Question

John Ovard, president of Mylar Inc., is looking forward to receiving the company’s second-quarter income statement. He knows the sales budget of 20,000 units sold was met during the second quarter and that this represented a 25% increase in sales over the first quarter. He is especially happy about the increase in sales, since Mylar is about to approach its bank for additional loan money for expansion purposes. He anticipates that the strong second quarter results will be a real plus in persuading the bank to extend the additional credit.
For this reason, Ovard is shocked when he receives the second-quarter income statement below, which shows a substantial drop in absorption costing operating income from the first quarter.

Mylar Inc. Income Statements For the first two quarters
	Quarter 1		Quarter 2
Sales		$1,600,000		$2,000,000
Cost of goods sold:
Opening inventory	$210,000		$490,000
Add: cost of goods manufactured	1,400,000		980,000
	1,610,000		1,470,000
Less: ending inventory	490,000		70,000
Add: underapplied overhead	0	1,120,000	240,000	1,640,000
Gross margin		480,000		360,000
Selling and administrative expenses		310,000		330,000
Operating income		$170,000		$30,000

Ovard is certain there is an error somewhere and immediately calls the controller into his office to find the problem. The controller states, “That 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 operating income.”

Ovard is angered by the controller’s explanation: “I call you in here to find out why income dropped when sales went up, and 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.

	Quarter
	First	Second	Third	Fourth
Budgeted sales	16,000	20,000	20,000	24,000
Actual sales	16,000	20,000	--	--
Budgeted production	20,000	20,000	20,000	20,000
Actual production	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.

Assignment Instructions

Take on the role of the controller of Mylar Inc. Write a memo to Ovard to explain the following:

1-What characteristic of absorption costing caused the drop in operating income for the second quarter?

2-Prepare a contribution format income statement for each quarter using variable costing, and reconcile the resulting operating income figure to that of the absorption costing operating income for each quarter.

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

4-Provide Ovard with an example: Assume 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.)

5-How many units would have been produced during the second quarter under lean production?

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

Answer 1

1.

• Net operating income depends upon both production and sales, thus explanation of controller was correct
• However, due to a reduction in production, the company was not able to absorb its fixed manufacturing overhead which resulted in a decrease of income.

2.

Part 2
	Quarter 1	Quarter 2
Sales	$16,00,000.00	$20,00,000.00
Var Mfg OH	$4,80,000.00	$6,00,000.00
Var. Sales OH	$80,000.00	$1,00,000.00
Contribution	$10,40,000.00	$13,00,000.00
Fixed Mfg OH	$8,00,000.00	$8,00,000.00
Fixed Sales OH	$2,30,000.00	$2,30,000.00
Profit	$10,000.00	$2,70,000.00
Reconcilliation
	Quarter 1	Quarter 2
Var. Costing Profit	$10,000.00	$2,70,000.00
Deduct Fixed Mfg OH from opening inventory	$(1,20,000.00)
Adjust F.M.OH from 1st quarter to 2nd quarter	$2,80,000.00	$(2,80,000.00)
Add F.M.OH deffered from 2nd quarter to future		$40,000.00
	$1,70,000.00	$30,000.00

3.

Advantages

• Helps in forecasting and reporting
• Helps in better decision making as it is more visible and easier to understand
• Profits vary directly with sales volume

Disadvantages

• Difficult to determine fixed and variable costs
• Not acceptable for external reporting

4.

Units sold 15000

Less: Beg. invnetory 7000

Units produced during quarter 8000