Cost Behavior Case Study

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Behavior

There are some differences between the income statements when compiled under absorption costing and under contribution margin. In this instance, the basic income statement is compiled without knowing the costs that go into the absorption costing. One of the differences is that absorption costing reflects the costs of all the activities that go into the production of the good. So when you have an income statement produced under absorption costing it will look as follows:

Revenue

COGS

Gross Profit

SGA Exp

Net Income

The fixed costs are $800,000, so the contribution margin income statement would be as follows:

Revenue

COGS

Gross Profit

Fixed Costs

Net income

350000

For the next quarter, if production is 50,000 units, the absorption statement would be:

Revenue

2500000

COGS

1800000

Gross Profit

700000

SGA Exp

350000

Net Income

350000

This statement reflects the fact that 50,000 units were produced, which is double the expected sales. The following statement reflects the contribution margin approach:

Revenue

2500000

COGS

3150000

Gross Profit

-650000

SGA Exp

800000

Net Income

-1450000

Both income statements show that the company lost money.

The production costs per unit do not change. The number of units is 50,000, and the costs are equivalent.

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The difference here is how the numbers are recorded, not what the numbers actually are, as those do not change. Mr. Rosen is doing his company a disservice by fiddling with numbers rather than improving performance is an organic way.

Mr. Rosen did not improve performance for the second quarter. The first issue is that the company has to understand that accounting techniques and performance are not equivalent. What a different accounting technique shows on paper does not change the fact that the company did the exact same thing in the quarter, regardless of how it was accounted for. The company cannot improve performance simply by producing more -- selling is what business does so if it is not selling more than it will not be functioning at a higher level.

Reporting is not the same thing as accounting. Reporting is quite specific, and governed by generally accepted accounting principles. These demand absorption costing. So that is what is recommended for Mr. Rosen in the future, that he stick to what is legal.

Mr. Rosen is not a serious candidate for the CEO position. If someone's idea of improving firm performance is to.....

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