Question

Chem-Melt produces and sells an ice-melting granular used on roadways and sidewalks in winter. The company annually produces and sells about 300,000 pounds of its granular. In its 10-year history, the company has never reported a net loss. Because of this year’s unusually mild winter, projected demand for its product is only 250,000 pounds. Based on its predicted production and sales of 250,000 pounds, the company projects the following income statement under absorption costing.

Sales (250,000 lbs. at \(8 per lb.) . . . . . . . . . . . . . . . . . . . . . . . \)2,000,000

Cost of goods sold (250,000 lbs. at \(6.80 per lb.) . . . . . . . . . 1,700,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .300,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . 450,000

Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \) (150,000)

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

Variable direct labor and materials costs per pound . . . . . . . . . . . \(2.00

Fixed production cost per pound (\)1,200,000∕250,000 lbs.) . . . . . . 4.80

Total product cost per pound . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6.80

The company’s selling and administrative expenses are all fixed. The president is concerned about the adverse reaction from its creditors and shareholders if the projected net loss is reported. The controller suggests that since the company has large storage capacity, it can report a net income by keeping its production at the usual 300,000-pound level even though it expects to sell only 250,000 pounds. The president was puzzled by the suggestion that the company can report a profit by producing more without increasing sales.

Required

1. Can the company report a net income by increasing production to 300,000 pounds and storing the excess production in inventory? Your explanation should include an income statement (using absorption costing) based on production of 300,000 pounds and sales of 250,000 pounds.

2. Should the company produce 300,000 pounds given that projected demand is 250,000 pounds? 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 to300,000 poundsand storing the excess production in inventory. The Net income for300,000 poundswill be$50,000.
2. Yes, the company should produce 300,000 poundsas it is earning more profit than the exact 250,000 pounds of production.

Step-by-step solution

Computation of Cost of goods sold

	250,000pounds	300,000pounds
Variable direct labor cost per ton	$2	$2
Add: Fixed costs per ton	$4.8	$4
Cost of goods sold per ton (a)	$6.8	$6
Unit sold (b)	250,000pounds	250,000pounds
Total cost of goods sold (a*b)	$1,700,000	$1,500,000

Computation of Income Statement-

	250,000pounds	250,000pounds
Sales (250,000pounds* $8)	$2.000,000	$2,000,000
Less: Cost of goods sold	($1,700,000)	($1,500,000)
Gross margin	$300,000	$500,000
Less:Selling& Administrative expenses	($450,000)	($450,000)
Net operating Income / (loss)	($150,000)	$50,000

Analysis-

If the company chooses to produce 300,000poundseven when the requirement is of 250,000pounds. The company will earn profit of $50,000 out of 300,000poundswhereas for 250,000poundsof production it will incur loss of($150,000). Thus, the company earns higher profit if it produced more units than it have to sell.