David Dobbins, president and chief operating officer (COO) of Daniel Dobbins Distillery, Inc., of Oakwoods, Tennessee, sat in his office pondering the results of the previous day's meeting of the board of directors and wondering whether he should submit the 1988 financial statements to the Ridgeview National Bank of Nashville, Tennessee in support of a recent loan request for $3 million, or whether he should wait until after next month's board meeting to clarify some of the preceding day's discussion. A great deal of controversy had arisen over the 1988 reported loss of $814,000 and how this result should be reported to the bank. The controversy revolved principally around the accounting treatment of various expenses reported in the "other costs" section of the operating statement. Mr. Dobbins knew that a decision had to be reached on these matters quickly, because the company had reached a point where additional working capital was needed immediately if it was to remain solvent.

Company History Founded in 1880 in Oakwoods by Daniel Dobbins. Major product – Old Trailridge Bourbon Whisky High quality of whisky due to the unusual iron-free spring water used in

the distillation process and the specially prepared fire-charred white oak barrels used in the aging process.

David Dobbins takes over in 1973 Constant demand over the years High demand surge forecasted due to maturity of Baby boom generation

Manufacturing Process Ingredients controlled by laws. Barrels can be used only once Barrels are made through a patented process Whisky has to mature for at least 4 years after the process. Stored in 50 gallon barrels for mellowing in warehouse

Maturing or Aging Process The 50-gallon barrels manufactured under a unique patented process at a

cost of more than $60 per barrel. The barrels could not be reused for aging future batches of bourbon whiskey but could be sold to used barrel dealers for $1 each at the end of the aging period.

The increased production in 1988 necessitated the leasing of an additional warehouse at an annual rental cost of $200,000. The temperature and humidity of the warehouse space had to be controlled, since the quality of the whiskey could be ruined by its aging too fast or too slowly.

A small amount of liquid was removed from representative barrels at this time and sent to the sampling laboratory for quality inspection (usually performed by skilled tasters). If the quality of the whiskey was not up to standard, certain measures were taken, such as adjusting the aging process, to bring it up to standard.

At this time, each barrel was also checked for leaks or seepage, and the required repairs were made.

On the average, the volume of liquid in a barrel declined by 30% during the aging period because of evaporation and leakage. Thus, a barrel originally filled with 50 gallons of new bourbon would, on the whole, produce only 35 gallons of aged bourbon.

The regauging operation was supervised by a government liquor tax agent, since it was at this point that federal excise tax of $21 per gallon was levied on the whiskey removed from the warehouse.

In 1987 and 1988, the company sold 30,000 regauged barrels of whiskey, equivalent to about 43,000 barrels of original production.

Excerpts from Board Meeting Low prospect of obtaining the $3 million loan needed in light of our 1988

loss of $814,000. We have shown annual profits since 1974, and our net sales of $42 million this year are the same as last year, and yet we incurred a net loss for the year.

It may appear that we are becoming less efficient in our production operation.

We increased production by 50% this year, and with this increased production our costs are bound to increase. You can't produce something for nothing.

Production costs must rise when production increases, but our inventory account takes care of the increased costs of deferring these product costs until a future period when the product is actually sold.

COGS did not increase in 1988, since the volume of sales was the same in 1988 as in 1987. The largest share of the increase in production costs has been deferred until future periods, as you can see by looking at the increase in our inventory account of more than $1 million.

The real reason for our loss this year was the large increase in other costs, composed chiefly of warehousing costs. The "Occupancy Costs" category in our P&L is really the summation of a group of expense accounts, including building depreciation or rent, heat, light, power, building maintenance, labor and supplies, real estate taxes, and insurance. In addition, warehouse labor cost also rose substantially in 1988.

We increased production, and this also means an increase in warehousing costs, since the increased production has to be aged for several years. You just can't age 50% more whiskey for the same amount of money.

The inventory account can only be charged with those costs associated with the direct production of whiskey, and our warehousing costs are handling or carrying costs, certainly not production costs.

The manufacturing process doesn't stop with the newly produced bourbon; why it isn't even marketable in that form. Aging is an absolutely essential part of the manufacturing process, and I think the cost of barrels and part of the warehouse labor should be treated as direct costs of the product.

Warehousing and aging costs are an absolutely essential ingredient of our final product.

Direct costs are those costs that are necessary to convert raw materials into the whiskey that goes into the aging barrels.

This is our cost of approximately $1 per gallon and includes the cost of raw materials going into the product such as grain, yeast, and malt; the direct labor necessary to convert these materials into whiskey; and the cost of any other overhead items that are needed to permit the workers to convert grain into whiskey.