Polly Peyrotte started designing and decorating fine china plates more than 100 years ago. As her artistry caught on, she became famous. She also had good business sense and what started as one creative woman’s design studio became Polly Plates, Inc. (PPI), with millions of dollars in annual revenue. As the years went by, Polly’s daughters and granddaughters became involved in the business. When Polly retired, they hired talented designers who built on Polly’s designs to continue the company’s fine china tradition. In recent decades, fewer and fewer family members have gone into the business and non-family managers are now running most parts of the operation. Some of these professional managers also now serve on the board of
directors. The few family members who remain on the board have become concerned about the business’ profitability in recent years and its potential for future growth. They worry, for example, that the delicate flowers and landscapes that were a mainstay of the company’s designs in the past might no longer appeal to today’s collectors. Anna Slevnik, vice president of marketing and one of the remaining family members involved in running the company, defended those designs at a recent board meeting. Anna noted that, “many of the plate designs feature acanthus leaves … which have adorned the world’s best architecture and most beautifully illuminated manuscripts for more than two millennia… they are timeless!”
At the 20x0 year-end board meeting (held in February of 20x1), the company’s controller, Robin Aul, reported that in calendar 20x0, PPI sold 15 million plates at an average price of $3/plate. The plates have total variable manufacturing costs (including direct materials, direct labor, and variable manufacturing overhead) of $1.40/plate.
The company has a fixed manufacturing overhead cost of $22 million per year. Much of this overhead is rent paid to various Peyrotte family members who have inherited, as personal assets, the real estate (land and buildings) in which the company manufactures and warehouses plates. Gareth Snyder, a tax advisor to Polly in the 1930s, used to preach, “hold depreciating assets in the company, but hold appreciating assets in your
personal portfolios and rent them to the company.”
The good news about PPI’s high fixed manufacturing costs is that they do provide enough capacity to make 60
million plates a year (which could come in handy if demand ever returns to the lofty levels of years gone by). In
addition, the company has selling and administrative costs (all fixed) of $3 million per year.
Robin noted that the 20x0 beginning and ending inventories of plates were both zero. She suggested that the
firm might be losing sales and should consider keeping more plates in inventory to meet sudden increases in
demand. Anna responded, “I believe controllers should stick to bean counting and leave important sales and
distribution decisions to those who are experienced in such matters.” She then added, “Harrumph!”
The company’s president, Barbara Boxtuttle, had hired consultant Deb Bett in October, 20x0, when she realized
the company was likely to show a net loss for the year that would end in December, 20x0. Earlier in the day (of
the board meeting), Barbara had received the consultant’s report and was not happy. The report concluded that
the company needed a new president. Further, the report recommended hiring Ms. Bett as a temporary president.
The report said she was someone who “could really turn the business around.”
Deb, when discussing her report at the board meeting, said her analysis showed strong evidence that PPI’s
customer base was no longer intact (her report used the phrase “dying off”) and that the company needed to
explore new markets. Over Anna’s groans, Deb said, “In addition to the lovely plates the company has been
selling for a century, we should open an exciting new market by printing funny sayings, slogans, and political
messages on the plates. To do this, we must open new marketing channels, ramp up production to fill those
channels, and spend more on advertising as we move into new markets.” Every time Deb said “we,” Barbara
winced.
A lively discussion among the board members ensued, ending with a motion, duly seconded, to adopt the
report’s recommendation. The motion passed with only one “nay” vote (Barbara’s). At the end of its regular
meeting, the board thanked Barbara for her years of devoted service, fired her, and asked her to leave the
building immediately. After a brief recess, the board reconvened in special session and voted unanimously to
elect Deb president and charged her with implementing the company’s foray into new markets and making the
company profitable once again.
To show her confidence, Deb agreed to a one-year contract, which provided that, if Deb managed to show a
profit at the end of one year (20x1), PPI would offer her an additional year. Further, Deb agreed to work for an
annual salary of $1 plus a bonus of 20% of annual net income. No profits, no bonus. Robin (the controller) made
sure that Deb’s employment contract included a provision that defined “net income,” for purposes of the
contract as net income calculated before taxes using absorption costing, noting that, “after all, absorption costing
is GAAP, and GAAP basis net income is what our auditors and bankers would expect to see in a contract like
this. I know other ways of calculating net income, but we are Polly’s Plates and our tradition is to use only the
best materials, most skilled workers, and the finest accounting principles, too!”
In 20x1, Deb implemented her plan. She hired new staff to write the funny sayings (for some reason, these new,
younger people called them “memes”), slogans and political messages to go on the plates, launched three
different advertising campaigns (one for each of the new marketing channels) and trained PPI salespeople to call
on the types of customers who would be interested in the new plate designs. As promised, she increased
production to fill the new marketing channels. PPI manufactured 50 million plates in 20x1 and sold 18 million
of them, a 20% increase in unit sales over 20x0. Deb told everyone on the board that she was thrilled with the
sales growth and was happy to have so many plates in inventory at the end of 20x1. She said she believed that
fresh orders would be pouring in the moment her new salespeople developed the new selling channels fully. She
firmly believed that the large ending inventory would come in handy for quick shipments as the demand would,
she was sure, “increase rapidly.”
Doing all this product development and opening new sales channels was, of course, expensive. The fixed selling
and administrative expenses (including Barbara’s severance package and Deb’s $1 salary) more than doubled
from $3 million in 20x0 to $7 million in 20x1. Fortunately, through what Deb described as “a firm hand on
operating costs and careful attention to competitor’s price points,” she kept variable costs per plate and the
plates’ average selling price the same as in 20x0.
One year later…
At the year-end board meeting for 20x1 (held in February 20x2), everyone was jubilant over the sharp rise in
sales and the financial results. Robin (the controller) provided a draft financial statement that showed a net
income of $13,880,000 (before taxes and Deb’s bonus). Celebratory champagne and caviar were served. The
controller handed Deb a check for $2,776,000 and the entire board gave her a standing ovation while chanting,
“One more year, one more year!”
After thanking the board for the opportunity to show “what a little fresh thinking could do for a company that
had been so stuck in the past” (and for the big fat bonus check), Deb expressed her regrets that she would be
unable to accept PPI’s offer to continue in the President’s position for a second year. She explained that she
would be on the next flight to Frostbite Falls, Minnesota to take on her next challenge. Jay Ward, CEO of
struggling cereal manufacturer Kernel Mills, had heard of Deb’s success at PPI and has asked her to help them
turn around their business.
The board was disappointed, but felt that Deb was leaving them in a great position to carry her brilliant idea into
a future of profitability and boundless growth and toasted to her continued success in helping companies turn
themselves around.

Requirements:

Prepare four income statements in reasonably good form for Polly Plates, including both absorption and variable costing income statements for 20x0 and 20x1.

From the absorption costing (also known as the “GAAP” or “external financial reporting” format) income statement for Polly Plates’ 20x0 year, provide the amount of net income (or loss) calculated.

One of the board members, hearing of the net loss expected for 20x0 at the first board meeting described above, asked whether anyone knew how many plates the company would need to sell to break even. Calculate PPI’s breakeven point (in plates) using 20x0’s cost structure. Recall that a company’s cost structure is its selling price per unit, variable cost per unit, and total fixed cost.

Another board member at the 20x0 meeting responded to that query, asking, “Who cares what it takes to make zero net income? I’d like to know what sales would be necessary to make $2 million a year… as we did in the old days! Harrumph!” Calculate the sales (in plates) PPI needed to yield a net income of $2 million, using 20x0’s cost structure.

As the discussion about breakeven points and profit planning wound down, an elderly board member awoke from his nap, saw the breakeven charts on the projection screen, and mumbled something about “direct costing.” His granddaughter (also on the board and a recent MBA graduate) responded by saying, “Wait! I think I remember that term. Yes, in fact, you can make a whole income statement using direct costing. In Professor Blatterfitzel’s class, we called it ‘variable costing’ or the ‘contribution margin format income statement,’ or something like that.” Refer to the income statement you prepared for PPI’s 20x0 year using variable costing (also called “direct costing” or “the contribution margin format”) and state the amount of net income (or net loss) calculated. How is this different from the one calculated from GAAP?

Calculate PPI’s 20x1 ending inventory amount (under absorption costing) in both plates and dollars using calculations you performed when creating the absorption costing income for that year.

Why are the two PPI 20x1 income statements prepared using variable costing (also called direct costing or contribution margin format costing) and absorption different amounts of net income (or net loss).