Author Question: Motivational considerations in denominator-level capacity selection Required: 1. If the plant ... (Read 98 times)

corkyiscool3328 · **on:** Jul 6, 2018

Motivational considerations in denominator-level capacity selection

Required:
1. If the plant manager of the Jacksonville Brewery gets a bonus based on operating income, which denominator-level capacity concept would he prefer to use? Explain.
2. What denominator-level capacity concept would Castle Lager prefer to use for U.S. income-tax reporting? Explain.
3. How might the IRS limit the flexibility of an absorption-costing company like Castle Lager attempting to minimize its taxable income?

Question 2

What is meant when we say that revenue and expenses fall under the umbrella of owner's equity? Why does revenue have the same placement of plus and minus signs as the Capital account, and why do expenses have the opposite placement of plus and minus signs as does the Capital account?

akudia · **Reply #1 on:** Jul 6, 2018

Answer to Question 1

1. If the plant manager gets a bonus based on operating income, he/she will prefer the denominator-level capacity to be based on normal capacity utilization (or master-budget utilization). In times of rising inventories, as in 2014, this denominator level will maximize the fixed overhead trapped in ending inventories and will minimize COGS and maximize operating income. Of course, the plant manager cannot always hope to increase inventories every period, but on the whole, he/she would still prefer to use normal capacity utilization because the smaller the denominator, the higher the amount of overhead costs capitalized for inventory units. Thus, if the plant manager wishes to be able to adjust plant operating income by building inventory, normal capacity utilization (or master-budget capacity utilization) would be preferred.

2. Given the data in this question, the theoretical capacity concept reports the lowest operating income and thus (other things being equal) the lowest tax bill for 2014. Castle Lager benefits by having deductions as early as possible. The theoretical capacity denominator-level concept maximizes the deductions for manufacturing costs.

3. The IRS may restrict the flexibility of a company in several ways:
a. Restrict the denominator-level concept choice (to say, practical capacity).
b. Restrict the cost line items that can be expensed rather than inventoried.
c. Restrict the ability of a company to use shorter write-off periods or more accelerated write-off periods for inventoriable costs.
d. Require proration or allocation of variances to represent actual costs and actual capacity used.

Answer to Question 2

Revenue is said to fall under the umbrella of owner's equity because revenue represents amounts earned by the business. Earnings serve to increase the owner's investment. Consequently, the placement of the plus and minus signs for revenue should be the same as that for Capital. Expenses are said to fall under the umbrella of owner's equity because expenses represent the costs of earning the revenue or doing business. Consequently, expenses are deductions from revenue and, as such, the placement of the plus and minus signs is the opposite of that for revenue, which also makes them the opposite of Capital.