It’s been tough going for the past couple of years, but we’re now a well-established company with a quality reputation. We now need to design a management accounting system to help us measure and evaluate our financial performance. I’d also like to use this system to evaluate and reward the performance of our production managers.

Donna Patricks, President, Little Creek Boatbuilders

BACKGROUND

Little Creek Boatbuilders, founded in 1995, built small sailing dinghies at a facility located along the Chesapeake Bay in Virginia. One of the company’s best selling boats was the Optimist, a boat sailed and raced worldwide by youngsters between the ages of eight and fifteen. The design and specifications were set and controlled by the International Optimist Dinghy Association (IODA). However, individual manufacturers had some flexibility within the rules to apply small design and manufacturing modifications in search of extra speed, strength or reliability. Two major builders in the United States, and two overseas, in addition to a number of smaller boat builders like Little Creek, built Optimists. Over 100,000 Optimists were registered worldwide.

Like many high-quality sailboats, the Optimist was built primarily by hand. The builder applied layers of plastic-resin-soaked fiberglass cloth into molds to shape the outer hull, hull liner and deck. These in turn were joined together. The outside layer of the hull was “gel coat,” a hard, smooth surface, sometimes with color added, sprayed into the hull mold. A thin layer of foam was placed between the outer hull and the liner when they were joined to provide strength and rigidity, as well as some flotation. Hardware was added last: sheet blocks, a mast step, and attachments for air . . .

Assignment

1. Construct income statements for 1995 and for 1996, using both absorption and variable costing assumptions. Include all appropriate detailed line items and subtotals. Carry out computations to the nearest cent to avoid rounding errors.
2. Explain why the two net income figures differ. Prepare a table that reconciles the differences in net incomes reported by absorption and variable costing, and explain precisely how and why the reported net income figures differ.
3. Suppose Little Creek had built 86 (instead of 85) James River Racers in 1995, but still sold only 70, such that 16 boats remained in inventory. Using both absorption and variable costing, determine by how much, if at all, the net income you calculated in Question 1 would change? Do these results make sense? Why or why not?
4. Which way of computing net income (variable or absorption costing) would you prefer Ms. Patricks use to measure and evaluate the production managers’ performance and to compute their bonus pool? Why? Which of these methods provides better information about the profitability of Little Creek’s operations? Why? Would one of these methods let a production manager exert more influence over his or her reported net income than the other? If so, how? Would you like the production managers to be able to exert this influence? Why or why
5. Suppose Ms. Patricks was considering the adoption of a just-in-time (JIT) production and inventory management system. Would absorption or variable costing provide a better basis for measuring, evaluating and rewarding production managers’ performance in the context of a JIT system? Which method—variable or absorption costing— would be more likely to promote goal congruence between the production managers and Ms. Patricks?
6. Which costing method should Ms. Patricks use?