# 296 given the facts in the case 1998 pre tax profit

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296
Given the facts in the case, 1998 pre-tax profit was:Sales revenues(4,000,000 @ \$3.50)\$14,000,000Cost of goods sold:Variable production costs(4,000,000 @ \$1.45)(\$5,800,000)Fixed production costs:From 1997 ending inventory(1,500,000 ×\$1.50)2,250,000From 1998 production sold in 1998(2,500,000 ×\$1.875)14,687,500(6,937,500)297
Operating profit1,262,500Interest expense__(100,000)Pre-tax profit\$1,162,5001Fixed cost per unit of 1998 production ==\$1.875Notice that total fixed overhead charged as expense in 1997 was \$6,000,000, whereas the figure for 1998 was \$6,937,500 (i.e., \$2,250,000 from 1997 ending inventory plus \$4,687,500 from 1998 production sold in 1998).298
Requirement 2:The problem could have been prevented had Mr. Carleton anticipated the artificial decrease in profit that was sure to take place as inventory levels were decreased. Then, this decrease could have been removed from the profit figure used to calculate the bonus. The easiest way to do this would have been to base the computation on variable cost income rather than absorption cost income.299
Had Baines Corporation been using variable costing as the computation base, the comparative income figures for 1997 and 1998 would have been:19971998Sales revenues(4,000,000 @ \$3.50)\$14,000,000\$14,000,000Cost of goods sold:Variable production costs(4,000,000 @ \$1.45)(5,800,000)(5,800,000)Fixed production costs (period expense)(6,000,000)(6,000,000)300
Operating profit2,200,0002,200,000Interest expense__(200,000) __(100,000)Pre-tax profit\$2,000,000)\$2,100,000On the variable costing basis, notice that the comparative income figures improved due to the reduction in interest cost. Using these figures to compute the bonuses would have reflected the managersÕ excellent efforts in controlling inventories.301
Although earnings are widely used as a basis for incentive compensation plans, there are several problems with earnings-based incentives. One of the more obvious ones is that earnings changes can be illusory when they result from changes in accounting procedures. Furthermore, accounting profit is not sensitive enough to capture situations like those where managers postpone discretionary expenditures in order to artificially raise the current periodÕs profits.302
C8-5. Handy & Harman: Comprehensive LIFO analysisThis case asks students to adjust between LIFO pre-tax income and FIFO pre-tax income. The LIFO reserve is so large that the setting also provides a nice vehicle for exploring ratio distortions (and required adjustments) for companies on LIFO. Explanations for the LIFO-FIFO income difference as well as the cumulative tax savings under LIFO are also covered.303
We have deliberately set the case in 1980 rather than in the 1990s because the issues that we want to illustrate are much more dramatic and transparent in this earlier period. There are two reasons for this. First, precious metals prices increased significantly in 1979. Second, the Hunt BrothersÕ attempt to corner the silver market occurred during this period, and their failure led to a steep fall in silver prices in 1980.