HBSP Product Number TCG 017

THE CRIMSON PRESS CURRICULUM CENTER

THE CRIMSON GROUP, INC.
In early August, Terry Silver, the new marketing vice president of Landau Company, was studying the July income statement. Silver found the statement puzzling: Julys sales had increased significantly over Junes, yet income was lower in July than in June. Silver was certain that margins on
Landaus products had not narrowed in July and therefore felt that there must be some mistake in
the July statement.
When Silver asked the companys chief accountant, Meredith Wilcox, for an explanation, Wilcox stated that production in July was well below standard volume because of employee vacations.
This had caused overhead to be underabsorbed, and a large unfavorable volume variance had been
generated, which more than offset the added gross margin from the sales increase. It was company
policy to charge all variances to the monthly income statement, and these production volume variances would all wash out by years end, Wilcox had said.
Silver, who knew little about accounting, found this explanation to be incomprehensible.

Educational material supplied by The Case Centre

Copyright encoded A76HM-JUJ9K-PJMN9I
Order reference F235441

With all the people in your department, I dont understand why you cant produce an income statement that
reflects the economics or our business. In the company that I left to come here, if sales went up, profits
went up. I dont see why that shouldnt be the case here, too.

As Wilcox left Silvers office, a presentation at a recent Institute of Management Accountants

meeting came to mind. At that meeting the controller of Winjum Company had described that
firms variable costing system, which charged fixed overhead to income as a period expense and
treated only variable production costs as inventoriable product costs. Winjums controller had
stressed that, other things being equal, variable costing caused income to move with sales only,
rather than being affected by both sales and production volume as was the case with full absorption
costing systems.
Wilcox decided to recast the June and July income statements and balance sheets using variable
costing. (The income statements as recast and as originally prepared, and the related inventory and
retained earnings impacts are shown in Exhibit 1.) Wilcox then showed these statements to Terry
Silver, who responded,
Now thats more like it! I knew July was a better month for us than June, and your new variable costing
statements reflect that. Tell your boss [Landaus controller] that at the next meeting of the executive committee Im going to suggest we change to this new method.

At the next executive committee meeting, Silver proposed adoption of variable costing for Landaus monthly internal income statements. The controller also supported this change, saying that it
would eliminate the time-consuming efforts of allocating fixed overhead to individual products.
These allocations had only led to arguments between product managers and the accounting staff.
The controller added that since variable costing segregated the cost of materials, direct labor, and
variable overhead from fixed overhead costs, managements cost control efforts would be enhanced.
Silver also felt that the margin figures provided by the new approach would be more useful than
the present ones for comparing the profitability of individual products. To illustrate the point, he
had worked out an example. With full costing, two products in Landaus line, numbers 129 and
243, would appear as follows:
_____________________________________________________________________________________________
This case was prepared by Professor James S. Reece. It is intended as a basis for class discussion and not to illustrate
either effective or ineffective handling of an administrative situation.
Copyright 2012 by James S. Reece and The Crimson Group, Inc. To order copies or request permission to reproduce this document, contact Harvard Business Publications (http://hbsp.harvard.edu/). Under provisions of United
States and international copyright laws, no part of this document may be reproduced, stored, or transmitted in any
form or by any means without written permission from The Crimson Group.

ecch the case for learning

Distributed by ecch, UK and USA

www.ecch.com
All rights reserved

North America
t +1 781 239 5884
e ecchusa@ecch.com

Rest of the world

t +44 (0)1234 750903
e ecch@ecch.com

Purchased for use on the SMM452 Strategic Cost Management, at Cass Business School.
Taught by Yeshwant Nama-Venkateswwaralu, from 10-Oct-2014 to 9-Apr-2015. Order ref F235441.
Usage permitted only within these parameters otherwise contact info@thecasecentre.org

Landau Company

Product
129
243

Standard
Production Cost
$2.54
3.05

Selling Price
$4.34
5.89

Unit Margin
$1.80
2.84

Margin Percent
41.5
48.2

Thus, product 243 would appear to be the more desirable one to sell. But on the proposed basis, the
numbers were as follows:
Product
129
243

Standard
Production Cost
$1.38
2.37

Selling Price
$4.34
5.89

Unit Margin
$2.96
3.52

Margin Percent
68.2
59.8

According to Silver, these numbers made it clear that product 129 was the more profitable.

If we use this new approach, the next thing we know you marketing types will be selling at your usual
markup over variable costs. How are going to pay the fixed costs then? Besides, in my 38 years of experience, its the lack of control over long-run costs that can bankrupt a company. Im opposed to any proposal
that causes us to take a myopic view of costs.

Educational material supplied by The Case Centre

Copyright encoded A76HM-JUJ9K-PJMN9I
Order reference F235441

The president also had some concerns, having further considered the proposal.
In the first place, if I add together the June and July pretax profit under each of these methods, I get almost
$117,000 with the present method, but only $99,000 under the proposed method. While Id be happy to
lower our reported profits from the standpoints of relations with our employee union and income taxes, I
dont think its a good idea as far as our owners and bankers are concerned. And I share Jamies [the treasurers] concern about controlling long-run costs. I think we should defer a decision on this matter until we
fully understand all of the implications.

Assignment
1.

Explain the reasons for the $29,287 difference in July ($65,099 - $35,812) between income before taxes under the two different methods. Be very specific in listing the elements that caused the difference.

2.

Critique the various pros and cons of the variable costing proposal that were presented in the meeting. What
arguments would you add?

3.

Assess Mr. Silvers arguments concerning products 129 and 243. If he could emphasize only one product,
which one should it be? Why?

4.

Should Landau adopt variable costing for its monthly income statements? Why or why not?

_____________________________________________________________________________________________
Landau Company June 2012
2 of 3

Purchased for use on the SMM452 Strategic Cost Management, at Cass Business School.
Taught by Yeshwant Nama-Venkateswwaralu, from 10-Oct-2014 to 9-Apr-2015. Order ref F235441.
Usage permitted only within these parameters otherwise contact info@thecasecentre.org

At this point, the treasurer spoke up.

LANDAU COMPANY
Exhibit 1. Income Statements and Selected Balance Sheet Items
June and July

Sales Revenue
Cost of sales at standard
Standard gross margin
Production cost variances*
Labor
Material
Overhead volume
Overhead spending

$865,428
484,640
$380,788

Actual gross margin

Fixed production overhead
Selling and administrative
Income before taxes

$382,279

(16,259)
12,416
1,730
3,604

301,250
$81,029

June
Variable
Costing
$865,428
337,517
$527,911
(16,259)
12,416
3,604
$527,672
192,883
301,250
$33,539

July
Full
Costing
$931,710
521,758
$409,952
(11,814)
8,972
(63,779
2,832
$346,163
310,351
$35,812

Variable
Costing
$931,710
363,367
$568,343
(11,814)
8,972
2,832
$568,333
192,883
310,351
$65,099

* Parentheses denote unfavorable (debit) variance.

Impact on Inventories and Retained Earnings
The only asset account affected by the difference in accounting method was Inventories; on the liabilities and
owners' equity side, only Retained Earnings was affected. (There was no tax liability impact since variable costing was
not permitted for income tax reporting purposes.)

As of 30-Jun
Full
Variable
Costing
Costing
Inventories
Retained Earnings

$1,680,291
$3,112,980

$1,170,203
$2,602,892

As of 31-Jul
Full
Variable
Costing
Costing
$1,583,817
$3,131,602

$1,103,016
$2,650,801

Purchased for use on the SMM452 Strategic Cost Management, at Cass Business School.
Taught by Yeshwant Nama-Venkateswwaralu, from 10-Oct-2014 to 9-Apr-2015. Order ref F235441.
Usage permitted only within these parameters otherwise contact info@thecasecentre.org

Educational material supplied by The Case Centre

Copyright encoded A76HM-JUJ9K-PJMN9I
Order reference F235441

Full
Costing