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¶ … Behavior
There are some differences between the income statements when compiled under absorption costing and under contribution margin. In this instance, the basic income statement is compiled without knowing the costs that go into the absorption costing. One of the differences is that absorption costing reflects the costs of all the activities that go into the production of the good. So when you have an income statement produced under absorption costing it will look as follows:
Revenue
COGS
Gross Profit
SGA Exp
Net Income
The fixed costs are $800,000, so the contribution margin income statement would be as follows:
Revenue
COGS
Gross Profit
Fixed Costs
Net income
350000
For the next quarter, if production is 50,000 units, the absorption statement would be:
Revenue
2500000
COGS
1800000
Gross Profit
700000
SGA Exp
350000
Net Income
350000
This statement reflects the fact that 50,000 units were produced, which is double the expected sales. The following statement reflects the contribution margin approach:
Revenue
2500000
COGS
3150000
Gross Profit
-650000
SGA Exp
800000
Net Income
-1450000
Both income statements...
The number of units is 50,000, and the costs are equivalent. The difference here is how the numbers are recorded, not what the numbers actually are, as those do not change. Mr. Rosen is doing his company a disservice by fiddling with numbers rather than improving performance is an organic way.
Mr. Rosen did not improve performance for the second quarter. The first issue is that the company has to understand that accounting techniques and performance are not equivalent. What a different accounting technique shows on paper does not change the fact that the company did the exact same thing in the quarter, regardless of how it was accounted for. The company cannot improve performance simply by producing more -- selling is what business does so if it is not selling more than it will not be functioning at a higher level.
Reporting is not the same thing as accounting. Reporting is quite specific, and governed by generally accepted accounting principles. These demand absorption costing. So that is what is recommended for Mr. Rosen in the future, that he stick to what is legal.
Mr. Rosen is not a serious candidate for the CEO position. If someone's idea of improving firm performance is to seek to perform accounting shenanigans, they are not CEO material. Again, you need to sell more in order to be better, not just produce more. Mr. Rosen is worthy of being fired, not elevation to the CEO role.
As far as the absorption approach, it is…
References
Investopedia. (2013). Definition of absorption costing. Investopedia. Retrieved December 23, 2013 from http://www.investopedia.com/terms/a/absorptioncosting.asp
Taylor, E. (2013). Disadvantages of absorption costing for a company. Houston Chronicle. Retrieved December 23, 2013 from http://smallbusiness.chron.com/disadvantages-absorption-costing-company-22732.html
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