A manufacturer of farm equipment is headed for financial distress. Bonuses of management are based on net income relative to budget. There has been a recent change in management, occurring in early 2001.

To the surprise of the new manager, the outgoing manager had sharply increased 2000 production, resulting in excessive levels of inventory on hand at the end of 2000. The manufacturer uses absorption costing for its inventories.

 

a. Explain why the old management increased production and inventories?

b. How might the remuneration plan of management be changed to reduce the likelihood that this would happen in the future? Briefly justify your choice and comment on the effects of your suggested change on sensitivity and precision?