The production manager at Terra Firma is responsible for estimating the percentage of completion for all terra cotta planters, figurines, and yard art. Recently, she determined that the work in process inventory was 40 percent complete with respect to conversion costs. Shortly after the production manager produced her monthly report, she received a call from the company's controller. He asked her to stop by his office for a conversation at the end of the day. Not quite knowing what to expect, she stopped by and found the controller poring over the monthly financial reports. He quickly told her that he was concerned about her estimate of the percentage completion for the work in process inventory. He also told her that he was worried the company would not be receiving the new loan that it so desperately needs. She asked how her report could affect the loan decision. He asked her to reconsider her production report. Before she left his office, he said that it would really help matters if she could see things his way and just increase the percentage of completion to 60 percent. After all, the inventory would be finished next month, anyway.
1. What impact will increasing the percentage of completion have on Terra Firma's financial statements? Use numbers to back up your answer.
2. Should the production manager agree with the request?
3. What actions should the production manager take with respect to discussing her conversation with others? Be sure to consider other employees as well as outside parties (for example, friends, law enforcement, the company's loan officer).
1. Conversion cost consists of direct labor and factory overhead. It is the amount of costs incurred to finish or convert the goods into a finished product. In this case, we have inventory that's 40% complete for conversion costs. If she increases the percentage of completion to 60% of inventory, it lowers conversion costs and increased finished goods. This increases the profit margin, which in turn increases the company's net income. It would show that more goods are completed than what actually are, and because the goods would be shown as 60% complete, only 40% would still be incurring costs. If the production manager shows 40% complete (as it should be), the other 60% would still be incurring ...
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