EXERCISE 7-9 (20 MINUTES)

5. As a practical matter, the scheme of building inventories in order to in-

crease profits would work. However, the $328,000 in fixed manufactur-

ing overhead is only deferred in inventory. It is an ax hanging over the

head of the managers. If the inventories are allowed to fall back to

normal levels in the next year, all of that deferred cost will be released

to the income statement. In order to keep using inventory buildups as a

way of meeting profit goals, inventories must keep growing year after

year. Eventually, someone on the Board of Directors is likely to question

the wisdom of such large inventories. Inventories tie up capital, take

space, result in operating problems, and expose the company to the risk

of obsolescence. When inventories are eventually cut due to these prob-

lems, all of the deferred costs will flow through to the income state-

ment—with a potentially devastating effect on net operating income.

Apart from this practical consideration, behavioral and ethical issues

should be addressed. Taking the ethical issue first, it is unlikely that

building up inventories is the kind of action the Board of Directors had in

mind when they set the profit goal. Chances are that the Board of Direc-

tors would object to this kind of manipulation if they were informed of

the reason for the buildup of inventories. The company must incur costs

in order to build inventories at the end of the year. Does this make any

sense when there is no indication that the excess inventories will be

needed to meet sales demand? Wouldn’t it be better to wait and meet

demand out of normal production as needed? Essentially, the managers

who approached Guochang are asking him to waste the owners’ money

so as to artificially inflate the reported net operating income so that they

can get a bonus.

Behaviorally, this is troubling because it suggests that the former CEO

left behind an unfortunate legacy in the form of managers who encour-

age questionable business practices. Guochang needs to set a new

moral climate in the company or there will likely be even bigger prob-

lems down the road. Guochang should firmly turn down the managers’

request and let them know why.

Case 7-19 (continued)

Having said all of that, it would not be easy for Guochang to turn down

a bonus that could be potentially as large as $25,000—which is precisely

what Guochang would be doing if he were to pass up the opportunity to

inflate the company’s earnings. And, his refusal to cooperate with the

other managers may create a great deal of resentment and bitterness.

This is a very difficult position for any manager to be in and many would

probably succumb to the temptation.