Ethics in Business
Consumers and attorney generals in more than 40 states accused a prominent nationwide chain of auto repair shops of misleading customers and selling them unnecessary parts and services, from brake jobs to front-end alignments. Lynn Sharpe Paine reported the situation as follows in “Managing for Organizational Integrity,” Harvard Business Review, Volume 72 Issue 3:
In the face of declining revenues, shrinking market share, and an increasingly competitive market … management attempted to spur performance of its auto centers. … The automotive service advisers were given product-specific sales quotas—sell so many springs, shock absorbers, alignments, or brake jobs per shift—and paid a commission based on sales. … [F]ailure to meet quotas could lead to a transfer or a reduction in work hours. Some employees spoke of the “pressure, pressure, pressure” to bring in sales.
This pressure-cooker atmosphere created conditions under which employees felt that the only way to satisfy top management was by selling products and services to customers that they didn’t really need.
Suppose all automotive repair businesses routinely followed the practice of attempting to sell customers unnecessary parts and services.
- How would this behavior affect customers? How might customers attempt to protect themselves against this behavior?
- How would this behavior probably affect profits and employment in the automotive service industry?
Ethics and the Manager
M. K. Gallant is president of Kranbrack Corporation, a company whose stock is traded on a national exchange. In a meeting with investment analysts at the beginning of the year, Gallant had predicted that the company’s earnings would grow by 20% this year. Unfortunately, sales have been less than expected for the year, and Gallant concluded within two weeks of the end of the fiscal year that it would be impossible to ultimately report an increase in earnings as large as predicted unless some drastic action was taken. Accordingly, Gallant has ordered that wherever possible, expenditures should be postponed to the new year—including canceling or postponing orders with suppliers, delaying planned maintenance and training, and cutting back on end-of-year advertising and travel. Additionally, Gallant ordered the company’s controller to carefully scrutinize all costs that are currently classified as period costs and reclassify as many as possible as product costs. The company is expected to have substantial inventories of work in process and finished goods at the end of the year.
- Why would reclassifying period costs as product costs increase this period’s reported earnings?
- Do you believe Gallant’s actions are ethical? Why or why not?
BIG INVENTORIES AT THE BIG THREE DETROIT AUTOMAKERS
The Big Three Detroit automakers have exorbitant inventories because they still rely on mass production, whereas Honda and Toyota use lean production methods. The Detroit automakers try to lower their average fixed overhead cost per unit by making as many vehicles as possible. This approach results in bloated inventories and the frequent use of incentives and rebates to generate sales. Toyota and Honda produce vehicles in response to customer orders, resulting in lower inventories and less reliance on costly marketing gimmicks.
If the U.S. automakers tried to improve their competitiveness by substantially lowering their inventories it would reduce profits. Can you explain why this would be the case for companies that use absorption costing? How would you feel as a manager if your inventory reduction efforts resulted in lower profits and a smaller bonus?
Source: Neal Boudette, “Big Dealer to Detroit: Fix How You Make Cars,” The Wall Street Journal, February 9, 2007, pp. A1 and A8
PROBLEM 9-20Behavioral Aspects of Budgeting; Ethics and the Manager
Norton Company, a manufacturer of infant furniture and carriages, is in the initial stages of preparing the annual budget for next year. Scott Ford has recently joined Norton’s accounting staff and is interested to learn as much as possible about the company’s budgeting process. During a recent lunch with Marge Atkins, sales manager, and Pete Granger, production manager, Ford initiated the following conversation.
Ford: Since I’m new around here and am going to be involved with the preparation of the annual budget, I’d be interested to learn how the two of you estimate sales and production numbers.
Atkins: We start out very methodically by looking at recent history, discussing what we know about current accounts, potential customers, and the general state of consumer spending. Then, we add that usual dose of intuition to come up with the best forecast we can.
Granger: I usually take the sales projections as the basis for my projections. Of course, we have to make an estimate of what this year’s ending inventories will be, which is sometimes difficult.
Ford: Why does that present a problem? There must have been an estimate of ending inventories in the budget for the current year.
Granger: Those numbers aren’t always reliable because Marge makes some adjustments to the sales numbers before passing them on to me.
Ford: What kind of adjustments?
Atkins: Well, we don’t want to fall short of the sales projections so we generally give ourselves a little breathing room by lowering the initial sales projection anywhere from 5% to 10%.
Granger: So, you can see why this year’s budget is not a very reliable starting point. We always have to adjust the projected production rates as the year progresses and, of course, this changes the ending inventory estimates. By the way, we make similar adjustments to expenses by adding at least 10% to the estimates; I think everyone around here does the same thing.
- Marge Atkins and Pete Granger have described the use of what is sometimes called budgetary slack.
- Explain why Atkins and Granger behave in this manner and describe the benefits they expect to realize from the use of budgetary slack.
- Explain how the use of budgetary slack can adversely affect Atkins and Granger.
- As a management accountant, Scott Ford believes that the behavior described by Marge Atkins and Pete Granger may be unethical. By referring to the IMA’s Statement of Ethical Professional Practice, explain why the use of budgetary slack may be unethical.
Ethics and the Manager; Rigging Standards
Stacy Cummins, the newly hired controller at Merced Home Products, Inc., was disturbed by what she had discovered about the standard costs at the Home Security Division. In looking over the past several years of quarterly income statements at the Home Security Division, she noticed that the first-quarter profits were always poor, the second-quarter profits were slightly better, the third-quarter profits were again slightly better, and the fourth quarter always ended with a spectacular performance in which the Home Security Division managed to meet or exceed its target profit for the year. She also was concerned to find letters from the company’s external auditors to top management warning about an unusual use of standard costs at the Home Security Division.
When Ms. Cummins ran across these letters, she asked the assistant controller, Gary Farber, if he knew what was going on at the Home Security Division. Gary said that it was common knowledge in the company that the vice president in charge of the Home Security Division, Preston Lansing, had rigged the standards at his division in order to produce the same quarterly income pattern every year. According to company policy, variances are taken directly to the income statement as an adjustment to cost of goods sold.
Favorable variances have the effect of increasing net operating income, and unfavorable variances have the effect of decreasing net operating income. Lansing had rigged the standards so that there were always large favorable variances. Company policy was a little vague about when these variances have to be reported on the divisional income statements. While the intent was clearly to recognize variances on the income statement in the period in which they arise, nothing in the company’s accounting manuals actually explicitly required this. So for many years Lansing had followed a practice of saving up the favorable variances and using them to create a nice smooth pattern of growing profits in the first three quarters, followed by a big “Christmas present” of an extremely good fourth quarter. (Financial reporting regulations forbid carrying variances forward from one year to the next on the annual audited financial statements, so all of the variances must appear on the divisional income statement by the end of the year.)
Ms. Cummins was concerned about these revelations and attempted to bring up the subject with the president of Merced Home Products but was told that “we all know what Lansing’s doing, but as long as he continues to turn in such good reports, don’t bother him.” When Ms. Cummins asked if the board of directors was aware of the situation, the president somewhat testily replied, “Of course they are aware.”
- How did Preston Lansing probably “rig” the standard costs—are the standards set too high or too low? Explain.
- Should Preston Lansing be permitted to continue his practice of managing reported profits?
- What should Stacy Cummins do in this situation?