Hampshire Company: Quantitative Analysis Case Study

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Inventory Management

With the business environment constantly changing, our managers must evaluate cost management issues that can impact operating costs and performance. A review of two costing methods (variable and absorption) for inventory was recently done using the financial information from our last fiscal year (2014).

Cost Allocation Method

The relevant costs (direct materials and labor, manufacturing overhead) show the company should be using the variable cost allocation method. Variable cost allocation includes all variable manufacturing costs (direct and indirect) as inventoriable costs while excluding fixed costs from inventoriable costs; fixed costs instead are accounted during the period they were incurred (Horngren, Datar, Rajan, 2015a, p. 329). Using variable costing, Hampshire had an operating income of $94,475 in 2014 versus an operating income of $148,475 using absorption costing (Testa, 2017b) (Table 1.).

Hampshire Company-FY2014

Variable Costing

Absorption Costing

Sales

750,000

750,000

Total Variable Costs

392,000

Ending Inventory

98,000

COGS

(456,000)

Variable Costs of Goods Sold

(294,000)

Gross Margin

294,000

Variable Selling Costs

(66,000)

Variable Selling Costs

(66,000)

Contribution Margin

390,000

Fixed Manufacturing Costs

(216,000)

Fixed Administrative Costs

(79,525)

Fixed Administrative Costs

(79,525)

Operating Income

97,475

Operating Income

148,475

Table 1. Cost Allocation Comparison. This figures shows the comparison between variable and absorption costing methods based on FY 2014 data

While both methods show relevant costs at $392,000, the absorption method has inventoried the fixed manufacturing costs for the year while the variable method has expensed it. The difference accounts for the number of umbrellas sold in 2014 that resulted in operating income, not from costs attributed to the cost of inventory (Horngren et al., 2015a, pp. 333-335).

By implementing variable costing, we are allowing our managers to, (1) determine actual cost per unit, (2) provide the ability to determine the financial health of the company as sales are the driving force behind the operating income each fiscal year, (3) use variable costing, “to sell additional units during a specific time frame”, by adding to Hampshire’s “bottom line in sales and profits because the units do not cost the company more money to produce” (Scott, n.d.), (4) eliminate performance based pressures, and (5) stop inflating operating income statements (Horngren et al., 2015a, p. 335).

Just-In-Time Inventory System

To further evaluate the company’s cost management issues, a review of just-in-time (JIT) inventory systems was conducted. JIT is a process allowing companies to purchase the necessary materials for production as they are needed (Horngren, Datar, Rajan, 2015b, p. 773). The implementation of JIT would result in certain advantages and disadvantages; each needs considerable attention.

Pros and Cons to JIT

The following are advantages that could be gained by adopting a JIT system; Hampshire Company (Gordon, 2014; Williams, n.d., para 3):

- would minimize the amounts of goods being held at any one point

- can create a more cost-efficient process for handling inventory

- would see operating costs dramatically reduced as a result of fewer carrying costs

- overall would increase productivity through training a more flexible work force

The review of JIT also found potential disadvantages to inventory management including; risk of running out of stock, loss of control over timing of production, and the relative complexity involved in planning the entire implementation along with initial costs and changing the mindset of the workforce (Barlow, 2015, “Disadvantages”; Williams, n.d., para 4). However, the managers feel that the advantages outweigh those disadvantages and would lead to lowering operating costs for the company once fully implemented.

Recommendation for Inventory Management

My group of manages involved in the review have decided to recommend moving from our current inventory system to a JIT production system. The managers found the implementation of JIT would directly benefit the company by; lowering operating costs and increasing productivity. However, the managers feel the most beneficial aspect of implementing a JIT system would be increased customer satisfaction with our umbrellas. By using JIT, the company would better meet the demand of our customer while eliminating the potential for over producing that results in wasted productions costs (e.g. 20,000 umbrellas not sold that cost $98,000 to produce in 2014) (Testa, 2017b). Under this system, Hampshire would lower the current carrying costs for inventory while meeting the demand for our umbrellas as the it occurs (Horngren et al., 2015b, p. 778). In 2014, the company only sold 75% of the umbrellas produced (Testa, 2017b). Implementing a JIT production system would foster the production of umbrellas dictated by demand while; removing unnecessary inventory