Case Scenario: George and Tammy
Tammy W., manager of a division specializing in concrete pipe and concrete blocks, had just been rebuffed by George J., president of the company. George had called a meeting of all divisional managers to discuss the downturn in business the company was experiencing. He had come down hard on the managers, pointing out that their jobs would be on the line if some immediate improvements were not forthcoming.
Tammy, acting as spokesperson for the divisional managers, had tried to explain to George why revenues and profits were declining. In the divisional managers’ view, business was suffering because residential and commercial construction was down. With the slump in the construction business, competition had intensified. Tammy indicated that her division had lost several bids to competitors who were bidding below the full cost of the product. Since company policy prohibited divisional managers from accepting any jobs below full cost, these bids were lost. Tammy, on behalf of the managers, requested a change in company policy concerning bids. She proposed that the floor for bids be changed to variable cost rather than full cost. In times of economic distress, she argued, bids that cover at least their variable costs would make a positive contribution toward covering fixed costs and help maintain the divisions’ profits. Tammy also proposed that divisional income statements be changed to a contribution margin (or “variable costing”) basis so that a better picture of divisional performance would be available.
Upon hearing the request, George flatly turned it down. He was convinced that all costs must be covered or the company would go under. “It’s impossible to sell a product for less than what it costs and stay in business. Those companies that do so will be the first ones to go bankrupt. Also, I want to see the income produced by your divisions when all costs are considered--not just variable costs. I don’t believe in variable costing.”
Tammy decided not to give up—she had had to stand up to George before—so she had the divisional controller collect the following information concerning the concrete block line:
Last quarter's production (and sales) 100,000 blocks
Unit manufacturing costs:
Direct materials $0.22
Direct labor 0.14
Variable overhead 0.09
Fixed overhead1 0.10
Total $0.55
Nonmanufacturing costs:
Selling costs:
Fixed $10,000
Variable 5% of sales
Administrative costs (all fixed) $20,000
Based on the volume level expected for the quarter (100,000 units)
Total fixed overhead costs were $10,000 (budgeted and actual). Variable overhead was incurred as expected. The average selling price for the 100,000 units sold was $0.90 per unit.
Question 1. Prepare absorption-costing and variable-costing income statements for the last quarter’s results. (Recall that income statements that feature gross margin are sometimes called absorption-costing statements, while those that feature contribution margin are sometimes called variable-costing statements.)
Question 2. Suppose that Tammy consults her marketing manager and finds that the division could have produced and sold 30,000 additional concrete blocks last quarter at a unit selling price of $0.54. Sufficient capacity was available for the additional production. Compute the total gross margin on the sale of these additional 30,000 blocks, assuming a price of $0.54. Now compute the total contribution margin on the 30,000 blocks. Explain why the two figures differ.
Question 3. Prepare absorption-costing and variable-costing income statements that reflect the sale of both the 100,000 units at the regular price of $0.90 and the additional 30,000 units at $0.54. Which figure in (2), gross margin or contribution margin, provides a better indication of the impact of the 30,000 additional units on the division’s profits? Explain.
Question 4. What approach would you take to convince George that variable costing is a useful managerial tool? Does he have any basis for his contention that a company must cover its full costs and that income statements should reflect all costs, not just variable costs? Explain.