Landau Company In early August, Terry Silver, the new marketing vice president of Landau Company, was studying the July income statement. Silver found the statement puzzling: July's sales had increased significantly over June's, yet income was lower in July than in June. Silver was certain that margins on Landau's products had not narrowed in July and therefore felt that there must be some mistake in the July statement. When Silver asked the company's chief accountant, Meredith Wilcox, for an explanation, Wil- cox stated that production in July was well below standard volume because of employee vacations This had caused overhead to be under absorbed, 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 year's end, Wilcox had said. Silver, who knew little about accounting, found this explanation to be "incomprehensible." With all the people in your department, I don't understand why you can't 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 don't see why that shouldn't be the case here, too. As Wilcox left Silver's 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 firm's variable costing system, which charged fixed overhead to income as a period expense and treated only variable production costs as inventoriable product costs. Winjum's 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 that's 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 [ Landau's controller] that at the next meeting of the executive committee I'm going to suggest we change to this new method. At the next executive committee meeting. Silver proposed adoption of variable costing for Landau's 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, management's 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 Landau's line, numbers 129 and 243, would appear as follows:Standard Product Production Cost Selling Price Unit Margin Margin Percent 129 $2.54 $4.34 $1.80 41.5 243 3.05 5.89 2.84 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: Standard Product Production Cost Selling Price Unit Margin Margin Percent 129 $1.38 $4.34 $2.96 68.2 243 2.37 5.89 3.52 59.8 According to Silver, these numbers made it clear that product 129 was the more profitable. At this point, the treasurer spoke up. 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, it's the lack of control over long-run costs that can bankrupt a company. I'm opposed to any proposal that causes us to take a myopic view of costs. 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 $1 17,000 with the present method, but only $99,000 under the proposed method. While I'd be happy to lower our reported profits from the standpoints of relations with our employee union and income taxes, I don't think it's a good idea as far as our owners and bankers are concerned. And I share Jamie's [ the treasurer's] 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 un- der 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? Assess Mr. Silver's 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 Exhibit 1. Income Statements and Selected Balance Sheet Items June and July June July Full Variable Full Variable Costing Costing Costing Costing Sales Revenue $865,428 $865,428 $931,710 $931,710 Cost of sales at standard 484.640 337,517 521,758 363,367 Standard gross margin $380, 788 $527,911 $409,952 $568.343 Production cost variances* Labor (16,259) (16,259) (11,814) (11,814) Material 12,416 12,416 8,972 8,972 Overhead volume 1,730 (63,779 Overhead spending 3.604 3,604 2,832 2,832 Actual gross margin $382,279 $527,672 $346,163 $568,333 Fixed production overhead 192,883 192.883 Selling and administrative 301,250 301,250 310,351 310,351 Income before taxes $81.029 $33.539 $35.812 $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 As of 31-Jul Full Variable Full Variable Costing Costing Costing Costing Inventories $1,680,291 $1,170,203 $1,583,817 $1,103,016 Retained Earnings $3,112,980 $2,602,892 $3,131,602 $2,650,801