CASE: The Case of the Perplexed President; Lean
Production

John Ovard, president of
Mylar Ltd., was looking forward to receiving the company’s second quarter
income statement. He knew that the sales budget of 20,000 units sold had been
met during the second quarter and that this represented a 25% increase in
sales over the first quarter. He was especially happy about the increase in
sales, since Mylar was about to approach its bank for additional loan money
for expansion purposes. He anticipated that the strong second-quarter results
would be a real plus in persuading the bank to extend the additional credit.

John Ovard, president of Mylar Ltd., was looking forward.jpg”>

For this reason, Mr. Ovard
was shocked when he received the second-quarter income statement below, which
showed a substantial drop in absorption costing net operating income from the
first quarter.

Mylar, First two Quarters

Mylar, First two Quarters

First Quarter

First Quarter

Sales

£1,600,000

£2,000,000

Cost of goods sold:

Beginning Inventory

£210,000

£490,000

Add cost of goods
manufactured

1,400,000

980,000

Goods available for sale

1,610,000

1,470,000

Less ending inventory

490,000

70,000

Cost of goods sold

1,120,000

1,400,000

Add underapplied overhead

0

1,120,000

240,000

1,640,000

Gross margin

480,000

360,000

Selling and admin
expenses

310,000

330,000

Net operating income

£170,000

£30,000

Mr. Ovard was certain there
had to be an error somewhere and immediately called the controller into his
office to find the problem. The controller stated, “That net operating income
is correct, John. Sales went up during the second quarter, but the problem is
in production. You see, we budgeted to produce 20,000 units each quarter, but a
strike in one of our supplier’s plants forced us to cut production back to only
14,000 units in the second quarter. That’s what caused the drop in net
operating income.”

Mr. Ovard was angered by
the controller’s explanation. “I call you in here to find out why income
dropped when sales went up, and you talk about production! So what if
production was off? What does that have to do with the sales that we made? If
sales go up, then income ought to go up. If your statements can’t show a simple
thing like that, then we’re due for some changes in your area!”

Budgeted production and
sales for the year, along with actual production and sales for the first two
quarters, are given below:

Quarter

First

Second

Third

Fourth

Budgeted sales (units)

16,000

20,000

20,000

24,000

Actual sales (units)

16,000

20,000

Budgeted production
(units)

20,000

20,000

20,000

20,000

Actual production (units)

20,000

14,000

The company’s plant is
heavily automated, so fixed manufacturing overhead costs total £800,000 per
quarter. Variable manufacturing costs are £30 per unit. The fixed manufacturing
overhead cost is applied to units of product at the rate of £40 per unit (based
on the budgeted production shown above). Any underapplied or overapplied
overhead is closed directly to cost of goods sold for the quarter.

The company had 3,000 units
in inventory to start the first quarter and uses the FIFO inventory flow
assumption. Variable selling and administrative expenses are £5 per unit sold.

Required:

1.
What characteristic
of absorption costing caused the drop in net operating income for the second
quarter and what could the controller have said to explain the problem?

2.
Prepare a
contribution format income statement for each quarter using variable costing.

3.
Reconcile the
absorption costing and the variable costing net operating income figures for
each quarter.

4.
Identify and
discuss the advantages and disadvantages of using the variable costing method
for internal reporting purposes.

5.
Assume that the
company had introduced Lean Production methods at the beginning of the second
quarter, resulting in zero ending inventory. (Sales and production during the
first quarter were as shown above.)

a.
How many units
would have been produced during the second quarter under Lean Production?

b.
Starting with the
third quarter, would you expect any difference between the net operating income
reported under absorption costing and under variable costing? Explain why there
would or would not be any difference.