How Volume Fluctuations Affect Earnings Using Absorption Costing
BBF Corporation

Essay

How Volume Fluctuations Affect Earnings using Absorption Costing
BBF Corporation is a manufacturer of a synthetic chemical. Gary Voss, president of the company, has been eager to get the operating results for the just-completed fiscal year. He was surprised when the income statement revealed that income before taxes had dropped to $885,500 from $900,000, even though sales volume had increased by 100,000 kilograms. The drop in net income occurred even though Voss had implemented two changes during the past 12 months to improve the company's profitability:
1. In response to a 10 percent increase in production costs, the sales price of the company's product was increased by 12 percent. This action took place on December 1, 1994, the first day of the current fiscal year.
2. The managers of the selling and administrative departments were given strict instructions to spend no more in the current fiscal year than last year.
BBF's accounting department prepared and distributed to top management the comparative income statements presented below. BBG CORPORATION
Statements of Operating Income
For the Years Ended November 30
($000s)
$\begin{array}{|l|r|r|}\hline &\text { Last } & \text { Current } \\&\text { Year } & \text { Year } \\\hline \text { Sales revenue } & \underline{\$ 9,000} & \underline{\$ 11,200} \\\hline \text { Cost of goods sold } & \$ 7,200 & \$ 8,320 \\\hline \text { Under/over-absorbed overhead } & \underline{(600)} & \underline{495} \\\\\hline \text { Adjusted cost of goods sold } & \underline{\$ 6,600} & \underline{\$ 8,815} \\\hline \text { Gross margin } & \$ 2,400 & \$ 2,385 \\\hline \begin{array}{l}\text { Selling and administrative } \\\text { expenses }\end{array} & \underline{1,500} & \underline{1,500} \\\hline \text { Income before taxes } & \$ 900 & \$ 885 \\\hline\end{array}$ The accounting staff also prepared related financial information to assist management in evaluating the company's performance. BBF uses the FIFO inventory method for finished goods. Budgeted and fixed overhead are equal and the beginning inventory last year has $3.00/kg. of fixed overhead. $$\begin{array}{|c|}\hline \text { BBG CORPORATION } \\\hline \text { Selected Operating and Financial Data } \\\hline\end{array}$$
$$\begin{array}{|l|r|r|}\hline &\text { Last Year } & \text { Current Year }\\\hline \text { Sales price } & \$ 10.00 / \mathrm{kg} . & \$ 11.20 / \mathrm{kg} . \\\hline \text { Material cost } & 1.50 / \mathrm{kg} . & 1.65 / \mathrm{kg} . \\\hline \text { Direct labor cost } & 2.50 / \mathrm{kg} . & 2.75 / \mathrm{kg} . \\\hline \text { Variable overhead cost } & 1.00 / \mathrm{kg} . & 1.10 / \mathrm{kg} . \\\hline \text { Fixed overhead cost } & 3.00 / \mathrm{kg} . & 3.30 / \mathrm{kg} . \\\hline \text { Total fixed overhead costs } & \$ 3,000,000 & \$ 3,300,000 \\\hline \text { Normal production volume } & 1,000,000 \mathrm{~kg} . & 1,000,000 \mathrm{~kg} . \\\hline \text { Selling and administrative } & & \\\hline \text { (all fixed) } & \$ 1,500,000 & \$ 1,500,000 \\\hline \text { Sales volume } & 900,000 \mathrm{~kg} . & 1,000,000 \mathrm{~kg} . \\\hline \text { Beginning inventory } & 300,000 \mathrm{~kg} . & 600,000 \mathrm{~kg} . \\\hline \text { Production } & 1,200,000 \mathrm{~kg} . & 850,000 \mathrm{~kg} . \\\hline\end{array}$$ Required:
a. Explain to Gary Voss why BBF Corporation's net income decreased in the current fiscal year despite the sales price and sales volume increases.
b. A member of BBF's accounting department has suggested that the company adopt variable (direct) costing for internal reporting purposes.
(i) Prepare an operating income statement through income before taxes for the current year ended November 30, using the variable (direct) costing method.
(ii) Present a numerical reconciliation of the difference in income before taxes using the absorption costing method as currently employed by BBF and the proposed variable costing method.
c. Identify and discuss the advantages and disadvantages of using variable costing for internal reporting purposes.