Inventory and Costs

IIM Lucknow, Noida Campus MANAGEMENT ACCOUNTING –II Assignment – II, Daniel Dobbins Distillery, Inc (Case Analysis) Submitted By: Rahul Srivastava (WMP08034) Vinay Joshi (WMP08045) ANALYSIS Company History * Founded in 1880 in Oakwoods by Daniel Dobbins. * Major product is Old Trailridge Bourbon Whisky * High quality of whisky due to the unusual iron-free spring water used in the distillation process and the specially prepared fire-charred white oak barrels used in the aging process. * David Dobbins takes over in 1973. * Constant demand over the years High demand surge forecasted due to maturity of Baby boom generation. Manufacturing Process * Ingredients controlled by laws. * Barrels can be used only once * Barrels are made through a patented process * Whisky has to mature for at least 4 years after the process. * Stored in 50 gallon barrels for mellowing in warehouse Maturing or Aging Process * The 50-gallon barrels manufactured under a unique patented process at acos t of more than $60 per barrel. The barrels could not be reused foraging future batches of bourbon whiskey but could be sold to used barrel dealers for $1 each at the end of the aging period. The increased production in 1988 necessitated the leasing of an additional warehouse at an annual rental cost of $200,000. The temperature and humidity of the warehouse space had to be controlled since the quality of the whiskey could be ruined by its aging too fast or too slowly. * A small amount of liquid was removed from representative barrels at this time and sent to the sampling laboratory for quality inspection (usually performed by skilled tasters). If the quality of the whiskey was not up to standard, certain measures were taken, such as adjusting the aging process, to bring it up to standard. At this time, each barrel was also checked for leaks or seepage, and the required repairs were made. * On the average, the volume of liquid in a barrel declined by 30% during the aging period becau se of evaporation and leakage. Thus, a barrel originally filled with 50 gallons of new bourbon would, on the whole, produce only 35 gallons of aged bourbon. * The re-gauging operation was supervised by a government liquor tax agent, since it was at this point that federal excise tax of $21 per gallon was levied on the whiskey removed from the warehouse. In 1987 and 1988, the company sold 30,000 re-gauged barrels of whiskey, equivalent to about 43,000 barrels of original production. Excerpts from Board Meeting * Low prospect of obtaining the $3 million loan needed in light of our 1988loss of $814,000. We have shown annual profits since 1974, and our net sales of $42 million this year are the same as last year, and yet we incurred a net loss for the year. * It may appear that we are becoming less efficient in our production operation. * We increased production by 50% this year, and with this increased production our costs are bound to increase.You can't produce something for nothing. * Production costs must rise when production increases, but our inventory account takes care of the increased costs of deferring these product costs until a future period when the product is actually sold. * COGS did not increase in 1988, since the volume of sales was the same in 1988 as in 1987. The largest share of the increase in production costs has-been deferred until future periods, as you can see by looking at the increase in our inventory account of more than $1 million. The real reason for our loss this year was the large increase in other costs, composed chiefly of warehousing costs. The â€Å"Occupancy Costs† category in our P is really the summation of a group of expense accounts, including building depreciation or rent, heat, light, power, building maintenance, labor and supplies, real estate taxes, and insurance. In addition, warehouse labor cost also rose substantially in 1988. * We increased production, and this also means an increase in warehousing costs, sin ce the increased production has to be aged for several years.You just can't age 50% more whiskey for the same amount of money. * The inventory account can only be charged with those costs associated with the direct production of whiskey, and our warehousing costs are handling or carrying costs, certainly not production costs. * The manufacturing process doesn't stop with the newly produced bourbon; why it isn't even marketable in that form. Aging is an absolutely essential part of the manufacturing process, and I think the cost of barrels and part of the warehouse labor should be treated as direct costs of the product. Warehousing and aging costs are an absolutely essential ingredient of our final product. * Direct costs are those costs that are necessary to convert raw materials into the whiskey that goes into the aging barrels. * This is our cost of approximately $1 per gallon and includes the cost of raw materials going into the product such as grain, yeast, and malt; the direct labor necessary to convert these materials into whiskey; and the cost of any other overhead items that are needed to permit the workers to convert grain into whiskey. The Problem The main issue at Daniel Dobbins Distillery, Inc. s a disagreement among the senior management with regards to the allocation of costs. Specifically, it is a question of whether to include Ageing Costs, Cost of Barrels, and Warehouse Expense as a part of inventory (in which case it will be an asset that belongs to the Balance Sheet) or as a part of Occupancy Costs (which will be listed in the Income Statement). Listing the above mentioned costs as part of the balance sheet will overstate the assets and understate the expenses misleading the actual profitability of the company. Alternatives 1. Leave all accounts as they are. . Transfer Cost of Barrel from Other Costs in the Income Statement to the Balance Sheet as a Contra-Asset that is part of Inventory. Transfer Ageing Costs from the Income Statement to th e Balance Sheet and list it under Long Term Contra-Assets. Break up Warehouse Labor into different temporary accounts that are spread out both on the Income Statement as well as the Balance Sheet. Evaluation of Alternatives Alternative 1: Strengths: This alternative improves the Net Profit figure in the Income Statement by increasing the value of Closing Inventory in the Balance Sheet.Weaknesses: Breaking up Warehouse Labor and accurately allocating the costs across the two financial statements may not be feasible. Opportunities: Choosing this alternative immediately improves its chances of securing the $3,000,000 loan from the bank. Threats: Carrying out this alternative poses the risk of the company getting unfavorable press which may have a negative impact on its reputation. Another threat is that this alternative could be misused by senior management as a way of hiding inefficiencies, bad expenses, overstating retained earnings, and understating expenses.Alternative 2: Logically Inventory costs include all the direct costs involved in the production process till the finished goods (ready for sale). As in this process ageing is an essential part of the manufacturing process, the cost of barrels and warehousing should be treated as direct costs otherwise it will affect the Income Statements for the subsequent years thereby misleading the actual profitability of the company. Other costs involved are: Occupancy Costs: Factory Building (Used for warehousing also) which is rented.Warehouse Labor & supervisor cost. Depreciation: Warehouse Equipment. All these costs will remain in COGS and Costs of Barrel used during the year at$63,00 per barrel will be added to (asset) Inventory and hence closing inventory(Effect in balance Sheet: Closing Inventory value increase) will shoot up and hence Net Profit Figure(in P&L statement) will also improve upon by the same amount. At the end of four years of aging process, barrels are removed and dumped into re-gauging tanks.Hen ce, all these costs will be added to (asset) Inventory and hence closing inventory (Effect in balance Sheet: Closing Inventory value increases) will shoot up and hence Net Profit Figure (in P&L statement) will also improve upon by the same amount. Another issue faced is possible difficulty in obtaining a $3 million loan due to reported loss of $814,000 for the year ended 1988. There is a need of urgency to solve the above matters and loan approval due to urgent need of working capital. The reason for such urgency and loss reporting are as follows: a.Increase in production capability: Daniel Dobbins increased its production capacity by 50% in 1988 to meet the expected increase in demand through 1991 to 1995. The production of whiskey takes 4 yrs before its ready for consumption and hence, the planning has to be done 4 yrs ahead to meet the required demand. b. Additional rent on new Warehouse: The increased production capacity in 1988 necessitated Daniel Dobbins to lease out a new sto rage warehouse at an annual rent of $200,000 which led to a sudden increase in expenses. c. Additional expenses related to warehouse Labor and supervisor.The higher the profit the stronger of company`s chance to get approved for the loan/credit by the Bank hence company should adopt the Accounting procedures stated above i. e. charging all direct costs as well as warehousing and ageing costs to Inventory and hence improving upon the Net Profit figures to increase company chances for loan approval. Few important points to be considered are: * Evaporation: A barrel is originally filled with 50 gallons of new bourbon but after aging only 35 gallons of aged bourbon is left. Cost of raw materials is incurred in producing 15 gallons of bourbon which gets lost due to evaporation.So accounting of this cost should also be considered. * Adjustment of aging process: If aged bourbon is not up to the standard, then each barrel needs to be checked for leaks or proliferated barrels and requires re pairs. Some more details: Because of the market forecast that the demand of straight whiskey will be doubled from 1987 to 1995, the board of Daniel Dobbins Whiskey Inc decided to increase the production of whiskey in 1988 by 50% of the 1987 volume to meet the anticipated increase in consumer demand from 1991 through 1995.The manufacturing process of whiskey can be divided into two stages: Under the first stage which consists of several different steps, raw materials are converted into a clear liquid with a sharp, biting taste. The second stage which is also called ‘Maturing or Aging Process’ involves maturing or aging for a minimum of four years under controlled temperature and humidity conditions. Because of the increase in cost of production in 1988, which will generate revenues only in 1991, the income statement of Daniel Dobbins Inc showed a net loss of $814000 which was a significant change from net profit of $1504000 in 1987.In order to get loan of $3 million from Ridgeview National Bank of Nashville, the point of consideration for COO of Daniel Dobbins Distillery is how to present the financial results of 1988 to the bank. This loan is critical for company to remain solvent. One of the key issues in this case is how to divide the increased costs in 1988 between ‘Inventoriable costs’ and ‘Period costs’. According to the case, while preparing the income statement in 1988, the costs of first stage was included under inventoriable costs and costs of second stage was included under Period costs which resulted in net loss in 1988.Increase in cost of production in second stage can be attributed to following increase in costs under second stage of manufacturing. a) Increased costs due to increase in the number of barrels used for aging. $1260,000 b) Increase in occupancy cost: $332,000 c) Increase in warehousing cost: $146,000 d) Increase in Labor and supplies expense: $30,000 e) Increase in Depreciation expense: $8000 f) Increase in cost of government supervision: $8000Each of the above increase in costs of production in 1988 can be transferred from period costs to inventoriable costs and net profits can be increased for year 1988 e. g. if we just transfer increase in costs due to increase in number of barrels ($1260,000) to balance sheet from income statement, the net profit of year 1988 will become ( $1260,000 – $814,000 = $446,000) but as a result the net profit of subsequent years will go down as the cost of goods sold will be increased in coming years.So the decision to transfer different costs to inventoriable costs which gets included as assets in balance sheet instead of expenses in income statement can be left to management depending upon how much profit it want to report in current as well as subsequent years. Since aging is an absolutely essential part of the manufacturing process and the manufacturing process doesn’t stop after the first stage, Costs of barrels and warehous e labor costs should be included under inventoriable costs. This will increase the profits of the company in 1988 and will also help them in getting the loan