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Absorption versus Variable Costing-Effects on Income

Rachel Yablonka assumed the responsibilities as executive manager of the Chair Division, Office Furniture and Fixtures, Inc. (OFF), on January 1, 2005, taking the place of her recently promoted predecessor. Rachel's own performance evaluation is directly tied to the division's annual net operating profit determined under absorption costing, and her quarterly bonus is determined as a percentage of net operating income. Rachel immediately began taking measures designed to reduce costs during future periods. Part of her cost-reduction efforts involved examining better ways to deal with inventory. After a careful review of the division's sales and production over the past quarter, Rachel concluded that inventory has been accumulating faster than sales. The division makes to order and does not normally carry any excess inventory. She decided that the buildup of excess inventory might be contributing to low profits. Rachel knows that excess inventory can lead to higher costs of material handling, warehousing, insurance, and auditing as well as keeping captial tied up when it could be more useful elsewhere. Further investigation disclosed that the excess inventory was being stored off site in newly rented warehouse facilities because of inadequate storage space in the division's own warehouses. Rachel immediately set out to eliminate the excess inventory by slowing down the rate of production during the first quarter of 2005. However, she was very disappointed when she saw the first quarter 2005 results. Instead of profits improving, the division experienced a net operating loss even though sales were flat and there was some reduction in warehousing and material handling costs. Quarterly performance data for the two quarters are as follows:

Fourth Quarter First Quarter

Units of beginning inventory 0 50,000
Units sold 200,000 200,000
Units produced 250,000 150,000
Average selling price per unit 500 500
Unit cost of production:
Direct labor cost per unit produced 50 50
Direct material cost per unit produced 200 200
Variable overhead cost per unit produced 30 25
Fixed Overhead assigned to each unit produced 70 115
Total unit cost 350 390

2004 2005

Revenue $100,000,000 $100,000,000
Cost of goods sold 70,000,000 76,000,000
Gross margin $ 30,000,000 $ 24,000,000
Selling and administrative exp. 25,000,000 25,000,000
Operating income 5,000,000 (1,000,000)

A. Why was the division's income significantly lower in first quarter 2005 than in fourth quarter 2004?
B. Why do you think the inventory buildup occurred at the end of the previous manager's term?
C. If you were Rachel, how would you handle this situation? Should you keep inventory levels low or high?
D. If you were the CEO of OFF, Inc., would you change Rachel's performance measurements? Explain why or why not?

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Solution Summary

The solution examines absorption versus variable costing-effects on income. Why the divisions income was significantly lower in the first quarter than in the fourth quarter is determined.