CASE 4: The Case of the Perplexed President: Lean Production John Ovard, president of Mylar Lid was looking forward to receiving the company's second quarter income statement. He knew that the sales budget of 20,000 untold had been met during the second quarter and that this represented a 25% increase in sales over the first Quarter. He was especially happy about the increase in sales, since Mylar was about to approach its bank for additional loan money for expansion purposes. He anticipated that the strong second-quarter results would be a real plus in persuading the bank to extend the additional credit for this reason, Mr. Ovard was shocked when he received the second-quarter income statement below, which showed a substantial drop in absorption costing net operating income from the first quarter First two Quarters Mylar, two Quarters First Quarter Quarter Cost of goods volt Beginning Inventory Add cost of goods manufactured Goods available for (490,000 900.000 210,000 1.400,000 1,610,000 490,000 1.120,000 140.000 70,000 1.400,000 240,000 3.120,000 Less ending inventory Cost of good Add underapplied Gross margin Selling and admin expenses Net operating income 310.000 120.000 1.640,000 10000 310,000 230,000 Mr. Ovard was certain there had to be an error somewhere and immediately called the controller into his office to find the problem. The controller stated, "That net operating income is correct, John Sales went up during the second quarter, but the problem is in production You see, we budgeted to produce 20,000 units each quarter, but a strike in one of our supplier's plants forced us to cut production back to only 14,000 units in the second quarter. That's what caused the drop in net operating income Mr. Oward was angered by the controller's explanation. "I call you in here to find out why income dropped whes sales went up, and you talk about production So what production was off? What does that have to do with the sales that we made it sales go up, the income ought to go up. If your statements can't show a simple thing like that, then we're due for some changes in your areal" Budgeted production and sales for the year, along with actual production and sales for the first two quarters are given below Quarter Second Third Budgeted est 16,000 20.000 20.000 24,000 Actualment 20,000 budgeted production 20.000 20,000 20,000 20,000 Actual production (20.000 The company's plant is heavily automated, so fed manufacturing overhead costs total 100.000 per water ble manufacturing costs are per unit. The fund manufacturing overhead cost is applied to units of product at the rate of 140 per unit (based on the budgeted Production shown above). Any underapplied or everapied overhead is closed directly to cost of goods sold for the quarter The company had 3.000 units in inventory to start the first quarter and use the inventory now assumption. Variable selling and administrative expenses are per unit sold. Required An Essay or Absorption costing vs Marginal Costing using the following guiding questions 1. What characteristic of absorption costing caused the drop in net operating income for the second quarter and what could the controller have said to explain the problem? 2. Prepare a contribution format income statement for each quarter using variable costing 3. Reconcile the absorption costing and the variable costing net operating income figures for each Quarter 4. Identity and discuss the advantages and disadvantages of using the variable costing method for internal reporting purposes