Graham, Inc.

This case is a "timeless" exercise in the logic of product costing systems for profit
determination. The problem is easy to see, difficult to explain and analyze, and impossible to
resolve!

The new president of Graham, Inc., Tom Graham, Jr. was very pleased with the turnaround in sales in
August. August sales were $200,000 greater than in July, so he had every reason to expect the income
statement to show a healthy increase over July's profit of $14,036. When the August report came in
showing a loss of $22,928, he was shocked (Exhibit l). After the initial shock, thinking there must be
some mistake, Graham called the controller, Andy Derrow, for an explanation. Derrow assured him,
however, that the figures were correct. The reason for the loss was that the company had reduced
production levels well below normal. This resulted in an unabsorbed production volume variance
which more than offset the impact of the increase in sales. He said that the rate of sales must equal
factory production or the same thing would happen every month. As it was, factory operations were out
of phase with sales. As long as the company followed GAAP accounting and charged the under- or
overabsorbed manufacturing overhead to the current income statement, the type of distortion which
occurred in August would happen.
The president had recovered totally from his initial shock: "You always seem to be able to talk
your way our of a jam, but I don't care about your fancy accounting principles. Common sense
indicates to me that when sales go up, and other things are reasonably the same, profit should also rise.
If your reports can't reflect this simple idea, why do I pay you so much money?"
Derrow had been troubled by the same question himself, but from a different angle. He took
the opportunity to suggest a different approach to the problem. He wanted to charge all fixed
manufacturing overhead for the current month to the income statement in a lump sum, the same as
selling and administrative expenses. Then there would be no problem with variations in under- or
overabsorbed overhead when the production volume changed. Cost of goods sold would reflect only
variable costs, which Derrow called "direct costs."
To illustrate, he reworked the August statement and found that the loss turned into a profit
(Exhibit 2). He showed this to the president and quipped, "You want profit for August—I'll give you
profit!" Graham's response was, "That's more like it!" But, after some consideration about the
corresponding increase in taxes and demands for wage and dividend increases resulting from big profit,
he said, "Maybe this idea isn't so good after all."
Derrow was in favor of the idea chiefly because it simplified accounting procedures. He was
always one for simple methods. Omission of fixed overhead costs from the product cost would
eliminate the tiresome and expensive task of determining an acceptable allocation of overhead to each
product. The change was doubly desirable to Derrow, since the current standard cost allocations were
out of date and were due to be recalculated anyway. He could neatly avoid the extra work by doing
away with the system!
The president wondered whether the proposed system might have any impact on cost control
or marketing efforts. Certainly, product costs would be lower now by the amount of fixed
manufacturing cost previously assigned to each unit.
154 Graham Inc.

QUESTIONS
1. Approximately how busy (realtive to a normal month) 5. From a managerial perspective, how does Graham,
 was the factory in August? Inc. earn a profit? Which costing system best reflects
the basic economics of the business?
2. Can you construct an income statement for a
"normal" month under both absorption costing and 6. What do you recommend?
direct costing? Analyze the profit variance for August
versus a normal month.
3. Be prepared to explain the profit differences shown in
Exhibits 1 and 2 ($-22,928 vs. $+34,272) and in
Ehxibit 3 ($+14,036 vs. $-59,432).

4. Could the problem in the case ever arise with respect

to annual income statements?

EXHIBIT 1
Graham, Inc.
Condensed Income Statement
for August, 1993
Sales
Standard Cost of Goods Sold 712 000
Standard Gross Margin $635,000
Less Manufacturing Variances
Labor (17,200)
Material 15,800
Overhead
Volume 107,480
Spending 5,380 111
460
Overall Gross Margin 523,540
Selling Costs
Sales Expenses 338,056
Sales Taxes 13,900
Freight Allowed 28 780 380,736
Administrative Costs
General and Administrative 108,060
Interest Expense 57 672 165 732
Profit (Loss)—Before Taxes

Graham Inc.
 155

EXHIBIT 2
Graham, Inc.
Condensed Income Statement (Proposed)
for August, 1993
Sales
Cost of Goods Sold (Standard "Variable" Cost) 492 000
Standard Contribution Margin $855,000
Selling Expenses
Sales Expenses 338,056
Sales Taxes 13,900
Freight Allowed 28 780 380 736
Merchandising Margin 474,264
Administrative Expenses
General and Administrative Expense 108,060
Interest Expense 57 672 165,732
Factory Overhead 270,280
Manufacturing Variances
Labor (17,200)
Material 15,800
Overhead Spending 5 380 3 980
Profit (Loss)—Before Taxes $34,272

EXHIBIT 3
Graham, Inc.
Condensed Income Statement
for July, 1993

As Actually Under Proposed Profit (Loss*efore Taxes

Prepared Method $14,036

Sales
Cost of Sales at Standard 610416 648
Gross Margin 521,696 713,464
Less Manufacturing Variances
Labor (21,704) (21,704)
Material 20,324 20,324
Overhead
Volume (1,788)
Spending 8,692 8,692
Fixed Factory Overhead 448
Profit before Administrative and Selling Expenses 172 704
Selling Expenses (Total) 341,928 341,928
Administrative Expenses (Total) 208 208
 A Note On GAAP Accounting
("Absorption Costing")versus
Throughput Accounting ("Direct
Costing")
For use with Graham, Inc. case

ABSORPTION COSTING
Under Generally Accepted Accounting Principles (GAAP) and IRS rules, raw material, direct labor,
and manufacturing overhead are all treated as product costs. All three cost components are assigned to
inventory for units produced. All three cost components flow through the income statement as cost of
good sold for units sold to customers. All nonmanufacturing expenses are treated as period expenses.
They flow through the income statement in the accounting period in which they are incurred. Common
examples of period expenses are selling, general, and administrative expenses. This traditional
approach to product costing, "absorption costing," classifies costs by function (i.e., manufacturing,
selling or administration).
An Example. Assume that a firm called the All-Fixed Company has discovered a process that
transforms air into a new product called Super-air. The manufacturing process consists of a machine
that is fully automated and requires no direct labor or purchased materials. The only production
ingredient required in the process is air for which we assume there is no cost. The annual production
costs are $12,000 (all fixed) for factory rental, machine depreciation, and maintenance. Selling and
administrative costs are constant each month at $200, regardless of sales or production volume. These
costs are all assumed to be constant within a range of 1 to 25,000 units of production. The normal
level of production is 16,000 units per year. The normal overhead absorption rate is $.75 per unit
($12,000 of production overhead costs divided by the normal volume of 16,000 units). The following
data pertain to the first 3 months of operations:

3 -Month
January February March Total
Units Sold (at $1 per unit)
1,000 1,000 2,000 4,000
Units Produced 2,000 1,000 1 ,ooo 4,000
Production Costs (All Fixed) $1,000 $1,000 $1,000 $3,000
Selling and Administrative
Expenses (All Fixed) $200 $200 $200 $600
Graham, Inc.
— Note On GAAP

Profit over the three months can be calculated as follows:

Conventional GAAP Accounting (Absorption Costing)

January February March Total

 157

Sales $1 000 Cost of Goods Sold: $1 000 $2 000 $4 000

Beginning Inventory (At Standard) 0 750 750 o

Production Cost 1 000 1 000 1 000 3 000
Available to Sell 1,000 1,750 1,750 3,000
Less Ending Inventory (at Standard) (750) (750) 0
Total CGS* 250 1 000 1 750 3 000
Gross Margin 750 0 250 1,000
Selling and Administration 200 200 200 600
PROFIT (Before Taxes) $550 $(200) $50 $400

*An alternative way of thinking about the CGS calculation:

1. Standard CGS ($.75 per unit sold) $750 $750 $1,500 $3,000
2. Production Volume Variance:
Production Cost Incurred 1,000 1,000 1,000 3,000
Production Cost Absorbed (1.500) (750) (750) (3.000)
Volume Variance 500F 250U 250U

1. + 2. Total CGS $250 $1.000 $1.750 $3.000

The "Profit Model." Under absorption costing, reported profit varies partly with sales and partly with
production. For every unit sold, reported profit goes up by the difference between sales price and standard manufacturing
cost—call this the "sales effect." In addition to this "sales effect," for every unit produced the production volume
variance is reduced by the amount of fixed production overhead absorbed for that unit—call this the "production effect."
This means, in effect, that every unit produced increases reported profit by reducing the production volume variance.
This amount for each unit produced is just the fixed manufacturing overhead absorption rate.
An alternative way of looking at absorption costing, therefore, is to say that reported profit equals the "sales
profit" (standard profit margin per unit X units sold) plus the "production profit" (fixed manufacturing overhead
absorption rate X units produced), less the total fixed cost incurred. We can illustrate this for the All-Fixed Company as
follows:

Janua Februa March Total

Sales Profit ($.25 per Unit Sold) $250 $250 $500 $1,000
Production Profit ($.75 per Unit Produced) 1,500 750 750 3,000
Less All fixed Costs Incurred (1.200) (1.200) (1.200) (3.600)
Reported Profit $550 $(200) $50 $400
Many trained accountants will dispute the idea that production level influences profit under absorption costing.
They don't think about the "profit model" as being affected by the production profit. Nevertheless, it is true.
158 Graham, Inc. — Note On GAAP

DIRECT COSTING
Many people believe that reported profit should be affected only by the sales level and not by the production level as
well. They argue that allowing managers to "earn" a profit by producing products that are not sold creates a
dysfunctional incentive to build inventory levels. There is an alternative accounting system, called "direct costing," in
which profit is only influenced by sales.
This result is achieved by reclassifying production costs according to their behavior (fixed versus variable)
rather than their function. Manufacturing overhead costs that don't vary with production are included with the traditional
period costs—selling and administration. Product costs then include only items that vary directly with volume, such as
direct material, direct labor (if any), and variable manufacturing overhead. The distinction between the conventional
product costing system (known as absorption or full costing) and this alternative product costing system (known as
direct, variable, or marginal costing) lies in the treatment of fixed manufacturing overhead costs.
Absorption costing treats all factory overhead as product cost, ignoring the fixed/variable distinction. Direct
costing includes as product costs only those manufacturing costs that vary directly with production. The following table
illustrates direct costing for the All-Fixed Company:

Direct Costing

Marc h

Total
Sales $1,000 $1,000 $2,000 $4,000
Cost of Goods Sold* 0 0
Contribution Margin 1,000 1,000 2,000 4,000
Fixed Expenses:
Production 1,000 1,000 1,000 3,000
Selling and Administration 200 200 200 600
Total 1 200 1 200 1 200 3 600
Profit Before Taxes $(200) $(200) $800 $400
*Since there are no volume dependent production costs in this example, there is no CGS. Profit contribution here equals
100% of sales

The "Profit Model." Under direct costing, profit varies directly with sales volume and only with sales volume.
Since cost of goods sold includes only variable manufacturing costs, gross margin is really the same as profit
contribution. Reported profit thus equals total profit contribution (contribution per unit times units sold) less total fixed
costs.

COMPARING THE TWO SYSTEMS FOR THE ALL-FIXED COMPANY

Under absorption costing, cost of goods sold and ending inventories consist only of fixed factory overhead. The ending
inventory is valued at standard cost of $.75 per unit. Under direct costing, there is no product cost to assign to cost of
goods sold or inventories because there is no variable cost of production.
Over the 3-month period, both product costing alternatives result in the same total earnings of $400 because
production equals sales. However, in January, absorption costing shows a profit of $550, whereas direct costing results in
a loss of $200. In February, absorption costing shows the same loss ($200) as direct costing. In March absorption costing
profit is only $50, while direct costing shows $800 profit. Can we explain these differences?
The key to understanding the effect on earnings and inventories lies in the accounting for fixed factory
overhead. Under direct costing, the income statement each period includes the fixed manufacturing overhead actually
incurred that period. Under absorption costing, the situation is more complicated. The income statement will include the
Graham, Inc. — Note On GAAP

fixed manufacturing cost which is part of the standard cost of goods sold (normal fixed manufacturing overhead costs per
unit times units sold). However, the income statement will also include the production volume variance for the period.
This represents under or over absorbed fixed manufacturing overhead during the period depending on whether
 159
production is below or above normal, respectively. The difference between profit reported under the two systems is
always equal to the difference in the amount of fixed manufacturing overhead charged in the income statement. For our
example, this can be illustrated as follows:

JanuaryFebruary March Total

Profit under Direct Costing $(200) $(200) $800 $400

Profit under Absorption Costing 550 (200) 50 400
Profit Difference

Fixed Manufacturing Cost Included in the

Income Statement:
$1.000 $1.000 $1.000 $3,000
Direct Costing

Absorption Costing
Standard Cost of Goods Sold $750 $750 $1,500 $3,000
Production Volume Variance 500F 250U 250U 0
$250 $1,000 $1.750 $3.00ö
Difference $750
THROUGHPUT ACCOUNTING
In the current environment, many firms consider only raw material cost to be volume dependent in the short run. In this
case the only "direct cost" is raw material and profit contribution equals sales less material cost. All cost other than raw
material is considered to be operating expense or overhead and flows through the income statement each month as period
expense. This version of direct costing is called "throughput accounting." Throughput is just defined as sales minus
materials cost.

SUMMARY
Accounting theory favors absorption costing under the argument that the unit of product should carry a share of all the
costs (fixed and variable) incurred to make it. Proponents of direct costing argue that reported profit should vary only
with sales, not with the level of production. They reject the accounting theory argument about "full" cost because of the
resulting impact on profit measurement—the level of production affects the level of profit.
The direct costing method also has broad appeal for product costing and cost control purposes because of its
close relationship to contribution analysis, break-even analysis, and to flexible budgets. Grouping all fixed costs together
leads at once to break-even analysis for decision making (cost-volume-profit analysis) and to flexible budgets for cost
control.
The managerial significance of direct versus absorption costing is beyond the scope of this note. This note is
intended only to clarify calculational issues—not to propose an answer as to which approach is "better." In fact, in
practice, both systems are widely used for internal reporting purposes.