Question

Anthony, Inc.

Alice Williams, the founder of Anthony, Inc. was previously a researcher at the University of Florida in the Veterinary School.  She discovered a compound that prevents, ticks, fleas, and heartworms from infecting dogs and that can be added as a powder to a dog’s food. More importantly, dogs love it. There is no longer a problem persuading dogs to take their preventive medication.

Alice is involved in a number of other projects and does not want to run the company she has set up to produce and market the new product. She has invested in setting up the business and has hired a general manager to oversee operations.  She has created the following compensation plan for her manager.

Management Incentive Plan

Executive Compensation: The General Manager will be paid a monthly bonus equal to 10% of the Income from Operations

In the first month of operations, the company had the following results:

Performance Report: December, 2018

Units: produced 30,000; sold 20,000;      

Selling Price: $20 per unit

Beginning inventory 0 (zero) units.

Variable Costs:

              Direct Materials $5 per unit

Direct Labor $3 per unit

Variable Manufacturing Overhead $1 per unit

Variable Selling and Administrative Costs  $2 per unit

Fixed Costs:

                    Manufacturing Overhead $120,000 per month

    Selling and Administrative Costs $15,000 per month

Required:

Alice has asked you to help her calculate the company’s Income from Operations for the first month.

You tell her it can be done in two ways: The Full Absorption Costing approach or the Contribution Method approach.

1. She asks you to show her both methods and explain the benefits and disadvantages of each.

2. She also asks you to recommend which one she should use,
   1. based on this month’s performance alone, and
   2. based on long term projections for a successful business.

For (a) and (b) above, state your reasons.

Answer 1

Absorption costing approach:

Sales (20000 units @ $20 per unit) 400,000

Less: Cost of goods sold

  Direct Material (30000 units @ $ 5 per unit) 150,000

Direct Labor cost (30000 @ $ 3 per unit)   90,000

Manufacturing OH

Variable (@ $ 1 per unit) 30,000

Fixed 120,000

Total Cost of Goods Sold 390,000

Gross Profit 10,000

Less: Selling & Adminstrative Expense

Variable (@ $ 2 per unit) 60,000

Fixed 15,000

Total Selling & Administrative Expense 75,000

Net Income / (Loss) (65,000)

Contribution Method Approach:

Sales (20000 units @ $20 per unit) 400,000

Less: Variable Expenses

  Direct Material (30000 units @ $ 5 per unit) 150,000

Direct Labor cost (30000 @ $ 3 per unit)    90,000

Manufacturing OH (@ $ 1 per unit)     30,000

Fixed OH (@ $ 2 per unit) 60,000

Total Variable Expense 330,000

Contribution Margin 70,000

Less: Fixed Expense

Manufacturing OH 120,000

Selling & Administrative OH 15,000

Total Fixed Expense 135,000

Net Income / (Loss) (65,000)

Benefits and disadvantages of both approach:

Though both approach derives same result, Absorption costing approach helps in submitting books of account for tax purpose. Contribution approach helps in order to know whether cost has to be controlled with respect to variable part or fixed part and take steps accordingly to achieve desired result.

Recommended:

Based on this month, contribution method looks good, as there is positive result till variable costing and only few steps has to be taken to control fixed cost to achieve positive result.

For long term successful business, books of accounts can be maintained at Absorption costing approach, as it is the approach recommended by GAAP and this helps in filing tax returns year on year.