Absorption and Variable Costing

THE CRIMSON PRESS CURRICULUM CENTER
THE CRIMSON GROUP, INC.

Landau Company
In early August, Terry Silver, the new marketing vice president of Landau Company, was studying
the July income statement. Silver found the statement puzzling: July’s sales had increased
significantly over June’s, yet income was lower in July than in June. Silver was certain that margins
on Landau’s products had not narrowed in July and therefore felt that there must be some mistake
in the July statement.
When Silver asked the company’s chief accountant, Meredith Wilcox, for an explanation, Wil-
cox stated that production in July was well below standard volume because of employee vacations.
This had caused overhead to be under absorbed, and a large unfavorable volume variance had been
generated, which more than offset the added gross margin from the sales increase. It was company
policy to charge all variances to the monthly income statement, and these production volume
variances would all wash out by year’s end, Wilcox had said.
Silver, who knew little about accounting, found this explanation to be “incomprehensible.”
With all the people in your department, I don’t understand why you can’t produce an income
statement that reflects the economics or our business. In the company that I left to come here,
if sales went up, profits went up. I don’t see why that shouldn’t be the case here, too.
As Wilcox left Silver’s office, a presentation at a recent Institute of Management Accountants

meeting came to mind. At that meeting the controller of Winjum Company had described that
firm’s variable costing system, which charged fixed overhead to income as a period expense and
treated only variable production costs as inventoriable product costs. Winjum’s controller had
stressed that, other things being equal, variable costing caused income to move with sales only,
rather than being affected by both sales and production volume as was the case with full absorption
costing systems.
Wilcox decided to recast the June and July income statements and balance sheets using variable
costing. (The income statements as recast and as originally prepared, and the related inventory and
retained earnings impacts are shown in Exhibit 1.) Wilcox then showed these statements to Terry
Silver, who responded,
Now that’s more like it! I knew July was a better month for us than June, and your new
“variable costing” statements reflect that. Tell your boss [Landau’s controller] that at the next
meeting of the executive committee I’m going to suggest we change to this new method.
At the next executive committee meeting, Silver proposed adoption of variable costing for
Landau’s monthly internal income statements. The controller also supported this change, saying
that it would eliminate the time-consuming efforts of allocating fixed overhead to individual
products. These allocations had only led to arguments between product managers and the
accounting staff. The controller added that since variable costing segregated the cost of materials,
direct labor, and variable overhead from fixed overhead costs, management’s cost control efforts
would be enhanced.
Silver also felt that the margin figures provided by the new approach would be more useful than
the present ones for comparing the profitability of individual products. To illustrate the point, he had
worked out an example. With full costing, two products in Landau’s line, numbers 129 and 243,
would appear as follows:
Standard
Product Production C o s t Selling Price Unit M a r g i n Margin Percent
129 $2.54 $4.34 $1.80 41.5
243 3.05 5.89 2.84 48.2
Thus, product 243 would appear to be the more desirable one to sell. But on the proposed basis, the
numbers were as follows:
Standard
Product Production C o s t Selling Price Unit M a r g i n Margin Percent
129 $1.38 $4.34 $2.96 68.2
243 2.37 5.89 3.52 59.8
According to Silver, these numbers made it clear that product 129 was the more profitable.
At this point, the treasurer spoke up.
If we use this new approach, the next thing we know you marketing types will be selling at
your usual markup over variable costs. How are going to pay the fixed costs then? Besides, in
my 38 years of experience, it’s the lack of control over long-run costs that can bankrupt a
company. I’m opposed to any proposal that causes us to take a myopic view of costs.
The president also had some concerns, having further considered the proposal.
In the first place, if I add together the June and July pretax profit under each of these methods, I get
almost $117,000 with the present method, but only $99,000 under the proposed method. While I’d be
happy to lower our reported profits from the standpoints of relations with our employee union and
income taxes, I don’t think it’s a good idea as far as our owners and bankers are concerned. And I share
Jamie’s [the treasurer’s] concern about controlling long-run costs. I think we should defer a decision on
this matter until we fully understand all of the implications.
Assignment
1. Explain the reasons for the $29,287 difference in July ($65,099 - $35,812) between income before taxes un-
der the two different methods. Be very specific in listing the elements that caused the difference.
2. Critique the various pros and cons of the variable costing proposal that were presented in the meeting. What
arguments would you add?
3. Assess Mr. Silver’s arguments concerning products 129 and 243. If he could emphasize only one product,
which one should it be? Why?
4. Should Landau adopt variable costing for its monthly income statements? Why or why not?
LANDAU COMPANY
Exhibit 1. Income Statements and Selected Balance Sheet Items
June and July
June July
Full Variable Full Variable
Costing Costing Costing Costing
Sales Revenue $865,428 $865,428 $931,710 $931,710

Cost of sales at standard 484,640 337,517 521,758 363,367
Standard gross margin $380,788 $527,911 $409,952 $568,343
Production cost variances*
Labor (16,259) (16,259) (11,814) (11,814)
Material 12,416 12,416 8,972 8,972
Overhead volume 1,730 (63,779
Overhead spending 3,604 3,604 2,832 2,832
Actual gross margin $382,279 $527,672 $346,163 $568,333

Fixed production overhead 192,883 192,883
Selling and administrative 301,250 301,250 310,351 310,351
Income before taxes $81,029 $33,539 $35,812 $65,099
* Parentheses denote unfavorable (debit) variance.
Impact on Inventories and Retained Earnings

The only asset account affected by the difference in accounting method was Inventories; on the liabilities and
owners' equity side, only Retained Earnings was affected. (There was no tax liability impact since variable costing was
not permitted for income tax reporting purposes.)
As of 30-Jun As of 31-Jul
Full Variable Full Variable
Costing Costing Costing Costing
Inventories $1,680,291 $1,170,203 $1,583,817 $1,103,016

Retained Earnings $3,112,980 $2,602,892 $3,131,602 $2,650,801

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Absorption and Variable Costing

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THE CRIMSON PRESS CURRICULUM CENTER

THE CRIMSON GROUP, INC.

As Wilcox left Silver’s office, a presentation at a recent Institute of Management Accountants

Sales Revenue $865,428 $865,428 $931,710 $931,710

Actual gross margin $382,279 $527,672 $346,163 $568,333

* Parentheses denote unfavorable (debit) variance.

Impact on Inventories and Retained Earnings

Inventories $1,680,291 $1,170,203 $1,583,817 $1,103,016

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