Question

John Ovard, president of Mylar Ltd., was looking forward to receiving the company's second quarter income statement. He knew that the sales budget of 20,000 units sold had been met during the second quarter and that this represented a 25% increase in sales over the first quarter. He was especially happy about the increase in sales, since Mylar was about to approach its bank for additional loan money for expansion purposes. He anticipated that the strong second-quarter results would be a real plus in persuading the bank to extend the additional credit.

For this reason, Mr. Ovard was shocked when he received the second-quarter income statement below, which showed a substantial drop in absorption costing net operating income from the first quarter.

Mylar, First two Quarters First Quarter

Sales

Cost of goods sold:

Beginning Inventory £210,000 Add cost of goods 1,400,000 manufactured

Goods available for 1,610,000 sale

Less ending inventory 490,000 Cost of goods sold 1,120,000 Add underapplied 0 overhead

Gross margin

Selling and admin

expenses

Net operating income

£1,600,000

1,120,000

480,000 310,000

£170,000

Mylar, First two Quarters

First Quarter

£490,000 980,000

1,470,000

70,000 1,400,000 240,000

£2,000,000

1,640,000

360,000 330,000

£30,000

Mr. Ovard was certain there had to be an error somewhere and immediately called the controller into his office to find the problem. The controller stated, “That net operating income is correct, John. Sales went up during the second quarter, but the problem is in production. You see, we budgeted to produce 20,000 units each quarter, but a strike in one of our supplier's plants forced us to cut production back to only 14,000 units in the second quarter. That's what caused the drop in net operating income.”

Mr. Ovard was angered by the controller's explanation. “I call you in here to find out why income dropped when sales went up, and you talk about production! So what if production was off? What does that have to do with the sales that we made? If sales go up, then income ought to go up. If your statements can't show a simple thing like that, then we're due for some changes in your area!”

Budgeted production and sales for the year, along with actual production and sales for the first two quarters, are given below:

Budgeted sales (units) Actual sales (units) Budgeted production (units)

Actual production (units)

Quarter

First Second Third Fourth 16,000 20,000 20,000 24,000

16,000 20,000 -

20,000 20,000 20,000 20,000

20,000 14,000 -

-

-

The company's plant is heavily automated, so fixed manufacturing overhead costs total £800,000 per quarter. Variable manufacturing costs are £30 per unit. The fixed manufacturing overhead cost is applied to units of product at the rate of £40 per unit (based on the budgeted production shown above). Any underapplied or overapplied overhead is closed directly to cost of goods sold for the quarter.

The company had 3,000 units in inventory to start the first quarter and uses the FIFO inventory flow assumption. Variable selling and administrative expenses are £5 per unit sold.

Required:

An Essay on Absorption costing vs Marginal Costing, using the following guiding questions.

1. What characteristic of absorption costing caused the drop in net operating income for the second quarter and what could the controller have said to explain the problem?

2. Prepare a contribution format income statement for each quarter using variable costing.

3. Reconcile the absorption costing and the variable costing net operating income figures for each quarter.

4. Identify and discuss the advantages and disadvantages of using the variable costing method for internal reporting purposes.

5. Assume that the company had introduced Lean Production methods at the beginning of the second quarter, resulting in zero ending inventory. (Sales and production during the first quarter were as shown above.)

a. How many units would have been produced during the second quarter under Lean Production?

b. Starting with the third quarter, would you expect any difference between the net operating income reported under absorption costing and under variable costing? Explain why there would or would not be any difference.

Answer 1

1.   Under absorption costing, the net operating income of a particular period is dependent on both production and sales. For this reason, the controller's explanation was accurate. He should have pointed out, however, that the reduction in production resulted in a large amount of underapplied overhead, which was added to cost of goods sold in the Second Quarter. By producing fewer units than planned, the company was not able to absorb all the fixed manufacturing overhead incurred during the quarter into units of product. The result was that this unabsorbed overhead ended up on the income statement as a charge against the period, thereby sharply slashing income.

2.		First Quarter	Second Quarter
	Sales...........................................................................	€1,600,000	€2,000,000
	Variable expenses:
	Variable manufacturing @ €30 per unit....................................................	480,000	600,000
	Variable selling and administrative @ €5 per unit......................................................	80,000	100,000
	Total variable expenses..............................................	560,000	700,000
	Contribution margin..................................................	1,040,000	1,300,000
	Fixed expenses:
	Fixed manufacturing overhead..............................	800,000	800,000
	Fixed selling and administrative*..........................	230,000	230,000
	Total fixed expenses..................................................	1,030,000	1,030,000
	Net operating income................................................	€ 10,000	€ 270,000

*	Selling and administrative expenses, First Quarter..	310,000
	Less variable portion (16,000 units × 5 per unit)...................................	80,000
	Fixed selling and administrative expenses...............	230,000

3.   To answer this part, it is helpful to prepare a schedule of inventories, production, and sales in units:

	Beginning Inventory	Units Produced	Units Sold	Ending Inventory
First Quarter.......................	3,000	20,000	16,000	7,000
Second Quarter...................	7,000	14,000	20,000	1,000

      Using these inventory data, the reconciliation would be as follows:

	First Quarter	Second Quarter
Variable costing net operating income................................	10,000	270,000
Deduct: Fixed manufacturing overhead cost released from inventory during the First Quarter (3,000 units × 40 per unit)....................................................................	(120,000)
Add (deduct): Fixed manufacturing overhead cost deferred in inventory from the First Quarter to the Second Quarter (7,000 units × 40 per unit)..................	280,000	(280,000)
Add: Fixed overhead manufacturing cost deferred in inventory from the Second Quarter to the future (1,000 units × 40 per unit).............................................		40,000
Absorption costing net operating income...........................	170,000	30,000

      Alternative solution:

Variable costing net operating income................................	10,000	270,000
Add: Fixed manufacturing overhead cost deferred in inventory to the Second Quarter (4,000 unit increase × 40 per unit)....................................................................	160,000
Deduct: Fixed manufacturing overhead cost released from inventory due to a decrease in inventory during the Second Quarter (6,000 unit decrease × 40 per unit).................................................................................		(240,000)
Absorption costing net operating income...........................	170,000	30,000

4.   The advantages of using the variable costing method for internal reporting purposes include the following:

      ●   Variable costing aids in forecasting and reporting income for decision-making purposes.

      ●   Fixed costs are reported in total amount, thereby increasing the opportunity for more effective control of these costs.

      ●   Profits vary directly with sales volume and are not affected by changes in inventory levels.

      ●   Analysis of cost-volume-profit relationships is facilitated and management is able to determine the break-even point and total profit for a given volume of production and sales.

      The disadvantages of using the variable costing method for internal reporting purposes include the following:

      ●   Variable costing lacks acceptability for external financial reporting and cannot be used for income taxes in the United States. As a result, additional record keeping costs may be required.

      ●   It may be difficult to determine what costs are fixed and what costs are variable.

5.   a.   Under lean production, production is geared strictly to sales. Therefore, the company would have produced only enough units during the quarter to meet sales needs. The computations are:

Units sold...................................................................................................	20,000
Less units in inventory at the beginning of the quarter..............................	7,000
Units produced during the quarter under lean production........................	13,000

            Although not asked for in the problem, a move to lean production during the Second Quarter would have reduced the company's reported net operating income even further. The loss for the quarter would have been:

Sales.............................................................................		2,000,000
Cost of goods sold:
Beginning inventory.................................................	490,000
Add cost of goods manufactured (13,000 units × $70 per unit)................................	910,000
Goods available for sale...........................................	1,400,000
Ending inventory.....................................................	0
Cost of goods sold...................................................	1,400,000
Add underapplied overhead*..................................	280,000	1,680,000
Gross margin................................................................		320,000
Selling and administrative expenses............................		330,000
Net operating loss........................................................		(10,000)

*	Overhead rates are based on 20,000 units produced each quarter. If only 13,000 units are produced, then the underapplied fixed manufacturing overhead will be: 7,000 units ×€ 40 per unit = €280,000.

      b.   Starting with the Third Quarter, there will be little or no difference between the incomes reported under variable costing and under absorption costing. The reason is that there will be few inventories on hand and therefore no way to shift fixed manufacturing overhead cost between periods under absorption costing.