Venus Family Packaging is a privately owned business that has been in operation since the late 1800s. The business, which has grown at a moderate pace, has remained competitive due to its dedication to customer service and quality.

In February 2012 the company hired production manager Marcy Lambert and controller Keith Waldrop. Both Lambert and Waldrop came from publicly held companies with performance-based compensation systems. Missing the opportunity they had once had to influence a significant portion of their total compensation, these two employees made several presentations to upper management about the desirability of changing the company's compensation system.

Company president and major stockholder John Williams, who is not one to adopt the latest fads, listened patiently to Lambert and Waldrop for two years. He also attended a couple of seminars on performance-based compensation systems. After much information gathering, he decided to implement a compensation system to reward managers based on the company's performance beginning in January 2014.

The new system was based on two benchmarks: unit product cost and operating income.

As the production supervisor, Lambert was rewarded on what she could control-production costs. Specifically, she was given a benchmark unit cost to achieve along with quality requirements. If she met or beat the benchmark unit cost (with a lower unit cost) while maintaining product quality, she would receive a bonus equal to 25% of her annual salary.

The controller, vice president of marketing, and president would be given 25% bonuses if operating income exceeded the benchmark.

At first the plan seemed to be working well. Income was growing, customers were happy because their orders were always filled quickly, and management had gained a newfound pride in the company's financial performance. But as the end of the year approached, people's behavior began to change. In November 2014, Lambert instructed David Daughdrill, the purchasing agent, to buy additional raw materials. When the inventory manager, Larissa Denton, got wind of the new purchases, she confronted Lambert. Lambert's response was,

"We need to make several thousand additional medium-sized boxes." Denton informed Lambert that the company had more than enough medium-sized boxes to make it through March of 2015, and there was no room to store the extra inventory. Lambert responded in a forceful tone, "Then you are going to have to rent some storage space because the products need to be made. I know of issues that you needn't be concerned with." Since Lambert was her boss, Denton did as she was told. But three weeks later, over morning coffee, she mentioned the growing inventory to Keith Waldrop. "I've noticed an increase in our inventory on the balance sheet and have wondered what was happening," Waldrop replied.

"But our inventory doesn't spoil, and the packaging is standard, so it won't become obsolete. I just record the events the way they occur. I don't see anything wrong with Lambert's actions."

Required

a. What might explain production manager Lambert's actions at the end of 2014?

b. If the company uses variable costing for internal reporting purposes, how do you think net income would compare to the net income reported under absorption costing in 2014?

c. How long do you think Lambert can keep building up inventory before someone calls a halt to it?

d. What responsibility does controller Keith Waldrop have to question Lambert's methods? Why does he choose to "look the other way"? By not following up on the unusual inventory increase he has noticed on the balance sheet, has Waldrop violated any ethical obligation he has to the company? Why or why not?

e. If Lambert overproduces inventory only in 2014, returning to normal production and inventory levels in 2015, do you think she has violated any ethical obligation she has to the company? Why or why not?

f. How might the compensation system be altered to mitigate Lambert's actions?