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 1). After the initial shock, thinking there must be some mistake, Graham called the controller, Andy Derrow, for an explanation. Derrow assured him, hhowever, 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 ut 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. Ifyour 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 2). He showed this to the president and quipped, “You want profit for August—T'll give you 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 afterall.” 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 ut 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.1s4 QUESTIONS 1. Approximately how busy (realtive to @ normal month) was the factory in August? 2. Can you construct an income statement for a “normal” month under both absorption costing and 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. $434,272) and in Ehxibit 3 ($+14,036 vs. $-59,432). 4, Could the problem in the case ever arise with respect’ to annual income statements? 5, From a managerial perspective, how does Graham, Inc. earn a profit? Which costing system best reflects, the basic economics of the business? 6. What do you recommend? = ne EXHIBIT 1 Graham, Ine. ‘Condensed Income Statement for August, 1993 Sales $1,347,000 Standard Cost of Goods Sold 212,000 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 51.672 65,732 Profit (Loss) —Before Taxes (22,928) ——Graham. Inc, EXHIBIT 2 Graham, Ine. Condensed Income Statement (Proposed) for August, 1993 Sales $1,347,000 Cost of Goods Sold (Standard “Variable” Cost) 492,000 Standard Contribution Margin Selling Expenses Sales Expenses 338,056 Sales Taxes 13,900 Freight Allowed 28.780 Merchandising Margin Administrative Expenses General and Administrative Expense Interest Expense S162 Factory Overhead Manufacturing Variances Labor (17,200) Material 15,800 Overhead Spending 5.380 Profit (Loss)—Before Taxes ‘$855,000 380,736 474.264 165,732 270,280 3.980 $34,272 _—.] SSS EXHIBIT 3 Graham, Ine. ‘Condensed Income Statement for July, 1993 As Actually Under Proposed Prepared Method Sales $1,132,112 $1,132,112 Cost of Sales at Standard 610.416 418,648 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 263,448 Profit before Administrative and Selling Expenses 516172 442,704 Selling Expenses (Total) 341,928 341,928 ‘Administrative Expenses (Total) 60,208 160.208 Profit (Loss)—Before Taxes $14,036 (59,432)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. Al three cost components are assigned to inventory for units produced. All three cost components flow through the income statement as cost of ‘00d 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.., 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 1,000 4,000 Production Costs (Alll Fixed) $1,000 $1,000 $1,000 $3,000 Selling and Administrative Expenses (All Fixed) $200 $200 $200 $600Graham, Inc. — Note On GAAP. 157 Profit over the three months can be calculated as follows: Conventional GAAP Accounting (Absorption Costing) January February March Total Sales $1,000 $1,000 $2,000 $4,000 Cost of Goods Sold: Beginning Inventory (At Standard) 0 750 750 0 Production Cost 1,000 1,000 1,000 3.000 Available to Sell 1,000 1,750 1,750 > ‘Less Ending Inventory (at Standard) (750) 750) 9 9 "Foal 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) $50 400 “An altemative way of thinking about the CGS calculation: 1, Standard CGS ($.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 4.500) (750) 750) 6.000) Volume Variance ‘SOF 250U 250U 0 1, +2.= Total CGS $250 1,000 $1,750 $3,000 The “Profit Model.” Under absorption costing, reported profit varies partly with sales and partly with Production. For every unit sold, reported profit goes up by the difference between sales price and standard ‘manufacturing cost—cal this the “sales effect.” In addition to this “sales effect,” for every unit produced the production volume variance is reduced by the amount of fixed production overhead absorbed for that unit—all this the “production effect.” This means, in effect, that every unit produced increases reported profit by reducing the production volume variance. This amount for each unit produced is just the fixed manufacturing overhead absorption rate. An alternative way of looking at absorption costing, therefore, is to say that reported profit equals the “sales Profit” (standard profit margin per unit X units gold) plus the “production profit” (fixed manufacturing overhead absorption rate X units produced) less the total fixed cost incurred. We can illustrate this forthe All-Fixed Company as follows: Fel otal Sales Profit ($.25 per Unit Sold) $250 $250 $500 $1,000 Production Profit ($.75 per Unit Produced) 1,500 730 150 3,000 Less All fixed Costs Incurred 4.200) 4.200) 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, itis 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 “eam” a profit by producing products that are not sold creates @ 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 altemative 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 January February. March. Total Sales $1,000 $1,000 $2,000 $4,000 Cost of Goods Sold* 9 0 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 tion. 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 direet costing results fn 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 earings 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, ine. — Note On GAAP. 159 fixed manufacturing cost which is part ofthe standard cost of goods sold (normal fixed manufacturing overhead costs per iit times units sold), However, the income statement will also include the production volume variance forthe period. ‘This represents under or over absorbed fixed manufacturing overhead during the period depending on whether production is below or above normal, respectively. The di is Iways equal to the difference in the amount of fix ged in the income statement. For our January February March Total Profit under Direct Costing $(200) (200) $800 $400 Profit under Absorption Costing 550 (200) 50 400 Profit Difference $250 Q $(750) Q Fixed Manufacturing Cost Included in the Income Statement: Direct Costing ‘$1,000 ‘$1000 ‘$1,000 $3,000 Absorption Costing Standard Cost of Goods Sold $750 $750 $1,500 Production Volume Variance ‘S0OF 250U 250U $250 81,000 ‘$L750 Difference S150 Q $250) THROUGHPUT ACCOUNTING {Inthe current environment, many firms consider only raw material cost to be volume dependent inthe 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 ¢lose 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 caleulational 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,