Undesirable Buildup of Inventories One problem with absorption costing (GAAP) is

Undesirable Buildup of Inventories
One problem with absorption costing (GAAP) is that it enables a manager to increase operating income in a specific period by simply increasing production – even if there is no customer demand for the additional production. Managers in companies with high fixed costs must manage capacity levels and make decisions about the use of available capacity which includes decisions on production and inventory policy. Performance incentives that are not well thought out could inadvertently incentivize actions by others that lead to higher short-term bonuses but leave detrimental long-term consequences for the company. A CEO whose bonus is tied to meeting certain financial metrics could direct a production manager to simply just produce more product and leave it sitting in the warehouse unsold to positively influence operating income. By producing more ending inventory, the firm’s margins and operating income can be made higher. To align the interests of managers and shareholders, high level decision makers are frequently evaluated and rewarded on the basis of reported operating income. Producing inventory makes the manager’s performance look better.
Camel Manufacturing is one of the largest producers of composite materials used in prefabricated metal barn construction. Builders can simply order the required products and assemble the structure on site significantly quicker than building each barn using only regular unfabricated construction materials. Camel wants to always be able to fill customer orders without delay, so it attempts to always maintain a sufficient quantity of finished goods inventory in its warehouse ready to ship. Storage of inventory is not free, and the company assumes additional risk of damage or obsolescence of any inventory in the warehouse.
Notice how Camel Manufacturing’s absorption costing income changes under two different production levels with sales exactly the same, beginning Finished Goods (FG) inventory exactly the same, and SG&A expenses exactly the same under either production level. Why would production levels change? One possibility is that the firm’s managers anticipate rapid growth in demand and want to make and store additional units to deal with possible production shortages in the next year. Although the company will assume more risk with additional inventory related to abrupt changes in expected demand or an increased chance of product obsolescence. Another motivation may be that managers are tempted to build inventory in order to get higher performance bonuses based on reported operating income.
Production of 2,000 units Production of 2,500 units
Unit Data
Beginning FG Inventory units 500 500
Production 2000 2500
Units available for sale 2500 3000
Sales (number of units) (1,850) (1,850)
Ending inventory units 650 1150
Camel Manufacturing stock is traded on a national exchange. Investment analyst at the beginning of the year (2023) predicted the company’s earnings would grow by 20% this year. Unfortunately, sales have been less than expected for the year, and Camel concluded within two weeks of the end of the fiscal year it would be impossible to report an increase in earnings as large as predicted unless some drastic action is taken. Accordingly, Camel ordered wherever possible, expenditures should be postponed to the new year – including canceling or postponing orders with suppliers, delaying planned maintenance, and training, and cutting back on end-of-year advertising and travel. Camel ordered the company’s controller to carefully scrutinize all costs currently classified as period costs and reclassify as many as possible as product costs. Additionally, Camel, who had already produced 2,000 units during the year, decided to produce another 500 units with no expectation of any additional sales. The company is expected to have substantial inventories at the end of the year.
Requirement
Internal Audit (IA) is concerned about the potential for earnings management and is preparing to address it with the audit committee of the board of directors next week. You have been asked to carefully prepare a two-page Executive Summary as a read-ahead document for the meeting. The executive summary should be exactly two pages and space is critical so you must be succinct with your wording. You should fully identify and explain the accounting concepts involved and fully address the items below logically within the narrative.
1. How does just producing more finished goods inventory while still only selling the same number of units increase reported operating income in the current period?
2. Why would reclassifying period costs as product costs increase this period’s reported earnings?
3. How could Camel adjust their current bonus program to better incentivize what is best for the company long-term instead of facilitating actions for the sole purpose of increasing compensation?
4. At what point did decision making switch from ethical to unethical considering the two extremes (1) optimizing business strategy to maximize profits and (2) just plain out manipulating financial statement numbers to achieve a specific outcome?