term, the business can sustain in the market and I (as in the question) can save the job as well if the suggestion is taken into account from the accountant. In that regard, it does make sense. When the sales is low, it’s obvious that the financial statement would show a lesser profit. However, with accountant suggestion, more products can be produced at a reduced price point to show more of inventory. Inventory does fall under the assets side of the statement and thus helps the business show a bigger image to the wider mass. With the production cost being low, the business can give a slight discount as well or either sale on the same price point to generate more profit from a single sell than they would normally without compromising on the quality (Bijvank & Vis, 2011). It’ll have a positive impact on the financial statements.
Analyzing both the sides of the equation, for the business to sustain, it’s good to go by the suggestion. However, if anyone analyzes the trend, look at the number and it comes out to a wider mass, it’ll send even more of a negative vibe than it would normally do. Sending a wave so big that would have a negative impact on the valuation of stocks than on normal case. It would also mean that the business shows a false, fabricated report to show profit which may not be taken very well by people. A report points out that the business with larger inventory would show slower sales pace while the one with lesser has a quicker sales (Ha, 1997). It only creates false expectations and a good position of the company generally with a higher valuation which may also be considered ethically wrong in some cases and may cause legal action. So, I think even if the suggestion from the accountant makes sense, it’s still a bit off from being good to put it into practicality.
Bijvank, M., & Vis, I. (2011). Lost-sales inventory theory: A review. European Journal Of Operational Research , 215 (1), 1-13.
Chenhall, R. (1996). Strategies of manufacturing flexibility, manufacturing performance measures and organizational performance: an empirical investigation. Integrated Manufacturing Systems , 7 (5), 25-32.
Ha, A. (1997). Inventory Rationing in a Make-to-Stock Production System with Several Demand Classes and Lost Sales. Management Science , 43 (8), 1093-1103.