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Absorption Costing Effect on Earnings when Volumes Fluctuate
BBG Corp is a manufacturer of a synthetic chemical. Gary Voss, president of the company, has been eager to get the operating results for the just-completed fiscal year. He was surprised when the income statement revealed that income before taxes had dropped to $885,500 from $900,000, even though sales volume had increased by 100,000 kilograms. The drop in net income occurred even though Voss had implemented two changes during the past 12 months to improve the company’s profitability:
1. In response to a 10 percent increase in production costs, the sales price of the company’s product was increased by 12 percent. This action took place on December 1, 1994, the first day of the current fiscal year.
2. The managers of the selling and administrative departments were given strict instructions to spend no more in the current fiscal year than last year. BBG’s accounting department prepared and distributed to top management the comparative income statements presented below.

BBG Corp Statements of Operating Income for Year Ended Nov 30 ($000s)
Last Year Current Year
Sales Revenue $9,000,000 $11,200,000
Cost of Goods Sold $7,200,000 $ 8,320,000
Under/over absorbed overhead $ (600,000) $ 495,000
Adjusted Cost of Goods Sold $6,600,000 $ 8,815,000
Gross Margin $2,400,000 $ 2,385,000
Selling & Administrative Expenses $1,500,000 $ 1,500,000
Income before Taxes $ 900,000 $ 885,000

The accounting staff also prepared related financial information to assist management in evaluating the company’s performance. BBG uses the FIFO inventory method for finished goods. Budgeted and fixed overhead are equal and the beginning inventory last year has $3.00/kg. of fixed overhead.

BBG Corp Selected Operating and Financial Data

Last Year Current Year
Sales Price $10.00/kg $11.20/kg
Material Cost $1.50/kg $1.65/kg
Direct Labor Cost $2.50/kg $2.75/kg
Variable Overhead Cost $1.00/kg $1.10/kg
Fixed Overhead Cost $3.00/kg $3.30/kg
Total Fixed Overhead Cost $3,000,000 $3,300,000
Normal Production Volume 1,000,000kg 1,000,000kg
Selling & Administrative (All Fixed) $1,500,000 $1,500,000
Sales Volume 900,000kg 1,000,000 kg
Beginning Inventory 300,000kg 600,000kg
Production 1,200,000kg 850,000kg

A. Explain to Gary Voss why BBG Corp’s net income decreased in the current fiscal year despite the sales price and sales volume increases.


a. In absorption (full) costing, as currently employed by BBG Corporation, fixed manufacturing overhead is considered a product cost rather than a period cost. Fixed manufacturing overhead is applied to production based upon a normal production volume of 1,000,000 kg. Thus, the fixed manufacturing overhead is applied to products in the same manner as variable costs even though they do not vary with production. In addition, if production and sales are not equal during the year, fixed manufacturing overhead costs are deferred as part of inventory costs (production exceeds sales) or released upon sale of inventory (sales exceed production).
During last year, production exceeded sales, resulting in a portion of the fixed manufacturing overhead costs being inventoried in finished goods rather than being recognized as an expense of the period. This resulted in last year’s income before taxes being higher than might be expected. Then in the current year, sales exceeded production resulting in more fixed manufacturing overhead costs being recognized. First, finished goods were sold out of inventory which meant that the fixed overhead costs that were incurred last year and inventoried were released as period costs in the current year. Secondly, fixed manufacturing overhead was underapplied this year because only 850,000 units were produced. This gave rise to underabsorbed overhead that was charged to cost of goods sold. Both of these factors increased cost of goods sold and resulted in a reduction of gross margin and income before taxes in the current year.