Be Company

1) The executive made this income statement using absorption costing. Absorption costing can be misleading at times. This is because it treats fixed manufacturing overhead as a variable cost by assigning a per unit amount of the fixed overhead to each unit of production. And, since they had inventory, a portion of the fixed cost is going to be carried over to the next accounting period. So, in this case, using the absorption method artificially inflated the profits during this period. Therefore, I don’t think the executive should have gotten the bonus.

Furthermore, the $1,400,000 “profit” is represented by a $1,400,000 share of

fixed production costs (5/30 X $8,400,000). The $1,400,000 which was placed in inventory is an asset only if it represents a future cost saving in the form of the lost profits on added sales that would otherwise be lost from increases in future production costs.

Income statement using absorption costing:

Sales 25,000,000 x $2.00 $50,000,000

Production Costs:

Variable:

30,000,000 x $1.00 ($30,000,000)

Fixed ($8,400,000)

Total: ($38,400,000)

Ending Inventory,

5,000,000 units (1/6) 6,400,000

Cost of Goods Sold: ($32,000,000)

Gross Margin: $18,000,000

Marketing, distribution, customer service costs

Variable ($12,500,000)

Fixed ($4,100,000)

Total: ($16,600,000)

Operating Income: $1,400,000

But we should use variable costing.

Income statement using variable costing:

Sales 25,000,000 x $2.00 $50,000,000

Variable Costs:

Variable Production:

25,000,000 x $1.00 ($25,000,000)