HeadGear, Inc.

HeadGear, Inc is a small manufacturer of headphones for use in commercial and personal applications. The HeadGear headphones are known for their outstanding sound quality and light weight, which makes them highly desirable especially in the commercial market for telemarketing firms and similar communication applications, despite the relatively high price. Although demand has grown steadily, profits have grown much more slowly, and John Hurley, the CEO, suspects productivity is falling, and costs are rising out of hand. John is concerned that the decline in profit growth will affect the stock price of the company and inhibit the firm’s efforts to raise new investment capital, which will be needed to continue the firm’s growth. While the firm is now operating at 68% of available production capacity, John thinks the market growth will soon exceed available capacity.

To improve profitability, John has decided to bring in a new COO with the objective of improving profitability very quickly. The new COO understands that profits must be improved within the coming 10-18 months. A bonus of 10% of profit improvement is promised the new COO if this goal is achieved. The following is the income statement for HeadGear for 2010, from the most recent annual report. Product costs for HeadGear include $25 per unit variable manufacturing costs and $1,920,000 per year fixed manufacturing overhead. Budgeted production was 120,000 units in 2010. Selling and administrative costs include a variable portion of $15 per unit and a fixed portion of $2,400,0000 per year. The same units costs and production level are also applicable for 2009. HeadGear Inc.

Income Statement for the Period Ended 12/31/2010
Sales (125,000 @$75) $ 9,375,000
Cost of Sales:
Beginning Inv: 5,000 @ $41 $  205,000
Cost of Production: 120,000 @ $41  4,920,000
Goods Available: 130,000 $5,125,000
Less Ending Inv: 0 @ $41 -0- $5,125,000
Gross Margin $4,250,000
Selling and Administrative
Variable Costs: 125,000 @ $15 $ 1,875,000
Fixed Costs   2,400,000 $4,275,000
Net loss $  <25,000>

The new COO is convinced that the problem is the need to aggressively market the product, and that the apparent decline in productivity is really due to underutilization of capacity. The COO increases fixed manufacturing costs to $2,100,000 and variable selling costs to $16 per unit and fixed selling costs to $2,750,000 to help achieve this goal. Budgeted sales and production for 2008 are set at 175,000 units. Actual production was 175,000 as planned but sales for 2008 turned out to be only 140,000 units, short of the target. The new COO claims that profits have increased considerably, and is looking forward to the promised bonus. REQUIRED:

1. Calculate the absorption cost net income for 2011, assuming the new selling costs, and that manufacturing costs remain the same as 2010. 2. Calculate the variable cost net income for 2011 and explain why it is different from the absorption cost net income. 3. Is the new COO due a bonus? Comment on the effectiveness of Hurley’s plan to improve profits by hiring the new COO and promising the bonus. 4. Identify and explain any important ethical issues you see in this case.

1. Calculate the absorption cost net income for 2011, assuming the new selling costs, and that manufacturing costs remain the same as 2010. See attached Excel sheet for computation. The case mentions 2008 where I believe they are discussing 2011 assumptions. Also, the requirement says to use 2010 manufacturing costs so I didn’t use the new fixed costs mentioned in the case. However, if you need to change these assumptions based on your professor’s instructions, you can change the assumptions (yellow cells) and the entire solution will update perfectly. 2. Calculate the variable cost net income for 2011 and explain why it is different from the absorption cost net income. See the attached Excel sheet for computation and reconciliation by showing the ending inventory costs.

3. Is the new COO due a bonus? Comment on the effectiveness of Hurley’s plan to improve profits by hiring the new COO and promising the bonus. No, the COO is not due a bonus. The reason the profits seem higher under absorption costing is that there are substantial fixed costs of the period that were capitalized because production was so much higher than sales. The fixed costs is trapped on the balance sheet and will be expensed when the items are sold. See reconciliation in Excel for a visual on this. 4. Identify and explain any important ethical issues you see in this case. In determining the fixed costs per unit for the period for absorption costing (not needed for variable costing since the entire fixed cost is expensed as a cost of the month, not a cost of units), you spread the fixed costs across all the units made. Since production was increased substantially, the fixed cost per unit was reduced: Fixed manufacturing cost per unit:

at 140,000 units $ 13.71
at 175,000 units $ 10.97
This gives the illusion of lower cost of goods sold (and thus higher profits) but it is, in fact, just a temporary capitalizing of the fixed manufacturing costs due to inventory build up. While building inventories does “trap” fixed costs on the balance sheet, pressuring managers to improve profits gives them an incentive to build inventories to spread the fixed costs thinner and make COGS smaller per unit. This is not ethical. Building inventories in order to improve a profit computation is not profession or ethical but the pressure to perform can create such a temptation.

Your tutorial is 315 words plus three exhibits in Excel (attached) and includes a discussion of how building inventories impacts profits. An ethical consideration is mentioned. The excel template can be used with other similar absorption versus variable costing methods as the formulas point to the assumption cells and can be updated for any problem. Click in cells to see computations. This should give you a general idea so you can create a report in your own words.