As a practical matter, the scheme of building inventories to increase profits would work. However, the $800,000 in fixed manufacturing overhead is only deferred in inventory. It is an axe 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 target profits, 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 problems, all of the deferred costs will flow through to the income statement—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 this is the kind of action the Board of Directors had in mind when they set the target profit. Chances are that the Board of Directors would object to this kind of manipula-tion if they were informed of the reason for the buildup of inventories. The company must incur addi-tional costs to build inventories at the end of the year. Does this make any sense when there is no indi-cation 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 Michael are asking him to waste the owners’ money so as to artificially inflate the reported net operat-ing income so that they can get a bonus.
Behaviorally, this is troubling because it suggests that the former CEO left behind an unfortunate lega-cy in the form of managers who encourage questionable business practices. Michael needs to set a new moral climate in the company or there will likely be even bigger problems down the road. Michael should firmly turn down the managers’ request and let them know why.
Having said all of that, it would not be easy for Michael to turn down $50,000—which is precisely what Michael 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.