Ronald performance remained constant for the two periods. According to the absorption costing income statement the net income increased as shown in the excel spreadsheet. The net profit increased from $438,000 in the first quarter to $475,000 in the second quarter. This shows an 8.45% increase in net income as shown in the excel sheet. However, according to contribution margin income statement; the net income remained the same in both quarters. The profit levels for both periods remained at $250,000.The increase in profits in the second quarter under absorption income statement can be explained by changes in inventory levels. Since inventories have an element of fixed cost, closing inventories defer some of the current period fixed costs to future periods. The higher net income in the quarter two compared to the quarter one can be traced to the increased volume of closing inventory between the two periods. Therefore, the actual performance did not improve between the two quarters. This is evident from the sales volume which remained constant between the two periods. The fixed costs also remained unchanged during the two periods.
I would suggest that Ronald should prepare two sets of income statements. One set under absorption income statement for external reporting purposes. This is because it is a requirement by the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) to prepare financial reports using absorption costing method. Since Ekland Division of Ystad Industries is a company and should comply with these regulations. Ronald should also prepare another set of income statements using contribution margin income statement method. Contribution margin income statement is important in making managerial decisions and is more useful to managers than absorption income statement. Information from contribution margin income statement can be used directly in performing cost volume analysis which is important in determining the optimal level to operate. Secondly, contribution margin income statement eliminates fluctuation in profits due to changes in inventory level and is, therefore, more relevant in evaluating performance over time.
Ronald should be considered for CEO position of Ekland Division of Ystad Industries. Ronald has steered his division to profitability consistently in the first and the second quarters. Both the contribution margin income statements and the absorption costing income statements show positive net income for both quarters. In fact, the net income increased under the absorption income statement from $438,000 in the first quarter to $475,000 in the second quarter while the net income levels for both periods remained at $250,000 under contribution margin income statement. However the board of directors of Ekland Division of Ystad Industries should evaluate the performance of other division managers in choosing the CEO of Ekland Division of Ystad Industries. They should then select the division manager with the best performance. Although Ronald is performing relatively well as shown by the income statements, there could be other managers who performed better.
Disadvantages of absorption income statement
Absorption costing may prevent a business from engaging in profitable business opportunities. When a company uses absorption costing as a base for evaluating probable investment projects, it has to factor in a portion of its fixed cost that may indicate a project is unprofitable. However, in cases where a business has excess capacity, investing in a different project or increasing current capacity may not increase fixed cost as portrayed by absorption costing income statement. This is different from contribution margin income statement which only considers variable costs. This is consistent with project evaluation techniques which only considers future additional costs and ignore sunk and fixed costs.Therefore; a business may reject some profitable investments when it has excess capacity if it uses absorption income statement.
The second disadvantage is that absorption income statement is prone to fluctuations. Absorption income statement profits fluctuate between periods due to changes in inventories. Profit may remain the same or move in opposite directions with variable costs. Fixed costs of a given period are carried forward to future periods in the closing inventories. Profits of a company may increase or reduce due to inventory changes. Different companies may have different absorption rates for fixed costs even if they have the same fixed costs. It also common for managers to change the absorption rate of fixed expenses to achieve predetermined profits for selfish needs. Absorption income statement makes it easier to engage in creative accounting since the absorption rate is based on estimated production levels and estimated fixed costs. Therefore, absorption costing makes trend and cross sectional analysis of income statements difficult.
Lastly, absorption income statement makes it difficult to perform cost volume profit (CVP) analysis using information obtained from the income statement. CVP analysis evaluates the production level required to break even and to start earning profits by measuring contribution available to meet the fixed expenses at different levels of output. Contribution is the difference between sales and variable cost. Therefore there is need to eliminate the fixed costs absorbed in absorption accounting when performing CVP analysis. CVP analysis is important in determining the optimal level that a firm should operate.
References
Eisen, P. (2000). Accounting (4, illustrated ed.). New York: Barron's Educational Series.
Gibson, C. H. (2010). Financial Reporting & Analysis: Using Financial Accounting Information (12 ed.). London: Cengage Learning.
Jordan, J. P., & Harris, G. L. (2011). Cost Accounting: Principles and Practice (reprint ed.). South Carolina: BiblioBazaar.
Kinney, M. R., & Raiborn, C. A. (2008). Cost Accounting: Foundations and Evolutions (7, illustrated ed.). London: Cengage Learning.
