Answered Essay: Old Turkey Mash is a whiskey manufactured by distilling grains and corn and then aging the mixture for five years in 50-gallon o

Old Turkey Mash is a whiskey manufactured by distilling grains and corn and then aging the mixture for five years in 50-gallon oak barrels. Distilling requires about a week and aging takes place in carefully controlled warehouses. Before it ages, the whiskey is too bitter to be consumed. Ageing mellows the brew and ultimately the consumer. The cost of the product prior to aging is $100 per barrel (direct plus indirect cost of distilling). In the aging process, each barrel must be inspected monthly and any leaks repaired. Every six months the barrels are rotated and sampled for quality. Costs of direct labor and materials in the aging process (excluding the cost of oak barrels) amount to $50 per barrel per year (all variable). As the whiskey ages, evaporation and leakage cause each 50 gallon barrel to produce only 40 gallons of bottled whiskey. New oak barrels cost $75 each and cannot be reused. After aging, they are cut in half and sold for flowerpots. The revenues generated from sales of the pots just cover the costs of disposing of the used barrels. As soon as the whiskey is aged 5 years, it is bottled and sold to wholesalers.

While domestic consumption of whiskey is falling, an aggressive international marketing campaign has opened up new international markets. The firm is in the third year of a five year campaign to double production. Because it takes 5 years to increase production (an additional barrel of mash produced today does not emerge from the aging process for 5 years), the firm is adding 100,000 gallons of distilled product each year. Prior to the expansion, 500,000 distilled gallons were produced each year. Distilled output is being increased 100,000 gallons a year for five years until it reaches 1 million gallons. Distilled output is currently 800,000 gallons and is projected to rise to 900,000 gallons next year. The accompanying table describes production, sales, and inventory in the aging process.

Base year       Year 1             Year 2                  Year 3

Production (distilled gallons) 500,000           600,000          700,000               800,000

Aged gallons sold                            400,000           400,000          400,000               400,000

Warehouse Inventory at Beginning of Year

4year old bbls                                   10,000           10,000             10,000                   10,000

3year old bbls                                   10,000           10,000             10,000                   10,000

2year old bbls                                   10,000           10,000             10,000                   12,000

1year old bbls                                   10,000           10,000             12,000                   14,000

New bbls added                               10,000           12,000             14,000                   16,000

=Total bbls to be aged in year 50,000           52,000             56,000                   62,000

(bbls=barrels)

Warehousing rental costs to age the base year production of 10,000 barrels per year are $1 million per year. Additional warehouse rental cost of $40,000 per year must be incurred to age each additional 20,000 barrels (100,000 distilled gallons). All costs incurred in warehousing re treated as handling or carrying costs and are written off when incurred. Bottled Old Turkey is sold to distributors for $15 per gallon. These income statements summarize the firm’s current operating function. Also add 25,000 in advertising to the income statement.

 

Base year         Year 1             Year 2                  Year 3

Revenues $6,000,000      $6,000,000     $6,000,000       $6,000,000

Less:

Cost of goods sold:

10,000 bbls @ $100/bbl 1,000,000           1,000,000       1,000,000         1,000,000

Oak barrels 750,000              900,000       1,050,000         1,200,000

Warehouse rental 1,000,000          1,040,000       1,120,000         1,240,000

Warehouse direct costs 2,500,000          2,600,000       2,800,000         3,100,000

Net Income (loss)

Before taxes $ 750,000         $   460,000       $    30,000       $ (540,000)

Income taxes (30%) 225,000              138,000                9,000           (162,000)

Net income after taxes $   525,000        $    322,000      $     21,000      $   (378,000)

Management is quite concerned about the loss that is projected for the third year of the expansion (the current year). The president has scheduled a meeting with the local bank to review the firm’s current financial performance. This bank has been lending the firm the capital to finance the production expansion.

Required:

1. Instead of writing off all the warehousing and oak barrel costs, prepare revised income statements for years 1-3, treating the warehousing and barrel costs as product costs.

2. Which set of income statements (those given or the ones you prepared) should the president show the bank at the meeting? Justify your answer.

* Please explain how you got your answers in the revised income statements I couldn’t figure it out.

Expert Answer

 

Answer a.
Income Statements
Base Year Year 1 Year 2 Year 3
Revenues          6,000,000          6,000,000          6,000,000          6,000,000
Less: Cost of Goods Sold
bbls distilled @100 per bbl          1,000,000          1,000,000          1,000,000          1,000,000
Oak barrels              750,000              750,000              750,000              750,000
Warehouse rental          1,000,000          1,000,000          1,000,000          1,000,000
Warehouse Direct cost          2,500,000          2,500,000          2,500,000          2,500,000
Net Income before taxes              750,000              750,000              750,000              750,000
Income Taxes -30%              225,000              225,000              225,000              225,000
Net Income after taxes              525,000              525,000              525,000              525,000
Increase in income from capitalizing aging costs                          –              203,000              504,000              903,000
Answer b.
The president first find out if the firm continue to write off aging costs as period expenses for costs as period expenses for taxes while capitalizing these costs for financial reporting purposes. If the tax rules are such that the firm can keep separate books, then take both sets of income statement and the cash flow statements to the bank and find out which set of statements they feel more accurately reflects the firms financial condition.
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