Alberta Gauge Company Ltd, a small manufacturing company in Calgary, Alberta, ma

Question

Alberta Gauge Company Ltd, a small manufacturing company in Calgary, Alberta, manufactures three types of electrical gauges used in a variety of machinery. For many years the company has been profitable and has operated at capacity. However in the last 2 years, prices on all gauges were reduced and selling expenses increased to meet competition and keep the plant operating at capacity. Second-quarter results for the current year, which follow, typify experience. Alberta Gauge Company Income Statement Second Quarter (In thousands) Q-Gauge E-Gauge R-Gauge Total Sales $1,600 $900 $900 $3,400 Cost of goods sold 1,048 770 950 2,768 Gross Margin $552 $130 $(50) $632 Selling and admin expenses 370 185 135 690 Income before taxes $182 $(55) $(185) $(58) Alice Carlo, the company president is concerned about the results of the pricing, selling and production prices. After reviewing the second-quarter results, she asked her management staff to consider the following three suggestions. Discontinue the R-gauge line immediately. R-gauge would not be returned to the product line unless the problems with the gauge can be identified and resolved. Increase quarterly sales promotion by $100,000 on the Q-gauge product line in order to increase sales volume by 15 percent. Cut production on the E-gauge line by 50 percent, and cut the traceable advertising and promotion for this line to $20,000 each quarter. Jason Sperry, the controller, suggested a more careful study of the financial relationships to determine the possible effects on the company’s operating results of the presidents proposed course of action. The president agreed and assigned JoAnn Brower, the assistant controller to prepare an analysis. Brower has gathered the following information. All three gauges are manufactured with common equipment and facilities. The selling and administrative expenses is allocated to the three gauge lines based on average sales volume over the past three years. Special selling expenses (primarily advertising, promotion and shipping) are incurred for each gauge as follows: Quarterly Advertising and Promotion Q-Gauge $210,000 E-Gauge 100,000 R-Gauge 40,000 The unit manufacturing costs for the three products are as follows: Q-Gauge E-Gauge R-Gauge Direct Material $31 $17 $50 Direct Labor 40 20 60 Variable Manufacturing overhead 45 30 60 Fixed Manufacturing overhead 15 10 20 Total $131 $77 $190 The unit sales prices for the three products are as follows: Q-Gauge $200 E-Gauge 90 R-Gauge 180 The company is manufacturing at capacity and is selling all the gauges it produces. Required: 1. JoAnn Brower says that Alberta Gauge Company’s product line income statement for the second quarter is not suitable for analyzing proposals and making decisions such as the ones suggested by Alice Carlo. Write a memo to Alberta Gauge’s president that addresses the following points. a. Explain why the product line income statement as presented is not suitable for analysis and decision making. b. Describe an alternative income statement format that would be more suitable for analysis and decision making and explain why it is better.

Explanation / Answer

To: The President

Subject: Insufficient information to analyse financial statements.

The task of analyzing the financial statements is a difficult one. This task gets more difficult when the information available is not sufficient to make any decision. The income statement available for analyzing the financial statements is based on absorption costing. This is mainly for the external reporting purpose. But for the internal use of management it is always better to prepare income statement based on variable or marginal costing. The main drawback of the present income statement is this does not differentiate between fixed and variable cost and also the allocation base for the fixed expenses allocation is not appropriate.

For a better understanding of actual cost associated with the products it is necessary to have an idea of fixed and variable component associated with the cost that is incurring on the manufacturing of a product and also the allocation base used for fixed cost must be directly related with activity driver. For this purpose a variable costing income statement is always better to use because it clearly differentiate between fixed and variable cost. A clear distinction of fixed and variable cost is essential to understand cost behavior and to analysis the likely effect of any management decision likes discontinuance of a product or increase of expenses on the profitability of the company.

So, the income statement must be converted in variable costing income statement to analyzing the possible effect of the entire proposal made by management.

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