[nestle_life]

Hey guys, so I’m new at accounting and I’m having a somewhat hard time understanding this concept with inventory costs and production costs. Also, I don’t see what this has to do with the short-term interest costs – AT ALL. Why would it even matter?

Ethan, Inc. has seasonal demand for its products and management is considering whether level production or seasonal production should be implemented. The firms’s short-term interest cost is 8%, and management has developed the following information to make the decision:

Alternative 1 Alternative 2

Level production Seasonal production

Average inventory $1,500,000 $2,000,000

Production costs $6,000,000 $6,050,000

Which alternative should be accepted and how much is saved over the other alternative?

a. Alternative 1 with $500,000 in savings.

b. Alternative 2 with $50,000 in savings.

c. Alternative 2 with $10,000 in savings.

d. Alternative 1 with $10,000 in savings.

The answer is D. The explanation is as follows: Under the level production alternative, the firm would incur an additional

$40,000 [($1,500,000 ¨C $2,000,000) x 8%] in inventory holding costs but it would save $50,000 in production costs.

Now this is really confusing: If I went about it, I would think “OK, so I would save $500,000 in average inventory costs – make sense, but then I would incur an additional $50,000 costs in production costs. So, I would save $450,000”

I don’t understand why D is the answer, still, after reading the explanation. I don’t understand what short-term interest costs have to do with this. Who cares about that? Right?

[Anonymous]

Level production sort of flattens out the peaks and valley's in your income statement. As to the answer to the rest of your question, I'm gonna say “BUMP”. Maybe someone else can help.

[Author]

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