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, Wilcox stated that production in July was well below standard volume because of employee vacations. This had caused overhead to be underabsorbed, 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 Wilcox’s 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 also controller 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 . . ..
- Critique the various pros and cons of the variable costing proposal that were presented in the meeting. What arguments would you add?
- Should Landau adopt variable costing for its monthly income statements?