BBG Corporation is a manufacturer of a synthetic chemical. Gary Voss, president

ID: 2475976 • Letter: B

Question

BBG 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.

BBG's accounting department prepared and distributed to top management the comparative income statements presented below.

BBG Corporation

Statements of Operating Income

For Year Ended November 30

($000s)

The accounting staff also prepared related financial information to assist management in evaluating the company's performance. BBG 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.

BBG Corporation

Selected Operating and Financial Data

Required:

a. Explain to Gary Voss why BBG Corporation's net income decreased in the current fiscal year despite the sales price and sales volume increases.

b. A member of BBG'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 BBG and the proposed variable costing method.

c. Identify and discuss the advantages and disadvantages of using variable costing for internal reporting purposes.

Last Year Current Year Sales Revenue $9,000 $11,200 Cost of Goods Sold $7,200 $8,320 Under/over absorbed overhead (600) $495 Adjusted Cost of Goods Sold $6,600 $8,815 Gross Margin $2,400 $2,385 Selling and administrative expenses $1,500 $1,500 Income before taxes $900 $885

Explanation / Answer

Although sales volume increased by 100,000 kg. causing an increase in contribution margin, because inventories went down significantly since last year, much of the fixed costs that had accumulated in the opening inventories were released to cost of goods sold during the year.

(i)

Sales

(1,000,000 units * $11.20)

$11,200,000

Variable costs

Opening inventory

(600,000 kg * $5)

$3,000,000

Cost of goods manufactured

(850,000 kg * $5.50)

$4,675,000

Less: Ending inventory

(450,000 kg * $5.50)

-$2,475,000

$5,200,000

Contribution margin

$6,000,000

Fixed costs

Manufacturing

$3,300,000

Selling and administrative

$1,500,000

$4,800,000

Operating income

$1,200,000

(ii)

Year

Fixed cost per kg in ending inventory

Inventory

Fixed costs in inventory

Last year

$3.00

600,000 Kg

-$1,800,000.00

Current year

$3.30

450,000 Kg

$1,485,000.00

-$315,000.00

Equals the difference in income between variable and absorption costing of: $1,200,000 - $885,000