This case study will look at Jokkmok Industries and one of its managers, Mr. Rosen, who is bucking for a promotion to CEO. His division uses absorption costing and has the ability to produce 50,000 units a quarter with a fixed overhead amount of $600,000. While the sales forecast shows that the company will only sell 25,000 units during each of the next two quarters, Mr. Rosen wants to double his budgeted production for the second quarter from 25,000 to 50,000 units. We will look at Mr. Rosen’s decision and see how it affects his company’s bottom line by putting the figures from last quarter and the next quarter into an absorption income statement and a contribution margin statement. From this we will be able to see the differences in production costs from the two income statements. These figures will let us be able to assess if Mr. Rosen has improved his division’s performance by increasing production. We will also be able to tell if absorption costing is a viable option for management to use when making decisions like increasing production when sales are not forecasted to improve. We will also discuss a few shortcomings of the absorption approach and how it relates to management. And finally, we will see if Mr. Rosen’s decision would allow him to be considered for the CEO position. Absorption vs. Variable Costing (Contribution margin)
“The main difference between variable costing and absorption costing is the accounting for fixed manufacturing costs.” (Horngren C. n.d.) This is never more evident than in this case study. Income statements prepared using these different methods usually produce different net operating income, and they will also produce different costs per unit sold. In order to completely fill out the income statements we will need to look at the 1st quarter’s income statement listed in Table 1.
From the data in table 1 we will need more data to input into the absorption and contribution margin income statements. This additional data is displayed in Table 2.
Now we will plug these numbers into both the absorption and contribution margin income statements shown in tables 3 and 4 below for both the 1st and 2nd quarters. Information for setting up these tables was obtained from the
article “Income Comparison of Variable and Absorption Costing” from Accountingexplanation.com.
One can notice right away that there are some major differences between the two income statements especially in the 2nd quarter’s net operating income. Under absorption the net operating income is $650,000 and Mr. Rosen would think that his bottom line is looking better and he could almost see himself in the corner office. But running the numbers using the variable costing method in the contribution income statement, the increase in production shows the same net operating income as the previous quarter which was $350,000. So how can the bottom line look so much better under absorption than contribution? The main reasons have to do with fixed manufacturing overhead and inventories. Fixed manufacturing overhead are things like rent, facilities expenses, salaries, and insurance that do not change over a given period of time. “Since fixed overhead costs do not change substantially, they are easy to predict, and so should rarely vary from the budgeted amount.” (Bragg 2013) This is demonstrated in the cost per unit sold difference between the first and second quarters.
First quarter’s was $72 while 2nd was $60. The reason is because fixed manufacturing costs are involved in the equation. In absorption you have to take the fixed manufacturing costs ($600,000) and divide by the total units manufactured (50,000) to get $12 per unit. Now you add that to the cost per unit manufactured on Table 1 ($48) to get a total of $60 per unit manufactured. When the company only produced 25,000 units the cost was $72 per unit. ((600,000/25,000) + $48 = $72). Now the excess fixed manufacturing costs are rolled into inventory for the next quarter. As shown in the less ending inventory in Table 3 ($1,500,000), because 25,000 units of the units manufactured were not sold. Contribution margin or variable costing does not break up the fixed manufacturing costs, instead it puts in the entire amount of $600,000 into the quarter and does not roll over the fixed costs into inventory. (As shown in the line fixed manufacturing overhead below the contribution margin.) However, in variable costing, $48 of manufacturing cost per unit is rolled over in the inventory. Because variable costing accounts for the fixed costs entirely it is the better option for knowing where your company stands.
Besides the problems with absorption costing listed above, it considers fixed manufacturing overhead as product cost which shows a higher cost per unit than variable costing. As a result, it does not help management decide the selling price of a product. In the example above table 3 shows $72 and $60 per unit sold, while table 4, the variable cost per unit sold is $55. Also absorption costing can make the bottom line look better than it is by removing product costs from the income statement by producing inventory. This way managers, like Mr. Rosen, who are evaluated on the basis of operating income can temporarily improve profitability by increasing production. But there some that still think there are advantages to absorption costing. “Advocates of absorption costing argue that all manufacturing costs must be assigned to products in order to properly match the costs of producing units of product with the revenues from the units when they are sold.” (Accountingexplanation.com n.d.) But given the reasons stated above variable costing is still the way to keep the books for the decision makers.
I would not recommend Mr. Rosen for the CEO position because he seems to have cooked the absorption books in his favor. By increasing his production he manipulated the fixed manufacturing costs to show them lower than they really are and thus showing a better net operating income. But the real costs are rapped up in inventory for the next quarter to worry about, like kicking the can down the road. There is something that Mr. Rosen could do, or might have been planning to do, to correct the inventory problem. He could plan on selling more units. What if market research shows that sales will increase by nearly 20% if Lokkmok drops prices by 5% to gain a competitive edge in the 3rd quarter? Look at Tables 5 and 6 below to show how dropping the prices and increasing sales to get rid of inventory would help the bottom line. Notice the difference between keeping the status quo of pricing and sales compared to the ‘what if’ third quarter numbers on both income statements.
Now notice the difference of the bottom line between the absorption ‘what if’ 3rd quarter and the contribution margin income statement, the bottom line suffers under absorption because sales are eating into the inventory, which is a good thing. But in reality the increase sales has increased revenue, eating away at inventory and actually helping the bottom line, as is the case on the contribution income statement which shows net operating income went up over 21%. Conclusion
We have discussed the shortfalls of absorption costing, while showing the many benefits of variable costing and the contribution income statement. Whether it showing the correct net operating income for a company that increases production, or that selling more units, cutting into inventory, and increases revenue actually helps the bottom line, variable costing is correct tool for decision makers.
Attached to the submitted Case assignment is the excel worksheet I used. I learned a lot about accounting and excel to complete this assignment. I had a fun time crunching the numbers to see how sales, fixed/variable costs, unit pricing and the like affect the income statement. Please feel free to open and change the yellow highlighted sections to see the outcomes. Please give me any feedback on the excel spreadsheet, for I was a broadcast journalism major 18 years ago and have not tinkered with spreadsheets too often. Thank you.
Horngren C. (n.d.) Chapter 9: Absorption/Variable Costing Retrieved from http://www.csus.edu/indiv/p/pforsichh/accountinginfo/121/documents/newCh09In-ClassProblemsHorngren13e-MYCOPY-X2.pdf
Bragg, S (2013) What is fixed overhead?, AccountingTools. Retrieved from http://www.accountingtools.com/questions-and-answers/what-is-fixed-overhead.html
Accountingexplanation.com. (n.d.). Advantages, Disadvantages, and Limitations of Variable Costing Systems. Retrieved from http://www.accountingexplanation.com/advantages_disadvantages_limitations_of_