Maurice Tutor
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IMPACT OF INVENTORY CHANGES ON ABSORPTIONCOSTING INCOME, DIVISIONAL PROFITABILITY
Dana Baird was manager of a new Medical Supplies Division. She had just finished her second year and had been visiting with the company’s vice president of operations. In the first year, the operating income for the division had shown a substantial increase over the prior year. Her second year saw an even greater increase. The vice president was extremely pleased and promised Dana a $5,000 bonus if the division showed a similar increase in profits for the upcoming year. Dana was elated. She was completely confident that the goal could be met. Sales contracts were already well ahead of last year’s performance, and she knew that there would be no increases in costs.
At the end of the third year, Dana received the following data regarding operations for the first three years:
|
 |
Year 1 |
Year 2 |
Year 3 |
|
Production |
10,000 |
11,000 |
9,000 |
|
Sales (in units) |
8,000 |
10,000 |
12,000 |
|
Unit selling price |
$10 |
$10 |
$10 |
|
Unit costs: |
 |
 |
 |
|
Fixed overhead |
$2.90 |
$3.00 |
$3.00 |
|
Variable overhead |
$1.00 |
$1.00 |
$1.00 |
|
Direct materials |
$1.90 |
$2.00 |
$2.00 |
|
Direct labor |
$1.00 |
$1.00 |
$1.00 |
|
Variable selling |
$0.40 |
$0.50 |
$0.50 |
|
Actual fixed overhead |
$29,000 |
$30,000 |
$30,000 |
|
Other fixed costs |
$9,000 |
$10,000 |
$10,000 |
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|
 |
Yearly Income Statements |
||
|
 |
Year 1 |
Year 2 |
Year 3 |
|
Sales revenue |
$80,000 |
$100,000 |
$120,000 |
|
Less: Cost of goods sold |
54,400 |
67,000 |
86,600 |
|
Gross margin |
$25,600 |
$ 33,000 |
$ 33,400 |
|
Less: Selling and administrative expenses |
12,200 |
15,000 |
16,000 |
|
Operating income |
$13,400 |
$ 18,000 |
$ 17,400 |
Upon examining the operating data, Dana was pleased. Sales had increased by 20 percent over the previous year, and costs had remained stable. However, when she saw the yearly income statements, she was dismayed and perplexed. Instead of seeing a significant increase in income for the third year, she saw a small decrease. Surely, the accounting department had made an error.
Required:
1. Explain to Dana why she lost her $5,000 bonus.
2. Prepare variable-costing income statements for each of the three years. Reconcile the differences between the absorption-costing and variable-costing incomes.
3. If you were the vice president of Dana’s company, which income statement (variable-costing or absorption-costing) would you prefer to use for evaluating Dana’s performance? Why?