Over-Production Incentives, ROA and Residual Income
Eaststar manufactures and distributes a complete line of home appliances worldwide. Lynn Tweedie is the U.S. Space Saver Dishwasher product manager for Eaststar Appliances. Her responsibilities include pricing, planning, and sales of Eaststar's Space Saver dishwasher in the United States. It is the end of the third quarter and Tweedie is deciding how many Space Saver washers to produce in the fourth quarter. Given sales from the first three quarters and orders for the last quarter, she expects total sales for the year to be 73,000 washers at $200 per unit. There are 12,000 washers in inventory at a (LIFO) cost of $90 per washer. The factory produced 58,000 washers in the first three quarters of this year and Tweedie is considering ordering an additional 10,000, 15,000, or 20,000 washers in the fourth quarter. The plant's capacity can easily accommodate any of these volume levels without affecting fixed costs or variable cost per unit. The variable manufacturing cost of the washer is $75 and the plant has fixed annual costs of $1.3 million. Manufacturing overhead is allocated to dishwashers based on units. Tweedie's selling and administrative expenses consist of $15 of variable cost per washer and fixed cost of $2.92 million. The dishwasher division has a 17 percent weighted-average cost of capital and invested capital (not including inventories) of $18 million. Eaststar uses full absorption costing.
Required:
a. Prepare a table showing annual accounting earnings prepared under absorption costing for the Space Saver dishwasher for annual production levels of 68,000, 73,000, and 78,000 washers.
b. If Lynn Tweedie's bonus depends on reported accounting earnings from Space Saver dishwashers, what production quantity is she likely to select for the fourth quarter?
c. Prepare a table computing the valuation of the ending inventory (under LIFO) for annual production levels of 68,000, 73,000, and 78,000 washers.
d. If Lynn Tweedie's bonus depends on residual income from Space Saver dishwashers, what production quantity is she likely to select for the fourth quarter?
e. How would your answer change in part (d) if Tweedie's bonus was based on return on assets?

Question

Quizplus · Accepted Answer

The Answer is a. Annual earnings for various production levels is given in the following table:

$a. Annual earnings for various production levels is given in the following table: 1 5,000 units × $90/unit 2 $1,300,000 × (73,000/78,000) 3 73,000 × $15 b. Tweedie is likely to produce 20,000 washers in the fourth quarter or 78,000 for the year as this level maximizes reported profit. c. The ending inventory values for various production levels are: \begin{array} { | l | r | r | r | } \hline ext { Annual production } & 68,000 & 73,000 & 78,000 \ \hline ext { Beginning inventory } & 12,000 & 12,000 & 12,000 \ \hline ext { Production } & 68,000 & 73,000 & 78,000 \ \hline \begin{array} { l } ext { Less: Sales } \ ext { Ending inventory } \end{array} & ( 73,000 ) & ( 73,000 ) & ( 73,000 ) \ &7,000&12,000&7,000\ \hline \begin{array} { l } ext { Ending Inventory @ } \ ext { LIFO cost: } \end{array} & & & \ \hline \begin{array} { l } ext { Units from the } \ ext { beginning inventory } \end{array} & 7,000 & 12,000 & 12,000 \ \hline \begin{array} { l } ext { Valued at } \$ 90 / ext { washer } \end{array} & \$ 630,000 & \$ 1,080,000 & \$ 1,080,000 \ \hline \begin{array} { l } ext { Units from current } \ ext { year production } \end{array} & 0 & 0& 5,000\ \hline \begin{array} { l } ext { Valued at current year } \ ext { cost: } \end{array} & & & \ \hline \begin{array} { l } ext { (\$75+ } \ \$ 1,300,000 / 78,000 = \ \$ 91.6666 ) \end{array} & & & \$ 458,333 \ \hline \begin{array} { l } ext { Total inventory value } \ ext { at cost (LIF0) } \end{array} & \$ 630,000 & \$ 1,080,000 & \$ 1,538,333 \ \hline \end{array} d. Residual income for various production levels: \begin{array}{|l|r|r|r|} \hline \begin{array}{l} ext { Annual } \ ext { production } \end{array} & 68,000 & 73,000 & 78,000 \ \hline \begin{array}{l} ext { Total inventory } \ ext { value at cost } \ ext { (LIFO) } \end{array} & \$ 630,000 & \$ 1,080,000 & \$ 1,538,333 \ \hline \begin{array}{l} ext { Invested capital } \ ext { excluding } \ ext { inventories } \end{array} & \underline{18,000,000} & \underline{18,000,000}& \underline{18,000,000} \ \hline \begin{array}{l} ext { Total invested } \ ext { capital } \end{array} & \$ 18,630,000 & \$ 19,080,000 & \$ 19,538,333 \ \hline \begin{array}{l} ext { Times weighted } \ ext { average cost of } \ ext { capital } \end{array} & \underline{0.17} & \underline{0.17} & \underline{0.17} \ \hline \begin{array}{l} ext { Residual } \ ext { income }^{1} \end{array} & \$ 567,900 & \$ 566,400 & \$ 571,817 \ \hline \end{array} 1 Net income - 15% × total invested capital Based on the above data, Tweedie is likely to produce 78,000 washers, since this level maximizes her residual income. e. ROA for various production levels: \begin{array} { | l | r | r | r | } \hline \begin{array} { l } ext { Annual } \ ext { production } \end{array} & 68,000 & 73,000 & 78,000 \ \hline ext { Net income } & \$ 3,735,000 & \$ 3,810,000 & \$ 3,893,333 \ \hline \begin{array} { l } ext { Divided by Total } \ ext { invested capital } \end{array} & \underline{\$ 18,630,000} & \underline{\$ 19,080,000} & \underline{\$ 19.538,333} \ \hline ext { ROA } & 20.05 \% & 19.97 \% & 19.93 \% \ \hline \end{array} If Tweedie is rewarded based on ROA she is likely to produce 68,000 washers for the year.$
¹ 5,000 units × $90/unit
² $1,300,000 × (73,000/78,000)
³ 73,000 × $15
b. Tweedie is likely to produce 20,000 washers in the fourth quarter or 78,000 for the year as this level maximizes reported profit.
c. The ending inventory values for various production levels are:

\begin{array} { | l | r | r | r | } \hline ext { Annual production } & 68,000 & 73,000 & 78,000 \\hline ext { Beginning inventory } & 12,000 & 12,000 & 12,000 \\hline ext { Production } & 68,000 & 73,000 & 78,000 \\hline \begin{array} { l } ext { Less: Sales } \ ext { Ending inventory }\end{array} & ( 73,000 ) & ( 73,000 ) & ( 73,000 ) \&7,000&12,000&7,000\\hline \begin{array} { l } ext { Ending Inventory @ } \ ext { LIFO cost: }\end{array} & & & \\hline \begin{array} { l } ext { Units from the } \ ext { beginning inventory }\end{array} & 7,000 & 12,000 & 12,000 \\hline \begin{array} { l } ext { Valued at } \$ 90 / ext { washer }\end{array} & \$ 630,000 & \$ 1,080,000 & \$ 1,080,000 \\hline \begin{array} { l } ext { Units from current } \ ext { year production }\end{array} & 0 & 0& 5,000\\hline \begin{array} { l } ext { Valued at current year } \ ext { cost: }\end{array} & & & \\hline \begin{array} { l } ext { (\$75+ } \\$ 1,300,000 / 78,000 = \\$ 91.6666 )\end{array} & & & \$ 458,333 \\hline \begin{array} { l } ext { Total inventory value } \ ext { at cost (LIF0) }\end{array} & \$ 630,000 & \$ 1,080,000 & \$ 1,538,333 \\hline\end{array}

d. Residual income for various production levels:

\begin{array}{|l|r|r|r|}\hline \begin{array}{l} ext { Annual } \ ext { production }\end{array} & 68,000 & 73,000 & 78,000 \\hline \begin{array}{l} ext { Total inventory } \ ext { value at cost } \ ext { (LIFO) }\end{array} & \$ 630,000 & \$ 1,080,000 & \$ 1,538,333 \\hline \begin{array}{l} ext { Invested capital } \ ext { excluding } \ ext { inventories }\end{array} & \underline{18,000,000} & \underline{18,000,000}& \underline{18,000,000} \\hline \begin{array}{l} ext { Total invested } \ ext { capital }\end{array} & \$ 18,630,000 & \$ 19,080,000 & \$ 19,538,333 \\hline \begin{array}{l} ext { Times weighted } \ ext { average cost of } \ ext { capital }\end{array} & \underline{0.17} & \underline{0.17} & \underline{0.17} \\hline \begin{array}{l} ext { Residual } \ ext { income }^{1}\end{array} & \$ 567,900 & \$ 566,400 & \$ 571,817 \\hline\end{array}

¹ Net income - 15% × total invested capital
Based on the above data, Tweedie is likely to produce 78,000 washers, since this level maximizes her residual income.
e. ROA for various production levels:

\begin{array} { | l | r | r | r | } \hline \begin{array} { l } ext { Annual } \ ext { production }\end{array} & 68,000 & 73,000 & 78,000 \\hline ext { Net income } & \$ 3,735,000 & \$ 3,810,000 & \$ 3,893,333 \\hline \begin{array} { l } ext { Divided by Total } \ ext { invested capital }\end{array} & \underline{\$ 18,630,000} & \underline{\$ 19,080,000} & \underline{\$ 19.538,333} \\hline ext { ROA } & 20.05 \% & 19.97 \% & 19.93 \% \\hline\end{array}

If Tweedie is rewarded based on ROA she is likely to produce 68,000 washers for the year.