Absorption vs Variable Costing

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Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010

INCOME INFLATION:ABSORPTION COSTING VS. VARIABLE

Geri B. Wink, Colorado State University – PuebloLaurie J. Corradino, Colorado State University – Pueblo

CASE DESCRIPTION

The primary subject matter of this case concerns income inflation opportunities when GAAPbased absorption costing is used as compared to internally used variable costing when moreinventory is produced than sold. Secondary issues examined include distinctions between financialand managerial accounting; ethical responsibilities of managers, Certified Public Accountants andCertified Management Accountants; organizational climate of institutions; fixed costs vs. variablecosts; and how inaccurate reporting in one year may affect financial statements in other years. Thiscase can be tailored to three different difficulty levels; level two , appropriate for sophomorePrinciples of Managerial Accounting; level three, appropriate for junior Cost Accounting; and levelfive, appropriate for graduate level Managerial Accounting. This case is designed to be taught inone-half hour of class time and is expected to require one hour of outside preparation by students.

CASE SYNOPSIS

Robert had no idea how much his life was about to change. He thought he had acquired a“forever” career with a financially strong company. What he had not considered, though, was theeffect his new supervisor could have on his career.

This case examines the income inflation opportunities available to unethical managers.These opportunities arise when production exceeds sales and occurs as a result of the differencesbetween absorption costing and variable costing.

An absorption costing income statement is provided at three different sales levels withproduction remaining constant. The case asks students to use that information to prepare a variablecosting income statement at those same levels assuming production remains constant. The case alsoasks students to differentiate between fixed and variable costs, to discuss ethical choices, and todiscuss the “tone at the top”.

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INTRODUCTION

Robert had no idea how much his life was about to change. He thought he had acquired a“forever” career with a financially strong company. What he had not considered, though, was theeffect his new supervisor could have on his career.

Robert Gonzales was a 28-year-old CMA and CPA who had recently become a member ofthe Institute of Management Accountants (IMA) and the American Institute of Certified PublicAccountants (AICPA). He was in his first year of being employed at a vehicle manufacturingfacility. For years, the plant had prided itself in its multiple lines including both compact cars andsport utility vehicles (SUVs). His supervisor, Gail Smith, was also a CMA and CPA. She had beenwith the company six months.

Robert, having consulted with the company’s former CPA, was aware the business hadalways used absorption costing for external reporting purposes as required by U.S. GenerallyAccepted Accounting Principles (GAAP). Income for internal reporting, though, had beencalculated based on variable costing, and it was those numbers that were used for employeecompensation and end-of-year bonuses. Those were the all-important numbers to most of theemployees and especially to Gail.

Who wouldn’t want to find a way to boost company income and get a few extra zeros addedto one’s paycheck, right? It was, therefore, no surprise that Gail, being the clever CPA that she was,decided to “test” the options herself. It was the perfect opportunity. Robert was relatively new tothe company and to the profession itself. Gail was fairly confident that Robert would be more thanwilling to listen to her. She was his supervisor, but, more than that, during the few months that shehad known him, he had always been eager to listen to her suggestions and to openly demonstrate hisadmiration for her and her many years of experience. Being fully aware of GAAP requirements,she knew there was nothing she could alter in the external realm. She definitely did not want toarouse any suspicion among the auditors. It was those internal reports that were uppermost on hermind when she sat in her office on that November afternoon. After laboring over the numbers forhours, it finally hit her. There were two costing options, variable and absorption. She was new tovariable costing for internal decision making. Previous organizations for which she had worked hadconsidered the method, but they all had ultimately chosen against it. Aha! She had found herincome inflation opportunity! When using GAAP based absorption costing as compared tointernally used variable costing, if more was produced than sold, then there was a chance for incomemanipulation. She was not only Robert’s supervisor but also one of three main managers at theplant. She was, thus, partially in charge of deciding on an appropriate production level everyquarter. Luckily for Gail, the other two managers were not as financially adept as she was. Theywould never have any clue that she was inflating income.

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The economy had been poor lately and that, coupled with soaring gas prices, had causedSUV sales to decline significantly over the past three months. It was another perfect opportunity.Could things get any better than this, thought Gail?

Over the next few weeks, Gail worked tirelessly to craft fail-proof arguments in favor ofkeeping SUV production constant despite the recent lack of adequate sales in that line. Then the daycame to use her verbal arsenal. She met early that day with the other two managers and, going downher, by then, overflowing list of “unsound” arguments that she had creatively spun to her benefit,she won the other managers over. Her self-claimed theory that the economy would soon beflourishing and that future gas prices would drop so low that even the most non-traveler type wouldhit the pavement to see the back roads of the country in an instant was accepted by her colleagueseasier than she had ever imagined. It was time to move on to Robert.

That afternoon she called Robert into her office. She explained to him about the decisionto keep production of SUVs steady despite the current sales predicament. He was surprised andconfused, but nonchalantly shrugged it off. What did he know? He was just a first-year entrant intothe auto industry. Maybe there was something he was missing, something that a little moreexperience would have revealed. It was not until Gail began to mention something abouteliminating the use of variable costing for internal purposes that he became suspicious. She toldhim that nothing would be changed in the externally submitted financials, but that she felt that itwould be best for company decision making if the internal reporting techniques were altered slightly.Robert was open to change, but what Gail was suggesting was not exactly a “slight” change. He hadremembered one of his professors dwelling on how changing from variable to absorption costingcould cause a significant change in reported income, especially if there was an overabundance ofinventory, and it was that same professor who had warned him and his classmates to watch out forsuch manipulation in their professional lives. But that could not be what was going on here, couldit? Gail had only worked for the plant a short time herself, but she still seemed to make decisionsin the best interests of the company. He continued to listen to her ideas and suggestions, but refusedto agree to any specific method until, as he told her, he had time to conduct further evaluation of theproposals.

Exposure by Robert to more diligent accounting instruction and ethical awareness was nota variable that Gail had factored into her plan. She realized that her simply fashioned arguments,which had worked so well on her fellow managers, would not be sufficient to make Robert abeliever. If she wanted her plan to work, she was going to have to amend her arguments so that theyhad less of a financial foundation. Robert was an astute accountant; she could see that now. Tosuccessfully convince him, she recognized that she was going to have to use his lack of industryknowledge to her advantage.

In the days following his encounter with Gail, Robert spent every free moment he hadevaluating his supervisor’s suggestion. He thought about it and plugged in numbers time and timeagain trying out various scenarios, and each time it came out the same way. When production

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remained constant but sales declined, the use of absorption costing as opposed to variable costingresulted in higher reported income. More than ever, he started to believe that it just was not hisindustry inexperience that was causing him to be leery of the proposed production increases. Maybeit was not sound industry policy at all.

He decided to investigate further into Gail’s employment history. He had been on herscreening committee six months earlier and her résumé was in his desk drawer. As he scanned thedocument, he noticed something intriguing: She had only been employed at her last company fora little over a year. Because she had only been there a short while, Robert had surmised that perhapsshe was one of those job jumpers who went from job to job using her financial and accountingknow-how to get what she wanted from the company and would leave before anyone was able tocatch on to her scheme. By that time, though, the company would be reeling from the countless badand irreversible decisions it made based upon the information she persuaded management to believeto be correct. Keeping such thoughts in the back of his mind, he decided to inspect the résuméfurther. The next previous job listed indicated Gail had been with that company a mere four months.The other listed jobs were also accompanied by ranges of work dates that were not typical of theprofession. Jackpot, thought Robert! There had been similar information flowing through theorganization’s grapevine, and the records had proved it. The short employment span being relatedto any deceptive practice was just a gut feeling on Robert’s part, but it was an instinct that he feltvery strongly about.

To further support his convictions, he decided to dig around for his old accounting textbooks.Sure enough, his cost accounting text illustrated a similar example. The text’s evaluation and hisown matched. But, why, he asked himself, would Gail want to boost internally reported income?Then it hit him. At the end of each fiscal year, the internally reported figures were reviewed, andbased upon the numbers and their changes from the previous year, decisions were made to issue orreject bonuses. Gail must be at it again, he thought; she has been here only six months, but sheclearly is directing the company in the wrong direction yet again in order to fulfill her ownobjectives. Further pondering the situation, he continued and exclaimed out loud, “She must beinterested in some extra cash for herself,” then thinking about it a bit more, “and it would not reallybe bad for the rest of us either.”

Going along with the plan, though, would cause the other managers to make decisions thatwould differ from those that would be made if the more proper variable costing method were used.Those decisions would include the choice to continue manufacturing SUVs at a constant level eventhough they clearly were not as profitable as any absorption-based numbers would indicate. He knewthat allowing such a misconception would be wrong, but it would help him and all the otheremployees who had families to support. He was in a bad situation, and he knew it. It was the typeof situation that he had often dreamed and feared about during his preparations to become anaccountant and then even more so when he had pursued the Certified Public Accountant (CPA) andCertified Management Accountant (CMA) designations. He had promised to take the CPA and

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CMA ethical codes of conduct as his own and now his supervisor’s directives and those very codeswere in conflict.

Gail, still up to her old tricks, had been working on non-financial arguments to present toRobert in hopes she could still convince him that absorption costing and the production changeswere superior to any other choice that the company could possibly make. In her conversation withRobert, she noted that the SUV was the company’s legacy and for that matter, was the legacy of theAmerican auto industry. The company could not just decrease production of such a popular line ofvehicles even if gas prices were off the charts. Demand would always be there, she argued. As shestated, the whole notion of “going green” was just another fad that would vanish as soon as theeconomy recovered. With the emergence of a new U.S. President who advocated a comprehensiveeconomic stimulus plan, she further declared that such a positive fiscal state looked more promisingthan ever. To provide support for the absorption costing method, she contended that absorptioncosting was good enough for external reporting why should it not be equally sound and acceptablefor internal reporting as well. Inside she knew fully well why, in this and many other cases, it wouldnot be acceptable, but she had done it so many times before, it had become nothing for her to beuntrue to herself and the ethical codes of her designations. Still, she could see it in Robert’sskeptical eyes. Could this be the time when she finally met her match and would be caught in theact?

Gail interpreted Robert’s reactions correctly. He was absolutely on to her. Now it was justup to him to decide what to do. He created a spreadsheet based on one set of his previouscalculations. To make things simple and to provide an analysis that the other managers might beable to at least conceptually understand, he decided to establish fixed overhead at $150 per unitbased on an estimated overhead and production of $15,000,000 and 100,000 units, respectively. His estimated figure for direct materials would be $100 per unit, direct labor would be $200 per unit,and variable manufacturing overhead would be $50 per unit. He created comparison budgets forthree different levels of sales for SUVs based upon those costs. The absorption portion of thatbudget is presented in Table 1. He gathered together the remaining support and his counter-arguments. All that was left was to decide if he was going to pursue his gut feeling or allow Gailto follow through with her plan once again.

Robert has a meeting with the other managers in two days to discuss his progress with thecompany. It is an ideal opportunity to disclose his findings. Having only been employed at thecompany for six months, he is not sure how his allegations and concerns will be received. He andthe other employees could be monetarily rewarded if he does not say anything. If he does openlyquestion Gail’s tactics with her superiors, his job could potentially be at stake.

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Table 1: Based on Absorption Costing

Partial Income Statement

Sales of 100,000 units Sales of 90,000 units Sales of 80,000 units

Sales 100,000,000 90,000,000 80,000,000

Less: COGS (50,000,000) (45,000,000) (40,000,000)

Gross Profit 50,000,000 45,000,000 40,000,000

Less: Fixed Manufacturing Overhead

Operating Income 50,000,000 45,000,000 40,000,000

Cost of Goods Sold and Ending Inventory

Sales of 100,000 units Sales of 90,000 units Sales of 80,000 units

Beginning Inventory 5,000,000 5,000,000 5,000,000

Add: Production at 100,000 units 50,000,000 50,000,000 50,000,000

Goods Available for Sale 55,000,000 55,000,000 55,000,000

Less: Sales (50,000,000) (45,000,000) (40,000,000)

Ending Inventory 5,000,000 10,000,000 15,000,000

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Absorption vs Variable Costing

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