49

INCOME INFLATION: ABSORPTION

COSTING VS. VARIABLE

Geri B. Wink, Colorado State University Pueblo

Laurie J. Corradino, Colorado State University Pueblo

CASE DESCRIPTION

The primary subject matter of this case concerns income inflation opportunities when
GAAP based absorption costing is used as compared to internally used variable costing when
more inventory is produced than sold. Secondary issues examined include distinctions between
financial and managerial accounting; ethical responsibilities of managers, Certified Public
Accountants and Certified Management Accountants; organizational climate of institutions; fixed
costs vs. variable costs; and how inaccurate reporting in one year may affect financial statements
in other years. This case can be tailored to three different difficulty levels; level two ,
appropriate for sophomore Principles of Managerial Accounting; level three, appropriate for
junior Cost Accounting; and level five, appropriate for graduate level Managerial Accounting.
This case is designed to be taught in one-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
the effect 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 differences
between absorption costing and variable costing.
An absorption costing income statement is provided at three different sales levels with
production remaining constant. The case asks students to use that information to prepare a
variable costing income statement at those same levels assuming production remains constant.
The case also asks students to differentiate between fixed and variable costs, to discuss ethical
choices, and to discuss the tone at the top.

Journal of the International Academy for Case Studies, Volume 16, Special Issue, Number 1, 2010
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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 the
effect his new supervisor could have on his career.
Robert Gonzales was a 28-year-old CMA and CPA who had recently become a member
of the Institute of Management Accountants (IMA) and the American Institute of Certified Public
Accountants (AICPA). He was in his first year of being employed at a vehicle manufacturing
facility. For years, the plant had prided itself in its multiple lines including both compact cars and
sport utility vehicles (SUVs). His supervisor, Gail Smith, was also a CMA and CPA. She had
been with the company six months.
Robert, having consulted with the companys former CPA, was aware the business had
always used absorption costing for external reporting purposes as required by U.S. Generally
Accepted Accounting Principles (GAAP). Income for internal reporting, though, had been
calculated based on variable costing, and it was those numbers that were used for employee
compensation and end-of-year bonuses. Those were the all-important numbers to most of the
employees and especially to Gail.
Who wouldnt want to find a way to boost company income and get a few extra zeros
added to ones 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 to the company and to the profession itself. Gail was fairly confident that Robert
would be more than willing to listen to her. She was his supervisor, but, more than that, during
the few months that she had known him, he had always been eager to listen to her suggestions
and to openly demonstrate his admiration 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 to arouse any suspicion among the auditors. It was those internal
reports that were uppermost on her mind when she sat in her office on that November afternoon.
After laboring over the numbers for hours, it finally hit her. There were two costing options,
variable and absorption. She was new to variable costing for internal decision making. Previous
organizations for which she had worked had considered the method, but they all had ultimately
chosen against it. Aha! She had found her income inflation opportunity! When using GAAP
based absorption costing as compared to internally used variable costing, if more was produced
than sold, then there was a chance for income manipulation. She was not only Roberts
supervisor but also one of three main managers at the plant. She was, thus, partially in charge of
deciding on an appropriate production level every quarter. Luckily for Gail, the other two
managers were not as financially adept as she was. They would 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 caused
SUV 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 of
keeping SUV production constant despite the recent lack of adequate sales in that line. Then the
day came to use her verbal arsenal. She met early that day with the other two managers and,
going down her, 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 be flourishing and that future gas prices would drop so low that even the most non-
traveler type would hit the pavement to see the back roads of the country in an instant was
accepted by her colleagues easier 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 decision
to keep production of SUVs steady despite the current sales predicament. He was surprised and
confused, but nonchalantly shrugged it off. What did he know? He was just a first-year entrant
into the auto industry. Maybe there was something he was missing, something that a little
more experience would have revealed. It was not until Gail began to mention something about
eliminating the use of variable costing for internal purposes that he became suspicious. She told
him that nothing would be changed in the externally submitted financials, but that she felt that it
would 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 had remembered one of his professors dwelling on how changing from variable to
absorption costing could cause a significant change in reported income, especially if there was an
overabundance of inventory, and it was that same professor who had warned him and his
classmates to watch out for such manipulation in their professional lives. But that could not be
what was going on here, could it? Gail had only worked for the plant a short time herself, but she
still seemed to make decisions in the best interests of the company. He continued to listen to her
ideas and suggestions, but refused to agree to any specific method until, as he told her, he had
time to conduct further evaluation of the proposals.
Exposure by Robert to more diligent accounting instruction and ethical awareness was not
a 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 a
believer. If she wanted her plan to work, she was going to have to amend her arguments so that
they had less of a financial foundation. Robert was an astute accountant; she could see that now.
To successfully convince him, she recognized that she was going to have to use his lack of
industry knowledge to her advantage.
In the days following his encounter with Gail, Robert spent every free moment he had
evaluating his supervisors suggestion. He thought about it and plugged in numbers time and
time again 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 costing
resulted in higher reported income. More than ever, he started to believe that it just was not his
industry inexperience that was causing him to be leery of the proposed production increases.
Maybe it was not sound industry policy at all.
He decided to investigate further into Gails employment history. He had been on her
screening committee six months earlier and her rsum was in his desk drawer. As he scanned
the document, he noticed something intriguing: She had only been employed at her last company
for a little over a year. Because she had only been there a short while, Robert had surmised that
perhaps she was one of those job jumpers who went from job to job using her financial and
accounting know-how to get what she wanted from the company and would leave before anyone
was able to catch on to her scheme. By that time, though, the company would be reeling from the
countless bad and irreversible decisions it made based upon the information she persuaded
management to believe to be correct. Keeping such thoughts in the back of his mind, he decided
to inspect the rsum further. 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 the profession. Jackpot, thought Robert! There had been similar
information flowing through the organizations grapevine, and the records had proved it. The
short employment span being related to any deceptive practice was just a gut feeling on Roberts
part, but it was an instinct that he felt very 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 texts
evaluation and his own 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, and based upon the numbers and their changes from the previous year, decisions
were made to issue or reject bonuses. Gail must be at it again, he thought; she has been here only
six months, but she clearly is directing the company in the wrong direction yet again in order to
fulfill her own objectives. Further pondering the situation, he continued and exclaimed out loud,
She must be interested in some extra cash for herself, then thinking about it a bit more, and it
would not really be bad for the rest of us either.
Going along with the plan, though, would cause the other managers to make decisions
that would 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 even though they clearly were not as profitable as any absorption-based numbers would
indicate. He knew that allowing such a misconception would be wrong, but it would help him
and all the other employees who had families to support. He was in a bad situation, and he knew
it. It was the type of situation that he had often dreamed and feared about during his preparations
to become an accountant and then even more so when he had pursued the Certified Public
Accountant (CPA) and Certified 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 supervisors directives and those very
codes were in conflict.
Gail, still up to her old tricks, had been working on non-financial arguments to present to
Robert in hopes she could still convince him that absorption costing and the production changes
were superior to any other choice that the company could possibly make. In her conversation
with Robert, she noted that the SUV was the companys legacy and for that matter, was the
legacy of the American auto industry. The company could not just decrease production of such a
popular line of vehicles even if gas prices were off the charts. Demand would always be there,
she argued. As she stated, the whole notion of going green was just another fad that would
vanish as soon as the economy recovered. With the emergence of a new U.S. President who
advocated a comprehensive economic stimulus plan, she further declared that such a positive
fiscal state looked more promising than ever. To provide support for the absorption costing
method, she contended that absorption costing was good enough for external reporting why
should it not be equally sound and acceptable for internal reporting as well. Inside she knew fully
well why, in this and many other cases, it would not be acceptable, but she had done it so many
times before, it had become nothing for her to be untrue to herself and the ethical codes of her
designations. Still, she could see it in Roberts skeptical eyes. Could this be the time when she
finally met her match and would be caught in the
act?
Gail interpreted Roberts reactions correctly. He was absolutely on to her. Now it was just
up to him to decide what to do. He created a spreadsheet based on one set of his previous
calculations. To make things simple and to provide an analysis that the other managers might be
able to at least conceptually understand, he decided to establish fixed overhead at $150 per unit
based 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 for three different levels of sales for SUVs based upon those costs. The absorption
portion of that budget 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 Gail to follow through with her plan once again.
Robert has a meeting with the other managers in two days to discuss his progress with the
company. It is an ideal opportunity to disclose his findings. Having only been employed at the
company for six months, he is not sure how his allegations and concerns will be received. He
and the other employees could be monetarily rewarded if he does not say anything. If he does
openly question Gails 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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