Question

Blazer Chemical produces and sells an ice-melting granular used on roadways and sidewalks in winter. It annually produces and sells about 100 tons of its granular. In its nine-year history, the company has never reported a net loss. However, because of this year’s unusually mild winter, projected demand for its product is only 60 tons. Based on its predicted production and sales of 60 tons, the company projects the following income statement (under absorption costing)

Sales (60 tons at \(21,000 per ton) . . . . . . . . . . . . . . . . . . \)1,260,000

Cost of goods sold (60 tons at \(16,000 per ton) . . . . . . . \)960,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .\( 300,000

Selling and administrative expenses . . . . . . . . . . . . . . . . .\) 318,600

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .\( (18,600)

Its product cost information follows and consists mainly of fixed cost because of its automated production process requiring expensive equipment.

Variable direct labor and material costs per ton . . . . . . . . \) 3,500

Fixed cost per ton (\(750,000 ÷ 60 tons) . . . . . . . . . . . . . . . . 12,500

Total product cost per ton . . . . . . . . . . . . . . . . . . . . . . . . . . \)16,000

Selling and administrative expenses consist of variable selling and administrative expenses of \(310 per ton and fixed selling and administrative expenses of \)300,000 per year. The company’s president is concerned about the adverse reaction from its creditors and shareholders if the projected net loss is reported.

The operations manager mentions that since the company has large storage capacity, it can report a net income by keeping its production at the usual 100-ton level even though it expects to sell only 60 tons. The president was puzzled by the suggestion that the company can report income by producing more without increasing sales.

Required

1. Can the company report a net income by increasing production to 100 tons and storing the excess production in inventory? Your explanation should include an income statement (using absorption costing) based on production of 100 tons and sales of 60 tons.

2. Should the company produce 100 tons given that projected demand is 60 tons? Explain, and also refer to any ethical implications of such a managerial decision.

Short answer

1. Yes, the companyreport a net income by increasing production to 100 tons and storing the excess production in inventory. The Net income for 100 tons will be $ 281,400.
2. Yes, the company should produce 100 tons as it is earning more profit than the exact 60 tons of production.

Step-by-step solution

Computation of Cost of goods sold

	60 tons	100 tons
Variable direct labor cost per ton	$3,500	$3,500
Add: Fixed costs per ton	$12,500	$7,500
Cost of goods sold per ton (a)	$16,000	$11,000
Unit sold (b)	60 tons	60 tons
Total cost of goods sold (a*b)	$960,00	$660,000

Step 2:Computation of Income

	60 tons	100 tons
Sales (60 tons* $21,000)	$1,260,000	$1,260,000
Less: Cost of goods sold	($960,000)	($660,000)
Gross margin	$300,000	$600,000
Less:Selling& Administrative expenses [(310 per ton* 60 ton)+ $300,000]	($318,600)	($318,600)
Net operating Income / (loss)	($18,600)	$281,400

Analysis

If the company chooses to produce 100 tons even when the requirement is of 60 tons. The company will earn profit of $281,400 out of 100 tons whereas for 60 tons of production it will incur loss of $18,600. Thus, the company earns higher profit if it produced more units than it have to sell.