Headgear Inc Case Study

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Evaluation of HeadGear, Inc.
Learning Team 8: Sebastiano Mangiafico, Fredy Quintero,
Zain Shahid, and Patricia Wood
University of Central Florida
ACG6425
June 28, 2012
Evaluation of HeadGear, Inc.
HeadGear, Inc is a small manufacturer of headphones for use in commercial and personal applications. In recent times, the demand for headphones has grown steadily; however, the company’s profits have grown at a slower rate. John Hurley, the chief executive officer (CEO), is concerned about the falling productivity and increasing costs. John is aware that if the profits continue to decline, the result can negatively affect the stock price of the company. A decline in stock prices will hinder the firm's ability to raise new investment capital, which is essential in the growth of the company. John made the decision to bring in a new chief operating officer (COO) with the objective of improving profitability very quickly. John incentivized the new COO with a 10% bonus if he attains the goal of profit improvement. The following is the income statement for HeadGear for the period ending 2002. HeadGear Inc.|

Income Statement for the period ending 12/31/2002|
Sales (125,000 @ $75)| | $9,375,000|
| | |
Cost of Sales:| | |
Beginning Inventory: (5,000 @ $41)| $205,000| |
Cost of Production: (120,000 @ $41)| $4,920,000| |
Goods Available: (130,000)| $5,125,000| |
Less Ending Inventory: (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 Income| | -$25,000|
Absorption Cost Net Income
The absorption cost net income is $330,000.

Variable manufacturing costs of $25 per are applied against the actual unit sales of 140,000 which gives $3.5M variable cost of sales. Additionally the budgeted fixed manufacturing costs per unit extended to the actual units sold resulting in $1.68M in fixed manufacturing costs; this resulted in $5.32M in gross margin/profit. SG&A expenses accounted for $2.24M in variable and $2.75M in fixed expenses that resulted in an operating income profit of $330K.

Absorption costing assumes that fixed manufacturing overhead costs are realized when the products are sold; therefore fixed costs associated with inventory is realized in the accounting period that the products are sold. By the new COO applying the absorption costing method in 2003, the company reflects a higher operating income because HeadGear does not realize the costs associated with the additional 35,000 units remaining in inventory that were not sold in the current period. The absorption costing method enables companies to delay showing the fixed costs for products in inventory until the products are sold; therefore, the fixed costs associated with the 35,000 units remaining in inventory would be realized in the next period when they are sold. Because the fixed overhead costs are not realized until the units are sold, HeadGear may over-inflate the actual profit in the current period. Over-inflation of the actual profit can give the illusion to the stakeholders the company is increasing profits at higher percent as compared to using other costing methods like variable costing. Variable Cost Net Income

The variable cost net income is -$90,000. Variable manufacturing costs of $25 per are applied against the actual unit sales of 140,000 resulting in $3.5M | | variable cost of sales. Additionally the budgeted fixed manufacturing costs per unit extended to the actual units produced resulted in $2.1M in fixed manufacturing costs; resulting in $4.9M in gross margin/profit. SG&A expenses accounted for $2.24M in variable and $2.75M in fixed expenses that resulted in an operating income loss of -$90K.

Variable costing realizes fixed manufacturing costs when units are produced and is not dependent on when a product is sold;...
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