Michael Lee was hired as chief executive officer (CEO) in late November by the board of directors of Hunter Electronics,
Michael felt that his first priority on the job was to restore employee morale€”which had suffered during the previous CEO€™s reign. He was particularly anxious to build a sense of trust between himself and the company€™s employees. His second priority was to prepare the budget for the coming year, which the board of directors wanted to review in their December 15 meeting.
After hammering out the details in meetings with key managers, Michael was able to put together a budget that he felt the company could realistically meet during the coming year. That budget appears below:
While the board of directors did not oppose the budget, they made it clear that the budget was not as ambitious as they had hoped. The most influential member of the board stated that €œmanagers should have to really stretch to meet profit goals.€ After some discussion, the board decided to set a profit goal of $4,800,000 for the coming year. To provide strong incentives and a win-win situation, the board agreed to pay out bonuses to top managers of $200,000 if this profit goal was eventually met. Michael€™s share of the bonus pool would be $50,000. The bonus would be all-or-nothing. If actual net operating income turned out to be $4,800,000 or more, the bonus would be paid. Otherwise, no bonus would be allowed.
1. Assuming that the company does not build up its inventory (i.e., production equals sales) and its selling price and cost structure remain the same, how many units of the DVD drive would have to be sold to meet the target net operating income of $4,800,000?
2. Verify your answer to (1) above by constructing a revised budget and budgeted absorption costing income statement that yields a net operating income of $4,800,000.
3. Unfortunately, by October of the next year it had become clear that the company would not be able to make the $4,800,000 target profit. In fact, it looked like the company would wind up the year as originally planned, with sales of 200,000 units, no ending inventories, and a profit of $4,000,000.
Several managers who were reluctant to lose their year-end bonuses approached Michael and suggested that the company could still show a profit of $4,800,000. The managers argued that at the present rate of sales, there was enough capacity to produce tens of thousands of additional DVD drives for the warehouse. Overtime costs might have to be incurred, but all of this additional cost would be assigned to the DVD drives in ending inventory.
If sales are 200,000 units for the year and the selling price and cost structure remain the same, how many units would have to be produced to show a profit of at least $4,800,000 under absorption costing? (Round your answer up to the nearest whole unit.)
4. Verify your answer to (3) above by constructing an absorption costing income statement.
5. Do you think Michael Lee should approve the plan to build ending inventories in order to attain the target profit?
6. What advice would you give to the board of directors concerning how they determine bonuses in thefuture?
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