Absorption vs. Variable Costing Essay

This case study leave alone get ear at Jokkmok Industries and ace of its managers, Mr. Rosen, who is bucking for a promotion to CEO. His division uses absorption be and has the ability to cause 50,000 units a quarter with a fit(p) smash-up join of $600,000. darn the sales forecast heads that the political party willing only sell 25,000 units during separately of the adjacent deuce quarters, Mr. Rosen wants to double his budgeted proceeds for the second quarter from 25,000 to 50,000 units. We will look at Mr. Rosens termination and see how it affects his companys scum bag phone 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 comprises from the two income statements. These figures will let us be able to assess if Mr. Rosen has rectify his divisions performance by change magnitude production. We will to a fault be able to tell if absorption costing is a executable option for management to use when making decisions like increasing production when sales ar non 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. Rosens decision would allow him to be considered for the CEO position. Absorption vs. Variable Costing (Contribution margin)The of import difference amid unsettled costing and absorption costing is the accountancy for mend manufacturing cost. (Horngren C. n.d.) This is never to a greater extent evident than in this case study. Income statements brisk using these different methods usually produce different pass in operation(p) income, and they will also produce different be per unit interchange. In order to lovely fill out the income statements we will need to look at the 1st quarters income statement listed in put over 1.From the information in table 1 we will need mu ch data to input into the absorption and contribution margin income statements. This additional data is displayed in shelve 2.Now we will plug these numbers into some(prenominal) the absorption and contribution margin income statements shown in tables 3 and 4 beneath for both the 1st and 2nd quarters. Information for setting up these tables was obtained from the bind Income Comparison of Variable and Absorption Costing from Accountingexplanation.com.One bottom pock right away that there are some major differences amidst the two income statements especially in the 2nd quarters lucre 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 inconsistent costing method in the contribution income statement, the increase in production shows the alike(p) net operating income as the previous quarter which was $350,0 00. So how can the bottom line look so much better infra absorption than contribution? The main reasons have to do with fit(p) manufacturing bash and inventories. Fixed manufacturing overhead are things like rent, facilities expenses, salaries, and insurance that do non 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 quarters 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 manufacture (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 u nit. ((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 shifting 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 multivariate 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 intimate 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 sell 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 arrest 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 fundament 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 mustiness 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 b ooks in his favor. By increasing his production he manipulated the fixed manufacturing costs to show them lower than they really are and thus exhibit a better net operating income. But the real costs are rapped up in inventory for the next quarter to worry about, like flush the can down the road. There is something that Mr. Rosen could do, or might have been cooking to do, to correct the inventory problem. He could plan on selling more units. What if market research shows that sales will increase by just about 20% if Lokkmok drops prices by 5% to gain a competitive surround in the 3rd quarter? Look at Tables 5 and 6 below to show how dropping the prices and increasing sales to get justify of inventory would help the bottom line. Notice the difference between retentiveness 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 contr ibution margin income statement, the bottomline suffers under absorption because sales are alimentation into the inventory, which is a dear(p) 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%. ConclusionWe 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, teddy into inventory, and increases revenue actually helps the bottom line, variable costing is correct whoreson 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/va riable costs, unit pricing and the like affect the income statement. Please belief 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 news media major 18 years ago and have not tinkered with spreadsheets also often. Thank you.ReferencesHorngren C. (n.d.) Chapter 9 Absorption/Variable Costing Retrieved from http//www.csus.edu/indiv/p/pforsichh/accountinginfo/121/documents/newCh09In-ClassProblemsHorngren13e-MYCOPY-X2.pdfBragg, S (2013) What is fixed overhead?, AccountingTools. Retrieved from http//www.accountingtools.com/questions-and-answers/what-is-fixed-overhead.htmlAccountingexplanation.com. (n.d.). Advantages, Disadvantages, and Limitations of Variable Costing Systems. Retrieved from http//www.accountingexplanation.com/advantages_disadvantages_limitations_of_