DISCUSSION QUESTIONS
Q20-1. Direct costs are direct materials, direct labor, and other costs directly assignable to a product.
Direct costing is a procedure by which only prime costs plus variable factory overhead are assigned to a product or inventory; all fixed costs are considered period costs.
Q20-2. Product costs are associated with the manufacture of a product and include direct materials, direct labor, and factory overhead. These costs are charged against revenue as cost of goods sold, or shown on the balance sheet as inventories of work in process and finished goods. Period costs are associated with the passage of time and are included as expenses in the income statement. Under direct costing, fixed factory overhead is treated as a period cost rather than as a product cost.
Q20-3. Under direct costing, only variable manufacturing costs are included in inventory. Under absorption costing (the current, generally accepted method of costing inventory for external reporting), all manufacturing costs, both variable and fixed, are included in inventory.
Q20-4. It is argued that fixed manufacturing costs are the expenses of maintaining productive capacity. Such expenses are more closely associated with the passage of time than with production activity and should, therefore, be charged to period expense rather than to the product.
Q20-5. The direct costing method is useful for internal reporting because it focuses attention on the fixed-variable cost relationship and the contribution margin concept. It facilitates managerial decision making, product pricing, and cost control. It allows certain calculations to be readily made, such as break-even points and contribution margins of products, sales territories, operating divisions, etc. The focus on the contribution margin (sales revenue less variable costs) enables management to emphasize profitability in making short-run business decisions. Fixed costs are not easily controllable in the short run and hence may not be particularly relevant for short-run business decisions.
20-1
Q20-6. Arguments for the use of direct costing include the following:
(a) For profit-planning and decision-making purposes, management requires costvolume-profit relationship data that are more readily available from direct cost statements than from absorption cost statements.
(b) Since fixed factory overhead is absorbed as a period cost, fluctuations in production and differences between the number of units produced and the number sold do not affect the per unit product cost.
(c) Direct costing reports are more easily understood by management because the statements follow management’s decision-making processes more closely than do absorption cost statements.
(d) Reporting the total fixed cost for the period in the income statement directs management’s attention to the relationship of such cost to profits.
(e) The elimination of allocated joint fixed cost permits a more objective appraisal of income contributions according to products, sales areas, kinds of customers, etc.
Cost-volume relationships are highlighted.
(f) The similarity of the underlying concepts of direct costing and flexible budgets facilitates the adoption and use of these methods for reporting and cost control.
(g) Direct costing provides a means of costing inventory that is similar to management’s concept of inventory cost as the current out-of-pocket expenditures necessary to produce or replace the inventory.
(h) Clerical costs are lower under direct costing because the method is simpler and does not require involved allocations of fixed costs or special analyses of absorption data.
(i) The computation of product costs is simpler and more reliable under direct costing because a basis for allocating the fixed costs, which involves estimates and personal judgment, is eliminated.

20-2 Chapter 20
Q20-7. Arguments against the use of direct costing include the following:
(a) Separation of costs into fixed and variable might be difficult, especially when such costs are semivariable in nature.
Moreover, all costs—including fixed costs—are variable at some level of production and in the long run.
(b) Long-range pricing of products and other long-range policy decisions require a knowledge of complete manufacturing cost, which would require additional separate computations to allocate fixed overhead.
(c) The pricing of inventories by the direct costing method is not acceptable for income tax computation purposes.
(d) Direct costing has not been recognized as conforming with generally accepted accounting principles applied in the preparation of financial statements for stockholders and the general public.
(e) Profits determined by direct costing are not
“true and proper” because of the exclusion of fixed production costs that are part of total production costs and inventory.
Production would not be possible without plant facilities, equipment, etc. To disregard these fixed costs violates the general principle of matching costs with revenue.
(f) The elimination of fixed costs from inventory results in a lower figure and consequent reduction of reported working capital for financial analysis purposes.
Q20-8. Assuming that the quantity of ending inventory is larger than the quantity of beginning inventory and the lifo method is used, operating income using direct costing would be smaller than operating income using absorption costing. Direct costing excludes fixed factory overhead from inventories because such costs are considered to be period costs which are expensed when incurred. In contrast, absorption costing includes fixed factory overhead in inventories because such costs are considered to be product costs, which are expensed only when the products are sold.
When the quantity of inventory increases during a period, direct costing produces a lower dollar increase in inventory than absorption costing, because fixed costs are expensed rather than charged to inventory. Since a smaller amount of current period cost is charged against income under the absorption costing method when inventories increase, absorption costing income would be larger than direct costing income.
Q20-9. The break-even point is the point at which costs and revenue are in equilibrium, showing neither profit nor loss for the business.
Q20-10. The contribution margin is the result of subtracting variable cost from the sales figure. The contribution margin indicates the amount available for the recovery of fixed cost and for profit.
Q20-11.(a) R(BE) = F
1 – V or (in words):
Revenue at the = Total fixed cost break-even point Contribution margin per dollar of sales
(b) Q(BE) = F
P – C or (in words):
Units of sales at = Total fixed cost break-even point Contribution margin per unit of sales
Q20-12. (1) Dollars of revenue and costs.
(2) Volume of output, expressed in units, percent of capacity, sales, or some other measure.
(3) Total cost line.
(4) Variable cost area.
(5) Fixed cost area.
(6) Break-even point.
(7) Loss area.
(8) Profit area.
(9) Sales line.
Q20-13. An analysis of the expected behavior of a firm’s expenses and revenue for the purpose of constructing a break-even chart is usually restricted to the output levels at which the firm is likely to operate. Assumptions about the level of fixed cost, the rate of variable cost, and sales prices are based on the operating conditions and managerial policies that will be in effect over the expected output levels.
These expected output levels represent the firm’s relevant range, and the cost-volumeprofit relationships shown in a break-even chart are applicable only to output levels within this range. The behavior of fixed cost, variable cost, and sales prices at levels of output below or above the relevant range are likely to result in an entirely different set of cost-volume-profit relationships because of

Chapter 20 20-3 changed operating conditions or managerial policies. The fact that the cost and revenue lines on a break-even chart are typically extended past the upper and lower limits of the relevant range should not, therefore, be interpreted to mean that they are valid for these levels of output.
A break-oven chart showing cost-volumeprofit relationships for all levels of output could be developed. The shapes of the cost and revenue lines in such a chart could not, however, be expected to approximate straight-line (linear) patterns. By restricting the underlying cost and revenue behavior assumptions in breakeven analyses to a relatively narrow output range (the range over which the firm is likely to operate), it is usually possible to assume linear behavior patterns without any significant distortions in cost-volume-profit relationships, thereby simplifying the analysis.
If the range over which a firm is likely to operate is quite wide, curvilinear functions may be employed; or it may be desirable to develop a number of break-even charts, each having its own relevant range, for which the underlying cost and revenue behavior assumptions are valid.
Q20-14. Weaknesses inherent in the preparation and use of break-even analysis are:
(a) When more than one product is produced, the contribution margin of each product will probably differ. Accordingly, a break-even analysis for the whole operation will not indicate the contribution of each product to fixed cost and the volume required for each product.
(b) Some costs are almost impossible to classify conclusively as being either fixed or variable.
(c) General economic conditions and other external factors may affect the data used in the analysis.
(d) In the final analysis, fixed cost is related to production and sales and, therefore, may decrease somewhat due to decreased production and sales—and vice versa.
(e) Quite often costs increase sharply at certain points in production and sales levels and then level out until a certain greater stage of production and/or sales is reached, at which time the phenomenon is repeated as production and/or sales are again increased.
(f) Performance must be constantly compared to the break-even analysis in order to determine whether the conditions that existed at the time of the calculations have held true, and whether any changes have been considered.
Q20-15. (a) With sales price per unit and total fixed cost remaining constant, the break-even point moves up rapidly as unit variable cost is increased; at the same time, the break-even point moves down as unit variable cost is decreased.
(b) A decrease in fixed cost lowers the breakeven point. An increase in fixed cost moves the break-even point higher.
Q20-16. The margin of safety is a selected sales figure less break-even sales. The margin of safety is a cushion against sales decreases. The greater the margin, the greater the cushion against suffering a loss.
Q20-17. Cost-volume-profit relationship is the relationship of profit to sales volume. This relationship is important to management because management tries at all times to keep volume, cost, price, and product mix in a ratio that will achieve a desired level of profit.
Q20-18. The Theory of Constraints is a specialized version of direct costing for use in short-run optimization decisions. A distinction between
TOC and direct costing is that TOC focuses on only the purely variable costs and does not consider direct labor to be purely variable.
Q20-19. Most companies that classify costs into fixed and variable categories treat direct labor as variable, so in direct costing, direct labor is assigned to products as a variable or incremental cost of production. In the Theory of
Constraints, direct labor is stipulated to be not purely variable and therefore is not treated as an incremental cost of output.
The difference between the contribution margin measure in direct costing and the throughput measure in TOC is that direct labor is one of the costs deducted from sales to calculate contribution margin, but direct labor is not a cost to be deducted from sales in calculating throughput.
There are many differences in emphasis between direct costing and the Theory of
Constraints. For example, while direct costing is widely used as an accounting approach for internal reporting of income and product cost, TOC deals heavily with the

20-4 improvement of constraints or bottlenecks in a production system.
Q20-20. Throughput is the rate at which a system generates money through sales. It is calculated as sales minus the purely variable costs, and often the only purely variable cost is the cost of materials.
Q20-21. Elevating a constraint means improving the constraint—improving the conditions at a bottleneck in the system. Its significance is greatest if the constraint is the tightest one in the
Chapter 20 system; there, any improvement will increase the total throughput of the entire system.
An improvement in product quality can help elevate a constraint because it can reduce the workload on a bottleneck resource. For example, removing defective units before rather than after they reach the bottleneck means there will be fewer units passing through the bottleneck. This has approximately the same effect on the bottleneck as increasing its capacity.

Chapter 20
EXERCISES
E20-1
Operating income for 20A using direct costing:
Sales (90,000 × $12) ..................................................................
$1,080,000
Variable cost of goods sold (90,000 × $4) ..............................
360,000
Gross contribution margin .......................................................
$ 720,000
Variable marketing and administrative expenses
(90,000 × $20) ................................................................
18,000
Contribution margin..................................................................
$ 702,000
Less fixed expenses:
Factory overhead........................................ $200,000
Marketing and administrative expenses ..
90,000 290,000
Operating income......................................................................
$ 412,000
E20-2
(1) Variable cost per unit:
$7,000,000 total variable cost
60% manufacturing cost portion
$4,200,000 total variable manufacturing cost
$4,200,000 total variable manufacturing cost
140,000 units actually produced
Fixed cost per unit:
$11,200,000 total fixed cost
50% manufacturing cost portion
$5,600,000 total fixed factory overhead
=
$5,600,000 total fixed factory overhead
160,000 units normal production volume
Full cost per unit at standard
Number of units sold during the year
Cost of goods sold at standard under absorption costing
=
$30 per unit
35 per unit
$65
× 100,000
$6,500,000
(2) Units actually produced during the year....................
Units sold during the year ...........................................
Unit increase in inventory ...........................................
Standard variable manufacturing cost per unit.........
140,000
100,000
40,000
× 30
Ending inventory at standard direct cost ..................
$1,200,000
20-5

20-6 Chapter 20
E20-2 (Concluded)
(3)
(4)
Normal production volume.....................................................
Units actually produced during the year ..............................
Excess of budget over actual production.............................
Fixed factory overhead per unit.............................................
×
160,000
140,000
20,000
$35
Factory overhead volume variance .......................................
$ 700,000
Sales (100,000 units × $180)...................................................
$18,000,000
Standard variable cost of goods sold (100,000 units × $30 unit variable cost)...........................................................
3,000,000
Gross contribution margin .....................................................
$15,000,000
Variable selling expense ($7,000,000 variable cost × 40%).
2,800,000
Contribution margin ................................................................
$12,200,000
Less fixed costs ......................................................................
11,200,000
Operating income under direct costing ................................
$1,000,000
E20-3
(1)
(2)
(3)
Income statement using absorption costing:
Sales (9,000 × $30) ..................................................................
Cost of goods sold (9,000 × ($10 + $5)) ................................
Gross profit ..............................................................................
Less commercial expenses....................................................
Operating income....................................................................
Income statement using direct costing:
Sales (9,000 × $30) ..................................................................
Variable cost of goods sold (9,000 × $10).............................
Contribution margin ................................................................
Less fixed expenses:
Factory overhead ..................................
Commercial expenses ..........................
$40,000
44,000
Operating income....................................................................
Computations explaining the difference in operating income:
Absorption costing operating income ..................................
Direct costing operating income ...........................................
Difference .................................................................................
Units produced during the period .........................................
Units sold during the period ..................................................
Unit decrease in finished goods inventory .........................
Fixed factory overhead charged to each unit of product under absorption costing ..............................................
Difference .................................................................................
$270,000
135,000
$135,000
44,000
$ 91,000
$270,000
90,000
$180,000
84,000
$ 96,000
$ 91,000
96,000
$ (5,000)
8,000
9,000
(1,000)
× $5
$ (5,000)

Chapter 20
E20-4
1 − $ .
80
=
1 − .
40
=
.
60
= $ ,
$10,000 ÷ $2 = 5,000 break-even point in units
(or)
− $.
80
= = break-even point in units
5,0 × $2 = $10,000 break-even point in dollars
E20-5
Materials ...................................................................................
Direct labor ..............................................................................
Variable factory overhead.......................................................
Variable marketing expense ...................................................
Total variable cost per unit.....................................................
Sales price per unit .................................................................
Variable cost per unit ..............................................................
Contribution margin per unit..................................................
Fixed factory overhead ...........................................................
Fixed marketing expense .......................................................
Fixed administrative expense ................................................
Total fixed expense .................................................................
(1)
(2)
(3)
$26,000 total fixed cost
$2 contribution margin
= 13,000 units of sales to break even
13,000 units × $5 per unit = $65,000 sales to break even
$26,000 fixed cost + $10,000 profit
$2 contribution margin
= 18,000 units
(4)
E20-6
18,000 units × $5 per unit = $90,000 sales
Planned sales ..........................................................................
Break-even sales .....................................................................
Margin of safety.......................................................................
$2,000,000
1,500,000
$ 500,000
$ 1.00
1.20
.50
.30
$ 3.00
$ 5.00
3.00
$ 2.00
$15,000
5,000
6,000
$26,000
20-7

20-8 Chapter 20
E20-6 (Continued)
$500,000 Margin of safety = 25% Margin of safety ratio
$2,000,000 Planned sales
E20-7
(1)
(2)
(3)
= $ , break-even point sales
.
62
$ ,
1
−
.
25
=
$ ,
.
75
= $ , actual sales
PR = C/M × M/S; PR = .62 × .25 = .155
$20,000 × .155 = $3,100 profit for the month
E20-8
(1)
(2)
$ ,
= $ , break-even sales
.
60
$ ,
1
−
.
20
=
$ ,
.
80
= $ , sales for the year
PR = C/M × M/S; PR = .20 × .60 = .12
$62,500 × .12 = $7,500 profit for the year
(3) Sales .........................................................................................
Variable cost ($62,500 × (1 – .60))..........................................
Contribution margin ($62,500 × .60) ......................................
E20-9
Sales:
(100,000 × $8).......................................
(200,000 × $6).......................................
Variable cost:
($800,000 × 30%)..................................
($1,200,000 × 25%)...............................
Contribution margin.........................................
Planned operating profit .................................
Fixed cost .........................................................
$62,500
25,000
$37,500
Chip A Chip B Total
$800,000
$1,200,000 $2,000,000
240,000
300,000 540,000
$560,000 $ 900,000 $1,460,000
270,000
$1,190,000

Chapter 20 20-9
E20-10
Sales price per unit ......................................................
Variable cost per unit ...................................................
Contribution margin per unit.......................................
Tables
$110
50
$ 60
$ , fixed cost
1
−
((($ 50
+ ×
$ 20 ))
÷
($ 110
+ ×
$ 35 )))
= $ , , or alternatively:
$ , fixed cost
($ 60 + × $ 15 )) ÷ ($ 110 + × $ 35 ))
= $ , ,
$ ,
$ 110
,
+ × sales
=
$ 35 ) or alternatively: hypotheti cal packages sa lles to break even
$
$ 60
, fixed cost
+ ×
$ 15 ) CM
= hypothetical packages
Chairs
$35
20
$15
6,000 packages × 1 table per package = 6,000 tables to break even
6,000 packages × 4 chairs per package = 24,000 chairs to break even
6,000 tables × $110 per table..............
= $ 660,000
24,000 chairs × $ 35 per chair ............
= 840,000
Total sales to break even....................
$1,500,000
E20-11
Product L Product M
Sales price per unit .............................
$20
Variable cost per unit ..........................
12
$15
10
Unit contribution margin ....................
$ 8
Expected sales mix .............................
× 2
$ 5
× 3
Contribution margin per hypothetical package .................
$16 + $15 = $31

20-10 Chapter 20
E20-11 (Concluded)
(1) $372,000 fixed cost
$31 contribution margin
= 12,000 packages to break even
12,000 packages
12,000 packages
24,000 units of L
36,000 units of M
×
×
×
×
2 units of L = 24,000 units of L
3 units of M = 36,000 units of M
$20
$15
=
=
$ 480,000 sales of L
540,000 sales of M
Break-even sales.......................................................
$1,020,000
(2) $372,000 fixed cost + $93,000 profit
$31 contribution margin
= 15,000 packages to achieve profit
15,000 packages
15,000 packages
30,000 units of L
45,000 units of M
×
×
×
×
2 units of L = 30,000 units of L
3 units of M = 45,000 units of M
$20
$15
=
=
$600,000 sales of L
675,000 sales of M
Sales to achieve profit..............................................
$1,275,000
E20-12
(1) Variable manufacturing cost...............................................................
Fixed manufacturing cost ...................................................................
Variable marketing expense................................................................
Fixed marketing and administrative expenses .................................
Total costs to produce and sell 70,000 units ....................................
$455,000 total cost
70,000 units
= $6.50 sales price per unit to break even
(2)
(3)
$210,000
80,000
105,000
60,000
$455,000
($80,000 + $60,000) fixed cost = 51,852 units
$8 – $4.50 – (10% × $8)
($147,000 + $60,000) fixed cost = 90,000 units
$8 – $4.50 – (15% × $8)
CGA-Canada (adapted). Reprint with permission.

Chapter 20 20-11

20-12 Chapter 20
E20-14
(1) throughput/unit = sales – materials cost = $45 – ($14 + $1) = $30
(2) Maximum throughput per month is $144,000. Total throughput for a period is the
$30/unit (from requirement 1) multiplied by the number of units shipped; units are limited by the lowest-capacity operation, which is Surface Prep’s 4,800 units per month: 4,800 units/month × $30/unit = $144,000/month.
(3) Surface Prep is the tightest constraint, with a 4,800-unit capacity.
E20-15
(1) No, they should not acquire the equipment. Gloss Coat is not the tightest constraint, so increasing its capacity will not help.
(2) Zero. Maximum monthly throughput will not increase.
(3) Yes, an additional Surface Prep (SP) crew should be hired. The increase in overall throughput more than justifies the cost.
(4) Maximum throughput will increase by about $15,000 per month (500 units/month
× $30/unit). SP is the tightest constraint, so increasing its capacity will increase throughput of the entire system until SP’s improvement causes another constraint to become the tightest. Gloss Coat, the second-tightest constraint, presently has capacity 500 units higher than SP’s.
E20-16
(1) Yes, an inspection should be created just prior to Surface Prep (SP). For each
1,000 shipped, 50 defectives enter SP—26, 14, and 10 arising in the three preceding operations, respectively. SP is the tightest constraint, so removing defectives prior to SP will increase total system throughput. At $30 throughput per unit, the 50 added units (per thousand shipped) do justify the added inspection.
(2) Removing all defectives just prior to SP will increase the number of good units entering SP by 50/1,000 or about 5%. With SP presently handling 4,800 units per month, a 5% increase in units shipped is .05 × 4,800 = 240. Additional throughput will be 240 units/month × $30/unit = $7,200 per month. Because the inspection will cost $1,800 per month, the monthly advantage of the added inspection operation will be $7,200 minus $1,800, or $5,400 per month.

Chapter 20 20-13
PROBLEMS
P20-1
Sales .......................................................
Less variable cost of goods sold ........
Gross contribution margin ...................
Less variable marketing expenses
(packing and shipping) ....................
Contribution margin..............................
Less traceable fixed expenses:
Manufacturing...................................
Marketing (advertising)....................
Total traceable fixed expense......
Product contribution.............................
Less common fixed expenses:
Manufacturing 1 .................................
Marketing 2 .........................................
Administration ..................................
Total common fixed expenses ....
Operating income..................................
TAYLOR TOOL CORPORATION
Product-Line Income Statement
(Contribution Margin Approach)
Total
$3,000,000
1,400,000
$1,600,000
Electronic
Tools
$1,500,000
700,000
$ 800,000
250,000
$1,350,000
$ 250,000
450,000
$ 700,000
$ 650,000
$ 300,000
100,000
150,000
$ 550,000
$ 100,000
100,000
$ 700,000
$ 100,000
200,000
$ 300,000
$ 400,000
Pneumatic
Tools
$1,000,000
500,000
$ 500,000
100,000
$ 400,000
$ 100,000
200,000
$ 300,000
$ 100,000
Hand
Tools
$500,000
200,000
$300,000
50,000
$250,000
$ 50,000
50,000
$100,000
$150,000
1 $1,950,000 absorption cost of goods sold – $1,400,000 variable costs – $250,000 traceable fixed cost
2 $800,000 total marketing costs – $250,000 variable expense – $450,000 advertising expense

20-14 Chapter 20
P20-2
(1) ROBERTS CORPORATION
Income Statement
For Year Ended 12-31-20–
Sales (52,000 × $25)......................................................................
$1,300,000
Cost of goods sold:
Standard full cost (52,000 × $15) .........................
$780,000
Net unfavorable variable cost variances .............
2,000
Unfavorable volume variance* .............................
5,000 787,000
Gross profit ...................................................................................
$ 513,000
Less commercial expenses:
Variable expenses (52,000 × $1)...........................
$ 52,000
Fixed expenses ......................................................
180,000 232,000
Operating income under absorption costing ............
$ 281,000
*Units budgeted for production during the year.........................
Units actually produced during the year....................................
Fixed factory overhead charged to each unit ............................
Unfavorable volume variance ......................................................
$
$
50,000
49,000
1,000
× 5
5,000
(2)
(3)
ROBERTS CORPORATION
Income Statement
For Year Ended 12-31-20–
Sales (52,000 × $25)......................................................................
$1,300,000
Cost of goods sold:
Standard variable cost (52,000 × $10) .................
$520,000
Net unfavorable variable cost variances .............
2,000 522,000
Gross contribution margin ..........................................
Variable commercial expenses (52,000 × $1) .............................
$ 778,000
52,000
Contribution margin .....................................................................
$ 726,000
Less fixed costs:
Factory overhead
(50,000 units budgeted × $5) ..........................
$250,000
Commercial expenses...........................................
180,000 430,000
Operating income under direct costing .....................................
$ 296,000
Operating income under absorption costing.............................
$ 281,000
Operating income under direct costing .....................................
296,000
Difference ......................................................................................
$ (15,000)
Units produced during the year ..................................................
Units sold during the year ...........................................................
49,000
52,000
Unit decrease in finished goods inventory ................................
Fixed factory overhead charged to each unit under absorption costing ....................................................................
$
(3,000)
× 5
Difference ......................................................................................
$ (15,000)

Chapter 20 20-15
P20-3
(1) PLACID CORPORATION
Income Statement
For Year Ended 12-31-20–
Sales (48,000 × $16)......................................................................
Cost of goods sold:
Standard full cost (48,000 × $9) ...........................
$432,000
Net unfavorable variable cost variances .............
1,000
Favorable volume variance* .................................
(3,000)
Gross profit ...................................................................................
Less commercial expenses:
Variable expenses (48,000 × $1)...........................
$48,000
Fixed expenses ......................................................
99,000
Operating income under absorption costing.............................
*Units budgeted for production during the year.........................
Units actually produced during the year....................................
(2)
(3)
Fixed factory overhead charged to each unit ............................
Favorable volume variance ..........................................................
PLACID CORPORATION
Income Statement
For Year Ended 12-31-20–
Sales (48,000 × $16)......................................................................
Cost of goods sold:
Standard variable cost (48,000 × $6) ...................
$288,000
Net unfavorable variable cost variances .............
1,000
Gross contribution margin ..........................................................
Variable commercial expenses (48,000 × $1) .............................
Contribution margin .....................................................................
Less fixed costs:
Factory overhead
(50,000 units budgeted × $3) ............................
$150,000
Commercial expenses...........................................
99,000
Operating income under direct costing .....................................
Operating income under absorption costing ............
Operating income under direct costing .....................
Difference ......................................................................
Units produced during the year ..................................
Units sold during the year ...........................................
Unit increase in finished goods inventory.................
Fixed factory overhead charged to each unit under absorption costing....................................................
Difference ......................................................................
$768,000
430,000
$338,000
147,000
$191,000
50,000
51,000
×
(1,000)
$3
$ (3,000)
$768,000
289,000
$479,000
48,000
$431,000
$182,000
$191,000
182,000
$ 9,000
×
$
249,000
51,000
48,000
3,000
$3
9,000

20-16 Chapter 20
P20-4
(1) Absorption costing:
(2)
Sales ................................................................
Direct materials ..............................................
Direct labor .....................................................
Variable factory overhead .............................
Fixed factory overhead..................................
Cost of goods manufactured ........................
Beginning inventory.......................................
Cost of goods available for sale...................
Ending inventory ............................................
Cost of goods sold ........................................
Gross profit.....................................................
Marketing and administrative expenses ......
Operating income...........................................
1
2
$1 + $2 + $1.50 + ($62,400 ÷ 30,000) = $6.58
$6.58 × 10,000 units = $65,800
$1 + $2 + $1.50 + ($62,400 ÷ 20,000) = $7.62
$7.62 × 4,000 units = $30,480
Direct Costing:
Sales ................................................................
Direct materials ..............................................
Direct labor .....................................................
Variable factory overhead .............................
Variable cost of goods manufactured..........
Beginning inventory.......................................
Variable cost of goods available for sale.....
Ending inventory ............................................
Variable cost of goods sold ..........................
Gross contribution margin ............................
Variable marketing and administrative expenses ................................................
Contribution margin.......................................
Less fixed expenses:
Factory overhead ..................................
Marketing and administrative ..............
Total fixed expense ........................................
Operating income...........................................
First
$200,000
Quarter
Second
$260,000
$ 30,000
60,000
45,000
62,400
$197,400
$ 20,000
40,000
30,000
62,400
$152,400
65,800
$197,400
65,800 1
$131,600
$68,400
25,000
$ 43,400
$218,200
30,480 2
$187,720
$72,280
28,000
$ 44,280
First
$200,000
Quarter
Second
$260,000
$ 30,000
60,000
45,000
$135,000
$ 20,000
40,000
30,000
$135,000
45,000
$ 90,000
45,000
$135,000
18,000
$90,000
$110,000
$117,000
$143,000
10,000
$100,000
13,000
$130,000
$ 62,400
15,000
$ 77,400
$ 22,600
$ 62,400
15,000
$ 77,400
$ 52,600

Chapter 20
P20-4 (Concluded)
(3)
Operating income under absorption costing
Operating income under direct costing.......
Difference........................................................
Change in inventory under absorption costing:
Ending inventory ...................................
Beginning inventory..............................
Increase (decrease) in inventory .........
Change in inventory under direct costing:
Ending inventory ...................................
Beginning inventory..............................
Increase (decrease) in inventory .........
Difference between absorption and direct costing.........................................
First
$43,400
22,600
$20,800
Quarter
Second
$ 44,280
52,600
$ (8,320)
$65,800
0
$65,800
$45,000
0
$45,000
$20,800
$ 30,480
65,800
$(35,320)
$18,000
45,000
$(27,000)
$ (8,320)
P20-5
Capital
Intensive
Labor
Intensive
Sales price ......................................................
Variable costs:
Materials................................................. $5.00
Direct labor ............................................
6.00
$30.00
$5.60
7.20
$30.00
Variable factory overhead ....................
3.00
4.80
Variable marketing expenses...............
2.00
16.00
2.00
19.60
Contribution margin per unit ........................
$14.00
$10.40
(a) Capital-intensive manufacturing method:
Fixed factory overhead ..................................................
$2,440,000
Fixed marketing expenses ............................................
500,000
Total fixed cost ...............................................................
$2,940,000
$2,940,000 fixed cost
$14 contribution margin per unit
= 210,000 units of sales to break even
(b) Labor-intensive manufacturing method:
Fixed factory overhead ..................................................
$1,320,000
Fixed marketing expenses ............................................
500,000
Total fixed cost ...............................................................
$1,820,000
$1,820,000 fixed cost
$10.40 contribution margin per unit
= 175,000 units of sales to break even
20-17

20-18 Chapter 20
P20-5 (Concluded)
(2) Kimbrell Company would be indifferent between the two alternative manufacturing methods at the volume of sales for which total cost was equal under both alternatives. Let Q equal the quantity of units of product manufactured and sold.
($16 × Q) + $2,940,000 = ($19.80 × Q) + $1,820,000
$2,940,000 – $1,820,000 = ($19.60 × Q) – ($16 × Q)
$1,120,000 = $ 3.60 × Q
311,111 = Q
Total cost will be the same for both manufacturing methods at 311,111 units of sales.
P20-6
(1) The number of units to break even at a per unit sales price of $38.50:
Variable costs:
Direct materials...................................................................... $ 60,000
Direct labor.............................................................................
40,000
Variable factory overhead.....................................................
20,000
Variable marketing and administrative expenses ..............
10,000
$130,000
$ , + $ ,
$ .
− $ .
*
=
$
$
,
.
=
*$130,000 ÷ 5,000 units = $26 variable cost per unit
(2) Units that must be sold to produce an $18,000 profit, at a $40 per unit sales price:
$ , + $ ,
$ 40 − $ 26
=
$ ,
$ 14
= units
(3) The price Castleton must charge at a 5,000-unit sales level, in order to produce a profit equal to 20% of sales:
Let x = sales price per unit
5,000x = 5,000($26) + $45,000 + 5,000 (.2x)
4,000x = $175,000 x = $43.75 sales price per unit
CGA-Canada (adapted). Reprint with permission.

Chapter 20
P20-7
Sales price per unit........................................
Less:
Variable manufacturing cost per unit .
Variable selling expense per unit
(5% of sales price) ..........................
Total variable cost per unit ..................
Contribution margin per unit ........................
B2
$180.00
$121.00
9.00
$130.00
$ 50.00
B4
$176.00*
$ 96.00
8.80
$104.80
$ 71.20
*$160 sales price per unit in 20A + ($160 × 10% increase in 20B)
Total fixed factory overhead
((20,000 B2’s + 40,000 B4’s) × $25 per unit).................
$1,500,000
Total fixed selling and administrative expenses..................
207,330
Total fixed costs ......................................................................
$1,707,330
$1,707,330 fixed cost + ($135,000 profit ÷ (1 – .4))
(2 B2’s × $50 CM each) + (3 B4’s × $71.20 CM each)
$1,707,330 fixed cost + $225,000 pretax profit
$313.60 CM per package
=
=
$1,932,330
$313.60
= 6,162 packages
6,162 packages × 2 units of B2 = 12,324 units of B2
6,162 packages × 3 units of B4 = 18,486 units of B4
20-19

20-20 Chapter 20
P20-8
(1) The 20A sales mix in units is 1:2 (70,000 tape recorders; 140,000 electronic calculators).
Let x = Number of tape recorders to break even
2x = Number of electronic calculators to break even
At break even:
Sales = Variable cost + Fixed cost
$15x + 2 ($22.50x) = $8x + 2 ($9.50x) + $1,320,000 1
$15x + $45x = $8x + $19x + $1,320,000
$60x = $27x + $1,320,000
$33x = $1,320,000 x = 40,000 tape recorders
2x = 80,000 electronic calculators
1 Fixed costs:
Factory overhead .....................................
$ 280,000
Marketing and administrative .................
1,040,000
Total........................................................
$1,320,000

Chapter 20 20-21
P20-8 (Continued)
(2) The following formula can be used to calculate the sales dollars required to earn an aftertax profit of 9% on sales, using 20B estimates:
S = VC(S) + FC +
P(S)
1 – T
Where: S = Necessary sales dollars
VC = Variable cost stated as a percentage of sales dollars (S)
FC = Fixed costs
P = Desired profit stated as a percentage of sales dollars (S)
T = Income tax rate
S = .46S
1 + $1,377,000 2 +
.09(S)
(1 – .55)
S = .46S + $1,377,000 + .2S
.34S = $1,377,000
S = $4,050,000
1 Variable cost rate for tape recorders and electronic calculators:
Tape
Recorders
Electronic
Calculators
Per
Unit %
Per
Unit %
Sales price ......................................................$15.00
100% $20.00 100.0%
Variable costs:
Materials................................................. $3.80
Direct labor ............................................
Factory overhead ..................................
2.20
2.00
$ 3.60
3.30
2.00
Total variable cost ............................. $7.80
52% $ 8.90
44.5%
Contribution margin....................................... $7.20
48% $11.10
55.5%
Composite variable cost rate per dollar of sales:
(.20 × Tape recorder variable cost rate) + (.80 × Calculator variable cost rate) =
.20 (.52) + .80 (.445) = .104 + .356 = .46
2 Fixed costs:
Factory overhead ...........................................................
Marketing and administrative .......................................
Additional advertising....................................................
$ 280,000
1,040,000
57,000
Total .............................................................................
$1,377,000

20-22 Chapter 20
P20-8 (Concluded)
(3) Let: x = Number of tape recorders to break even
3x = Number of electronic calculators to break even
At break even:
Sales = Variable cost + Fixed cost
$15x + 3($20x) = $7.80x + 3($8.90x) + $1,377,000
$15x + $60x = 7.80x + $26.70x + $1,377,000
$75x = $34.50x + $1,377,000
$40.50x = $1,377,000 x = 34,000 tape recorders
3x = 102,000 electronic calculators
P20-9
(1) (a) In order to break even, Almo must sell 500 units determined as follows:
Q(BE) =
F
P − C
=
$ ,
$ 400 − $ 200
= 500 units where F = fixed cost, P = sales price per unit, and C = variable cost per unit.
(b) To achieve an after-tax profit of $240,000, Almo must sell 2,500 units determined as follows:
Q =
F +
π
P − C
=
$ ,
+
($ ,
÷ −
.
40 ))
$ 400 − $ 200
=
$ ,
+
$ 400
$ 200
=
$ 500 000
$ 200
= units where P, F, and C are defined the same as in (1)(a), and
is the after-tax profit objective.

Chapter 20 20-23
P20-9 (Concluded)
(2) Almo Company should choose alternative (a) because it will result in the largest after tax profit.
Alternative (a):
Revenue = ($400 unit sales price × 350 units) + (($400 – $40 price reduction) × 2,700 units)
= $140,000 + $972,000
= $1,112,000
Variable Cost = $200 per unit × (350 units sold + 2,700 units to be sold)
= $610,000
After-tax Profit = (Revenue – Variable Cost – Fixed Cost) × (1 – Tax Rate)
= ($1,112,000 – $610,000 – $100,000) × (1 – .4)
= $402,000 × .6
= $241,200
Alternative (b):
Revenue = ($400 unit sales price × 350 units) + (($400 – $30 price reduction) × 2,200 units
= $140,000 + $814,000
= $954,000
Variable Cost = ($200 per unit × 350 units) + (($200 – $25 cost reduction) × 2,200 units)
= $70,000 + $385,000
= $455,000
After-tax Profit = (Revenue – Variable Cost – Fixed Cost) × (1 – Tax Rate)
= ($954,000 – $455,000 – $100,000) × (1 –.4)
= $399,000 × .6
= $239,400
Alternative (c):
Revenue = ($400 unit sales price × 350 units) + ($400 × (1 – 5% price reduction) × 2,000 units)
= $140,000 + $760,000
= $900,000
Variable Cost = $200 per unit × (350 units sold + 2,000 units to be sold)
= $470,000
After-tax Profit = (Revenue – Variable Cost – Fixed Cost) × (1 – Tax Rate)
= ($900,000 – $470,000 – ($100,000 – $10,000 cost reduction)) × (1 – .4)
= $340,000 × .6
= $204,000

20-24 Chapter 20
P20-10
(1) Estimated break-even point based on pro forma income statement:
(2)
Sales .........................................................................................
$10,000,000
Variable costs:
Cost of goods sold ...............................
Commissions paid to agents...............
$6,000,000
2,000,000 8,000,000
Contribution margin ................................................................
$2,000,000
Contribution margin ratio = $2,000,000 = 20% C/M
$10,000,000
$100,000 fixed cost = $500,000 break-even point
20% C/M
Estimated break-even point with the company employing its own salespersons:
Variable cost ratios:
Cost of goods sold to sales ($6,000,000 ÷ $10,000,000)
Commissions on sales ..................................................
Total variable cost ratio .............................................
60%
5%
65%
Contribution margin ratio = 1 – 65% variable cost ratio = 35%
Fixed costs:
Administrative ................................................................
Sales manager................................................................
Salaries of salespersons (3 × $30,000) ........................
Total fixed costs .........................................................
$100,000
160,000
90,000
$350,000
$350,000 fixed cost = $1,000,000 break-even point
35% C/M

Chapter 20 20-25
P20-10 (Concluded)
(3) Estimated sales volume to yield net income projected in pro forma income statement with independent sales agents receiving 25% commission:
Total income before income tax ............................................
$1,900,000
Fixed cost.................................................................................
100,000
Total fixed cost and profit ......................................................
$2,000,000
Variable cost ratios:
Cost of goods sold to sales.....................................................
60%
Commissions on sales .............................................................
25%
Total variable cost ratio....................................................
85%
Contribution margin ratio = 1 – 85% variable cost ratio = 15%
$2,000,000 fixed cost and profit = $13,333,333 sales
15% C/M
(4) Estimated sales volume to yield an identical income regardless of whether the company employs its own salespersons or continues with independent sales agents and pays them a 25% commission:
Total cost with agents = Total cost with company’s receiving 25% commission own sales force
(85% variable cost × sales) = (65% variable cost × sales)
+ $100,000 fixed cost + $350,000 fixed cost
20% × sales = $250,000 sales = $1,250,000

20-26 Chapter 20
CASES
C20-1
(1) Because Star Company uses absorption costing, income from operations is influenced by both sales volume and production volume. Sales volume was increased in the November 30 forecast, and at standard gross profit rates this would increase income from operations by $5,600. However, during this same period, production volume was below the January 1 forecast, causing an unplanned volume variance of $6,000. The volume variance and the increased marketing expenses (due to the 10% increase in sales) overshadowed the added profits from sales, as follows:
Increased sales ................................................
Increased cost of goods sold at standard ....
Increased gross profit at standard ................
Less:
Volume variance.........................................
$6,000
Increased marketing expense ..................
1,340
Decrease in income from operations ............
$ 26,800
21,200
$ 5,600
7,340
$(1,740)

Chapter 20 20-27
C20-1 (Concluded)
(2) Star Company could adopt direct costing. Under direct costing, fixed manufacturing costs would be treated as period costs and would not be assigned to production. Consequently, earnings would not be affected by production volume, but only by sales volume. Statements prepared on a direct-costing basis are as follows:
STAR COMPANY
Forecasts of Operating Results for 20—
Sales ................................................................
Forecasts as of
January 1 November 30
$268,000 $294,800
Variable costs:
Manufacturing...........................................
Marketing ..................................................
$182,000
13,400
$200,200*
14,740
Total variable cost ..............................
Contribution margin.......................................
Fixed costs:
Manufacturing...........................................
Administrative ..........................................
Total fixed cost ...................................
Income from operations ................................
$195,400
$ 72,600
$ 30,000
26,800
$ 56,800
$ 15,800
$214,940
$ 79,860
$ 30,000
26,800
$ 56,800
$ 23,060
*$182,000 × 110% = $200,200
Reconciliation of differences in income from operations:
January 1: No difference in absorption vs. direct costing because $30,000 fixed factory overhead was expensed in both cases.
November 30:
Direct costing .................................................
Absorption costing ........................................
Difference........................................................
Income from
Operations
$23,060
14,060
$ 9,000
Fixed factory overhead included in cost of goods sold at standard:
November 30 forecast ($30,000 in January 1 forecast
+ 10% sales volume increase) ....................
January 1 forecast .........................................
$33,000
30,000
Underapplied fixed factory overhead...........
Difference........................................................
$ 3,000
6,000
$ 9,000

20-28 Chapter 20
C20-2
(1) In absorption costing, as currently employed by RGS Corporation, fixed factory overhead is considered a product cost rather than a period cost. Fixed factory overhead is applied to production based on a normal capacity of 1,000,000 units.
Thus, the fixed factory overhead is applied to products in the same manner as variable costs, even though it does not vary with production. In addition, if production and sales are not equal during the year, fixed factory overhead is deferred as part of inventory costs (when production exceeds sales) or released upon sales of the inventory (when sales exceed production).
During 20A, production exceeded sales, resulting in a portion of the fixed factory overhead being inventoried in finished goods rather than being expensed in
20A. This resulted in 20A operating income being larger than it would have been if all fixed factory overhead had been charged against 20A sales revenue. Then in 20B, sales exceeded production, resulting In more fixed factory overhead being charged against 20B sales revenue than was incurred in 20B. First, finished goods were sold out of inventory, which meant that the part of fixed factory overhead that was incurred in 20A and inventoried in 20A was charged against 20B sales revenue. Second, fixed factory overhead was underapplied in
20B because only 850,000 units were produced (150,000 units less than normal capacity used in determining the factory overhead rate). This resulted in an unfavorable volume variance that was charged to the cost of goods sold in 20B. Both of these occurrences increased the cost of goods sold and resulted in a reduction of gross profit and operating income in 20B.

Chapter 20 20-29
C20-2 (Continued)
(2)
(a) RGB CORPORATION
Operating Income Statement
For the Years Ended November 30, 20A and 20B
(in thousands)
20A
Sales .......................................................
Variable cost of goods sold:
900,000 units at $5.00 ....................
300,000 units at $5.00 ....................
700,000 units at $5.50 ....................
Contribution margin..............................
Fixed expenses:
Fixed factory overhead..................
$3,000
Selling and administrative ............
1,500
Operating income..................................
$9,000
4,500
$4,500
4,500
0
20B
$11,200
$1,500
3,850 5,350
$ 5,850
$3,300
1,500 4,800
$ 1,050
(b) Reconciliation:
20A
Operating income— absorption costing.........................
Operating income— direct costing .................................
Difference...............................................
$ 900
0
$ 900
Difference accounted for as follows:
Inventory change under absorption costing:
Ending inventory:
300,000 units at $8.00 ............
$2,400
150,000 units at $8.80 ............
Beginning inventory: .................
0 $2,400
300,000 units at $8.00 ............
Inventory change under direct costing:
Ending inventory:
300,000 units at $5.00 ............
$1,500
150,000 units at $5.50 ............
Beginning inventory ..................
0
300,000 units at $5.00 ............
Difference ..............................................
1,500
$ 900
$1,320
2,400
$ 825
1,500
20B
$ 645
1,050
$ (405)
$(1,080)
(675)
$ (405)

20-30 Chapter 20
C20-2 (Concluded)
(3) The advantages of direct costing for internal reporting include the following:
(a) Direct costing aids in forecasting and in evaluating reported income for internal management decision-making purposes, because fixed costs are not arbitrarily allocated between accounting periods (or among different products, sales territories, operating divisions, etc.).
(b) Fixed costs are reported at incurred values (and not absorbed values), increasing opportunity for more effective control of these costs.
(c) Profits vary directly with sales volume and are unaffected by changes in inventory levels.
(d) Analysis of the cost-volume-profit relationship is facilitated, and management is able to determine the break-even point and total profit for a given volume of production and sales.
The disadvantages of direct costing for internal reporting include the following:
(a) Management may fail to consider properly the fixed cost element in longrange pricing decisions.
(b) Direct costing lacks acceptability for external financial reporting or as a basis for computing taxable income. As a consequence, additional recordkeeping costs must be incurred to use direct costing.
(c) The separation of costs into fixed and variable elements is a costly process.
In addition, the distinction between fixed and variable cost is not precise and not reliable at all levels of activity.
C20-3
(1) Daly would determine the number of units of Product Y that it would have to sell to attain a 20% profit on sales, by dividing total fixed costs plus desired profit
(i.e., 20% of sales price per unit multiplied by the units to attain a 20% profit) by unit contribution margin (i.e., sales price per unit less variable cost per unit).
(2) If variable cost per unit increases as a percentage of the sales price, Daly would have to sell more units of Product Y to break even. Because the unit contribution margin (i.e., sales price per unit less variable cost per unit) would be lower, Daly would have to sell more units to cover the fixed cost in order to break even.

Chapter 20 20-31
C20-3 (Concluded)
(3) The limitations of break-even and cost-volume-profit analysis in managerial decision making follow:
(a) The analysis is fundamentally a static analysis, and, in most cases, changes can be determined only by recomputing results. If a break-even chart is used, changes can be shown only by drawing a new chart or series of charts.
(b) The amount of fixed and variable cost, as well as the slope of the sales line, is meaningful in a defined range of activity and must be redefined for activity outside the relevant range.
(c) The analysis is highly dependent upon a meaningful separation of fixed and variable costs, which may be difficult to obtain in actual practice.
(d) The analysis is based on a single mix of products. If the mix is expected to change, the results must be recomputed.
(e) The analysis assumes that production technology (i.e., labor productivity, level of automation, and product specifications) will be unchanged. If changes in production technology are expected to occur, the analyst must consider the expected effects on costs.
(f) The analysis assumes that selling prices, input prices, and other market conditions will not change. Expected changes must be incorporated into the analysis. If a range of possible changes can occur, a different result must be determined for each possible combination.