Absorption Costing Effect on Earnings when Volumes Fluctuate
BBG Corp is a manufacturer of a synthetic chemical. Gary Voss, president of the company, has been eager to get the operating results for the just-completed fiscal year. He was surprised when the income statement revealed that income before taxes had dropped to $885,500 from $900,000, even though sales volume had increased by 100,000 kilograms. The drop in net income occurred even though Voss had implemented two changes during the past 12 months to improve the company’s profitability:
1. In response to a 10 percent increase in production costs, the sales price of the company’s product was increased by 12 percent. This action took place on December 1, 1994, the first day of the current fiscal year.
2. The managers of the selling and administrative departments were given strict instructions to spend no more in the current fiscal year than last year. BBG’s accounting department prepared and distributed to top management the comparative income statements presented below.
BBG Corp Statements of Operating Income for Year Ended Nov 30 ($000s)
Last Year Current Year
Sales Revenue $9,000,000 $11,200,000
Cost of Goods Sold $7,200,000 $ 8,320,000
Under/over absorbed overhead $ (600,000) $ 495,000
Adjusted Cost of Goods Sold $6,600,000 $ 8,815,000
Gross Margin $2,400,000 $ 2,385,000
Selling & Administrative Expenses $1,500,000 $ 1,500,000
Income before Taxes $ 900,000 $ 885,000
The accounting staff also prepared related financial information to assist management in evaluating the company’s performance. BBG uses the FIFO inventory method for finished goods. Budgeted and fixed overhead are equal and the beginning inventory last year has $3.00/kg. of fixed overhead.
BBG Corp Selected Operating and Financial Data
Last Year Current Year
Sales Price $10.00/kg $11.20/kg
Material Cost $1.50/kg $1.65/kg
Direct Labor Cost $2.50/kg $2.75/kg
Variable Overhead Cost $1.00/kg $1.10/kg
Fixed Overhead Cost $3.00/kg $3.30/kg
Total Fixed Overhead Cost $3,000,000 $3,300,000
Normal Production Volume 1,000,000kg 1,000,000kg
Selling & Administrative (All Fixed) $1,500,000 $1,500,000
Sales Volume 900,000kg 1,000,000 kg
Beginning Inventory 300,000kg 600,000kg
Production 1,200,000kg 850,000kg
A. Explain to Gary Voss why BBG Corp’s net income decreased in the current fiscal year despite the sales price and sales volume increases.
B. A member of BBG’s accounting dept suggested that the company adopt variable (direct) costing for internal reporting purposes.
1. Prepare an operating income statement through income before taxes for the current year ended Nov. 30 using the variable (direct) costing method.
2. Present a numerical reconciliation of the difference in income before taxes using the absorption costing method as currently employed by BBG and the proposed variable costing method.
C. Identify and discuss the advantages and disadvantages of using variable costing for internal reporting purposes.