Robert Buey became Chief Executive Officer of Phelps Manufacturing two years ago

Question

Robert Buey became Chief Executive Officer of Phelps Manufacturing two years ago. At the time, the company was reporting lagging profits, and Robert was brought in to "stir things up." The company has three divisions, electronics, fiber optics, and plumbing supplies. Robert has no interest in plumbing supplies, and one of the first things he did was to put pressure on his accountants to reallocate some of the company’s fixed costs away from the other two divisions to the plumbing division. This had the effect of causing the plumbing division to report losses during the last two years; in the past it had always reported low, but acceptable, net income. Robert felt that this reallocation would shine a favorable light on him in front of the board of directors because it meant that the electronics and fiber optics divisions would look like they were improving. Given that these are "businesses of the future," he believed that the stock market would react favorably to these increases, while not penalizing the poor results of the plumbing division. Without this shift in the allocation of the fixed costs, the profits of the electronics and fiber optics divisions would not have improved. But now the board of directors has suggested that the plumbing division be closed because it is reporting losses. This would mean that nearly 500 employees, many of whom have worked for Phelps their whole lives, would lose their jobs.



If a division is reporting losses, does that necessarily mean that it should be closed?

Was the reallocation of fixed costs across divisions unethical?

What should Robert do?

Explanation / Answer

A division shouldn't necessarily be closed because it is reporting losses. if it is making variable margin and contributing toward offsetting fixed costs, it should be kept open, at least in the short term. The allocation of costs was unethical unless it could be justified by an accounting study that showed that the fixed costs belonged in that division. Robert should get his accounting staff (or hire someone) to do a study (preferably activity based costing) to see what the appropriate allocation of fixed costs to the departments should be.

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