Patel company is a family-owned business and which you own 20% of the common sto
ID: 2485906 • Letter: P
Question
Patel company is a family-owned business and which you own 20% of the common stock and your brother and sister onw the remaining shares.The employment contract of Patel's new president Ran Moss, stipulates base salary of 128,000 per year plus 10% of income from operations in excess of 340,000. Moss uses the absorption costing method of reporting income from operations, which has averaged approximately 480,000 for the past several years
Sales for 2012, Moss's first year as a president of Patel company, are estimated at 40,000 units of the selling price of $96 per unit.To maximize the use of Patels productivity capacity , Moss has decided to manufacture 50,000 units rather than the 40,000 units of estimated sales. the beginning inventory at January 1st 2012 is insignificant in amount, and the manufacturing costs and selling and administrative expenses for the production of 40,000 and 50,000 units are as follows:
Manufacturing cost:
Variable 40,000 / $45 / 1,800.000
Fixed. 40,000 / $10 / 400.000
Total. /$55 / 2,200.000
Selling and administrative expenses:
Variable. 960,000
Fixed 320,000
Total 1,280,000
50,000 Units to Be Manufactured
Number of units / unit cost / total cost
Manufacturing cost:
Variable 50,000 / $45 / 2,250.000
Fixed. 50,000 /$8. / 400.000
Total. / $53. / 2,650.000
Selling and administrative expenses:
Variable 960,000
Fixed 320,000
Total 1,280,000
1-In one group, prepare an absorption costing income statement for the year ending December 31,2012, based on sales of 40,000 units and the manufacture of 40,000 units. In the other group, conduct the same analysis, assuming production of 50,000 units.
2-explain the defense in the income from operation reported in (1).
3-compute Moss’s total salary for the year 2012, based on sales of 40,000 units and the manufacture of 40,000 units (group 1) and 50,000 units (group 2). Compare your answers.
4 in addition to maximizing the use of Patel company’s productive capacity, why might Moss wish to manufacture 50,000 units rather than 40,000 units?
5 Can you suggest and alternative way in which Moss’s salary determinate, using a base salary of $128,000 and 10% of income from operation in excess of $340,000, so that salary could not be increased by simply manufacturing more units?
Explanation / Answer
1) INCOME STATEMENT UNDER ABSOPTION COSTING: group 1 group 2 Sales 3840000 3840000 Less: Cost of goods sold: Beginning inventory 0 0 Cost of goods manufactured 2200000 2650000 cost of goods available for sale 2200000 2650000 closing inventory 0 2200000 530000 2120000 Gross profit 1640000 1720000 Less: marketing & admn expenses variable 960000 960000 fixed 320000 1280000 320000 1280000 Net Operating Invome 360000 440000 2) The profit is higher when the production is 50000 units eventhough the sales is the same 40000 units only. The difference is due to the inclusion of fixed costs in the valuation of closing stock. The fixed costs included in the closing stock of 10000 units (when the production is 50000 units) of 8*10000 = $80000, reduces the COGS by the same amount. It is due to this reason that the Net Operating Income is high for production of 50000 units and sale of 40000 units. 3) Moses total salary: group 1 group 2 basic salary 128000 128000 10% of NOI in excess of $340000 2000 10000 Total salary 130000 138000 Moses salary is 8000 more when the production is 50000 units, eventhough the sales is the same 40000 units. The extra amount is due to the adoption of abosrption costing method for income determination. 4) To get higher incentive on the basis of NOI being greater than $340000. 5) It can be achieved by preparing Income Statement using variable costing method: The Income statement prepared under variable costing method would be as under: group 1 group 2 Sales 3840000 3840000 Less: Cost of goods sold: Beginning inventory 0 0 Cost of goods manufactured 1800000 2250000 cost of goods available for sale 1800000 2250000 closing inventory 0 1800000 450000 1800000 Gross contribution margin 2040000 2040000 Less: variable marketing & admn expenses 960000 960000 Contribution margin 1080000 1080000 Less: Fixed costs manufacturing 400000 400000 selling and administration 320000 720000 320000 720000 Net operating income 360000 360000 Under the marginal costing method, the fixed costs are not allocated to inventory with the result that the entire fixed expenses of a period are charged to the income statement as period cost. There would be no advantage in building up inventories. Under this method Moses total salary would be $130000 only, irrespective of the production quantity--as long as the sale is of the same quantity.