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Graham, Inc.

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This case is a "timeless" exercise in the logic of product costing systems for profit determination. The problem is easy to see, difficult to explain and analyze, and impossible to resolve! The new president of Graham, Inc., Tom Graham, Jr. was very pleased with the turnaround in sales in August. August sales were $200,000 greater than in July, so he had every reason to expect the income statement to show a healthy increase over July's profit of $14,036. When the August report came in showing a loss of $22,928, he was shocked (Exhibit 1). After the initial shock, thinking there must be some mistake, Graham called the controller, Andy Derrow., for an explanation. Derrow assured him, however, that the figures were correct. The reason for the loss was that the company had reduced production levels well below normal. This resulted in an unabsorbed production volume variance which more than offset the impact of the increase in sales. He said that the rate of sales must equal factory production or the same thing would happen every month. As it was", factory operations were out of phase with sales. As long as the company followed GAAP accounting and charged the under- or overabsorbed manufacturing overhead to the current income statement, the type of distortion which occurred in August would happen. The president had recovered totally from his initial shock: "You always seem to be able to talk your way our of a jam, but I don't care about your fancy accounting principles. Common sense indicates to me that when sales go up, and other things are reasonably the same, profit should also rise. If your reports can't reflect this simple idea, why do 1 pay you so much money?" Derrow had been troubled by the same question himself, but from a different angle. He took the opportunity to suggest a different approach to the problem. He wanted to charge all fixed manufacturing overhead for the current month to the income statement in a lump sum, the same as selling and administrative expenses. Then there would be no problem with variations in under- or overabsorbed overhead when the production volume changed. Cost of goods sold would reflect only variable costs, which Derrow called "direct costs." To illustrate, he reworked the August statement and found that the loss turned into a profit (Exhibit 2). He showed this to the president and quipped, "You want profit for AugustI'll give you profit!" Graham's response was, "That's more like it!" But, after some consideration about the corresponding increase in taxes and demands for wage and dividend increases resulting from big profit, he said, "Maybe this idea isn't so good after all." Derrow was in favor of the idea chiefly because it simplified accounting procedures. He was always one for simple methods. Omission of fixed overhead costs from the product cost would eliminate the tiresome and expensive task of determining an acceptable allocation of overhead to each product. The change was doubly desirable to Derrow, since the current standard cost allocations were out of date and were due to be recalculated anyway. He could neatly avoid ihe extra work by doing away with the system! The president wondered whether the proposed system might have any impact on cost control or marketing efforts. Certainly, product costs would be lower now by the amount of fixed manufacturing cost previously assigned to each unit.

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