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Chapter 8

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Chapter 8
Variable Costing: A Tool for Management
Discussion Case (30 minutes)
Discussion of this issue should include many of the following points:
1. Absorption costing is argued to better adhere to the “matching principle” than variable costing making it a better candidate for external financial reporting. The matching principle argues that revenues generated in a period should be matched with related costs incurred to generate those revenues (i.e., the unit cost of products produced should
only be recognized in the income statement when those units of product are actually sold). In addition, proponents of absorption costing
would argue that product costs should include ALL costs related to
manufacturing, whether they are variable or fixed.
2.“Phantom” or “illusory” profits are generated when a company produces
more product than they expect to sell in order to boost operating income. These profits are “illusory” in that they are not sustainable, nor
are they generated by productive means. They are purely an artefact of
the accounting system.
3. A firm with sales below breakeven could report profits assuming the
majority of their manufacturing costs were fixed and they overproduced in order to hold some of those fixed costs back in inventory at
the end of the period.
4. Some firms that have been accused of inventory manipulation since
2000 include Bristol-Myers Squibb Co., Diamond Foods and Coca-Cola.
Students could be asked to research these accusations in more detail
on the web and report on what they find. (Possible sources include
http://www.sec.gov/news/press/2005-118.htm,
http://www.huffingtonpost.com/2012/03/19/diamond-foodsaccounting-scandal_n_1361234.html)
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Solutions Manual, Chapter 8
1
Solutions to Questions
8-1
Absorption and variable costing differ in
how they handle fixed manufacturing overhead.
Under absorption costing, fixed manufacturing
overhead is treated as a product cost and hence
is an asset until products are sold. Under variable costing, fixed manufacturing overhead is
treated as a period cost and is expensed on the
current period’s income statement.
8-2
Advocates of variable costing argue that
variable costing simplifies short-term planning
since the income statement under variable costing is presented in the contribution format. In
this format, contribution margin, an important
short-term measure of profit, is prominently featured and therefore, provides information in a
simpler format to support the manager’s preparation of cost-volume-profit and other analyses
focused on the short-term. In addition, since
fixed costs do not change in the short-term, an
income statement that focuses the manager on
changes in variable cost is useful for short-term
decision making.
8-3
If production and sales are equal,
operating income should be the same under
absorption and variable costing. When production
equals sales, inventories do not increase or decrease and therefore under absorption costing
fixed manufacturing overhead cost cannot be
deferred in inventory or released from inventory.
8-4
If production exceeds sales, absorption
costing will usually show higher operating income than variable costing. When production
exceeds sales, inventories increase and under
absorption costing part of the fixed manufactur-
ing overhead cost of the current period is deferred in inventory to the next period. In contrast, all of the fixed manufacturing overhead
cost of the current period is immediately expensed under variable costing.
8-5
If fixed manufacturing overhead cost is
released from inventory, then inventory levels
must have decreased and therefore production
must have been less than sales.
8-6
Inventory increased. The increase resulted in fixed manufacturing overhead cost being charged to ending inventory on the balance
sheet. This reduced fixed manufacturing overhead cost resulting in a profit even though the
company operated at its breakeven level of
sales.
8-7
Generally speaking, variable costing
cannot be used externally for financial reporting
purposes although it can be used for tax purposes in Canada.
8-8
Differences in reported operating income between absorption and variable costing
arise because of changing levels of inventory. In
lean production, goods are produced strictly to
customers’ orders. With production geared to
sales, inventories are largely (or entirely) eliminated. If inventories are completely eliminated,
they cannot change from one period to another
and absorption costing and variable costing will
report the same operating income.
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2
Managerial Accounting, 11th Canadian Edition
Foundational Exercises
1. and 2.
The unit product costs under variable costing and absorption costing are
computed as follows:
Direct materials ..............................
Direct labor ....................................
Variable manufacturing overhead ....
Fixed manufacturing overhead
($800,000 ÷ 40,000 units) ...........
Unit product cost ............................
Variable
Costing
$24
14
2
Absorption
Costing
—
$40
$24
14
2
20
$60
3. and 4.
The total contribution margin and net operating income under variable
costing are computed as follows:
Sales .................................................
Variable expenses:
Variable cost of goods sold
(35,000 units × $40 per unit).........
Variable selling and administrative
(35,000 units × $4 per unit) ..........
Contribution margin ............................
Fixed expenses:
Fixed manufacturing overhead ..........
Fixed selling and administrative ........
Net operating loss ..............................
$2,800,000
$1,400,000
140,000 1,540,000
1,260,000
800,000
496,000 1,296,000
$ (36,000)
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Solutions Manual, Chapter 8
3
Foundational Exercises (continued)
5. and 6.
The total gross margin and net operating income under absorption costing are computed as follows:
Sales (35,000 units × $80 per unit) ........................... $2,800,000
Cost of goods sold (35,000 units × $60 per unit)........ 2,100,000
Gross margin ...........................................................
700,000
Selling and administrative expenses
[(35,000 units × $4 per unit) + $496,000] ..............
636,000
Net operating income ............................................... $ 64,000
7. The difference between the absorption and variable costing net operating incomes is explained as follows:
Manufacturing overhead deferred in (released from) inventory = Fixed
manufacturing overhead in ending inventory – Fixed manufacturing
overhead in beginning inventory = ($20 per unit × 5,000 units) − $0
= $100,000
Variable costing net operating loss...........................
Add fixed manufacturing overhead cost deferred in
inventory under absorption costing* .....................
Absorption costing net operating income .................
$(36,000)
100,000
$ 64,000
8. The break-even point in units is computed as follows:
Profit
$0
$0
$36Q
Q
Q
=
=
=
=
=
=
Unit CM × Q − Fixed expenses
($80 − $44) × Q − $1,296,000
($36) × Q − $1,296,000
$1,296,000
$1,296,000 ÷ $36
36,000 units
The break-even point is above the actual sales volume; however, in
question 6, the absorption costing net operating income is $64,000. This
counter-intuitive result emerges because $100,000 of fixed manufacturing overhead is deferred in inventory under absorption costing.
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4
Managerial Accounting, 11th Canadian Edition
Foundational Exercises (continued)
9. and 10.
The variable costing net operating income would be the same as the answer to question 4 as shown below:
Sales .................................................
Variable expenses:
Variable cost of goods sold
(35,000 units × $40 per unit).........
Variable selling and administrative
(35,000 units × $4 per unit) ..........
Contribution margin ............................
Fixed expenses:
Fixed manufacturing overhead ..........
Fixed selling and administrative ........
Net operating loss ..............................
$2,800,000
$1,400,000
140,000 1,540,000
1,260,000
800,000
496,000 1,296,000
$ (36,000)
When the number of units produced equals the number of units sold,
absorption costing net operating income equals the variable costing net
operating income. Therefore, the answer to question 11 is that the absorption costing net operating loss would be $36,000.
11.
Absorption costing income will be lower than variable costing income.
The variable costing income statement will only include the fixed
manufacturing overhead costs incurred during the second year of operations, whereas the absorption costing cost of goods sold will include all of the fixed manufacturing overhead costs incurred during
the second year of operations plus some of the fixed manufacturing
overhead costs that were deferred in inventory at the end of the prior
year.
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Solutions Manual, Chapter 8
5
Exercise 8-1 (15 minutes)
1. Under absorption costing, all manufacturing costs (variable and fixed)
are included in product costs.
Direct materials ............................................................
Direct labor ..................................................................
Variable manufacturing overhead ..................................
Fixed manufacturing overhead ($60,000 ÷ 250 units) .....
Absorption costing unit product cost ..............................
$100
320
40
240
$700
2. Under variable costing, only the variable manufacturing costs are included in product costs.
Direct materials ............................................................
Direct labor ..................................................................
Variable manufacturing overhead ..................................
Variable costing unit product cost ..................................
$100
320
40
$460
Note that selling and administrative expenses are not treated as product
costs under either absorption or variable costing. These expenses are
always treated as period costs and are charged against the current period’s revenue.
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6
Managerial Accounting, 11th Canadian Edition
Exercise 8-2 (20 minutes)
1. 25 units in ending inventory × $240 per unit fixed manufacturing overhead per unit = $6,000
2. The variable costing income statement appears below:
Sales ............................................................
Variable expenses:
Variable cost of goods sold
(225 units sold × $460 per unit) ...............
Variable selling and administrative expenses
(225 units × $20 per unit) ........................
Contribution margin.......................................
Fixed expenses:
Fixed manufacturing overhead .....................
Fixed selling and administrative expenses.....
Net operating income ....................................
$191,250
$103,500
4,500
60,000
20,000
108,000
83,250
80,000
$ 3,250
The difference in net operating income between variable and absorption
costing can be explained by the deferral of fixed manufacturing overhead cost in inventory that has taken place under the absorption costing
approach. Note from part (1) that $6,000 of fixed manufacturing overhead cost has been deferred in inventory to the next period. Thus, net
operating income under the absorption costing approach is $6,000 higher than it is under variable costing.
© McGraw-Hill Education Ltd. 2018. All rights reserved.
Solutions Manual, Chapter 8
7
Exercise 8-3 (20 minutes)
1.
Beginning inventories
(units) ..............................
Ending inventories (units) ....
Change in inventories
(units) ..............................
Variable costing operating
income .............................
Add: Fixed manufacturing
overhead cost deferred in
inventory under absorption costing (10 units ×
$2,500 per unit; 40 units
× $2,500 per unit) ............
Deduct: Fixed manufacturing overhead cost released from inventory under absorption costing (30
units × $2,500 per unit) ....
Absorption costing
operating income ..............
Year 1
Year 2
150
160
10
$292,400
Year 3
180
150
160
200
(30)
40
$269,200
25,000
$251,800
100,000
(75,000)
$317,400
$194,200
$351,800
2. Because absorption costing operating income was less than variable
costing operating income in Year 4, inventories must have decreased
during the year and hence fixed manufacturing overhead was released
from inventories. The amount released is just the difference between
the two operating incomes or $35,000 = $240,200 - $205,200.
Note: Using the change in inventory to do reconciliation is easy when production levels remain the same from year to year but students should be
cautioned that when production levels change, so do fixed overhead costs
per unit and you then must calculate overhead costs released and deferred
in inventories separately.
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8
Managerial Accounting, 11th Canadian Edition
Exercise 8-4 (30 minutes)
1. a. By assumption, the unit selling price, unit variable costs, and total
fixed costs are constant from year to year. Consequently, operating
income will vary with sales using variable costing. If sales increase,
variable costing operating income will increase. If sales decrease,
variable costing operating income will decrease. If sales are
constant, variable costing operating income will be constant. Because
variable costing operating income was $16,847 each year, unit sales
must have been the same in each year.
The same is not true of absorption costing operating income. Sales
and absorption costing operating income do not necessarily move in
the same direction because changes in inventories also affect
absorption costing operating income.
b. When variable costing operating income exceeds absorption costing
operating income, sales exceeds production. Inventories shrink and
fixed manufacturing overhead costs are released from inventories. In
contrast, when variable costing operating income is less than absorption
costing operating income, production exceeds sales. Inventories grow
and fixed manufacturing overhead costs are deferred in inventories.
The year-by-year effects are shown below.
Year 1
Year 2
Year 3
Variable costing
OI = Absorption
costing OI
Production = Sales
Inventories remain
the same
Variable costing
OI < Absorption
costing OI
Production > Sales
Variable costing
OI > Absorption
costing OI
Production < Sales
Inventories grow
Inventories shrink
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Solutions Manual, Chapter 8
9
Exercise 8-4 (continued)
2. a. As discussed in part (1 a) above, unit sales and variable costing
operating income move in the same direction when unit selling prices
and the cost structure are constant. Because variable costing operating
income declined, unit sales must have also declined. This is true even
though the absorption costing operating income increased. How can
that be? By manipulating production (and inventories) it may be
possible to maintain or increase the level of absorption costing operating income even though unit sales decline. However, eventually
inventories will grow to be so large that they cannot be ignored.
b. As stated in part (1 b) above, when variable costing operating income
is less than absorption costing operating income, production exceeds
sales. Inventories grow and fixed manufacturing overhead costs are
deferred in inventories. The year-by-year effects are shown below.
Year 1
Year 2
Year 3
Variable costing
OI = Absorption
costing OI
Production = Sales
Inventories remain
the same
Variable costing
OI < Absorption
costing OI
Production > Sales
Variable costing
OI < Absorption
costing OI
Production > Sales
Inventories grow
Inventories grow
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10
Managerial Accounting, 11th Canadian Edition
Exercise 8-4 (continued)
3. Variable costing appears to provide a much better picture of economic
reality than absorption costing in the examples above. In the first case,
absorption costing operating income fluctuates even though unit sales
are the same each year and unit selling prices, unit variable costs, and
total fixed costs remain the same. In the second case, absorption costing
operating income increases from year to year even though unit sales
decline. Absorption costing operating income is potentially more subject
to manipulation than variable costing. Simply by changing production
levels (and thereby deferring or releasing costs from inventory) absorption costing operating income can be manipulated upward or downward.
Note: This exercise is based on the following data:
Common data:
Annual fixed manufacturing costs .......
Contribution margin per unit ..............
Annual fixed SGA costs ......................
Part 1:
Beginning inventory ...........................
Production ........................................
Sales ................................................
Ending ..............................................
Variable costing operating income ......
Deduct Fixed manufacturing overhead
in beginning inventory* .................
Add Fixed manufacturing overhead in
ending inventory ...........................
Absorption costing operating income
$153,153
$35,000
$180,000
Year 1
Year 2
Year 3
$16,847
$16,847
$16,847
$15,315
$15,315
$27,846
$15,315
$16,847
$27,846
$29,378
$17,017
$6,018
1
10
10
1
1
11
10
2
2
9
10
1
* Fixed manufacturing overhead in beginning inventory is assumed in both
parts 1 and 2 for Year 1. A FIFO inventory flow assumption is used.
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Solutions Manual, Chapter 8
11
Exercise 8-4 (continued)
Part 2:
Beginning inventory ....................
Production .................................
Sales .........................................
Ending .......................................
Variable costing operating
income (loss) .........................
Deduct Fixed manufacturing
overhead in beginning inventory* ........................................
Add Fixed manufacturing overhead in ending inventory ........
Absorption costing operating
income ..................................
Year 1
Year 2
$16,847
($18,153)
($53,153)
$15,315
$15,315
$51,051
$15,315
$51,051
$122,522
$16,847
$17,583
$18,318
1
10
10
1
1
12
9
4
Year 3
4
20
8
16
* Fixed manufacturing overhead in beginning inventory is assumed in both
parts 1 and 2 for Year 1. A FIFO inventory flow assumption is used.
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12
Managerial Accounting, 11th Canadian Edition
Exercise 8-5 (30 minutes)
1. Under variable costing, only the variable manufacturing costs are included in product costs.
Direct materials ....................................
Direct labour ........................................
Variable manufacturing overhead ..........
Unit product cost ..................................
$ 8
10
2
$20
Note that selling and administrative expenses are not treated as product
costs; that is, they are not included in the costs that are inventoried.
These expenses are always treated as period costs and are charged
against the current period’s revenue.
2. The variable costing income statement appears below:
Sales (21,500 × $35) ..........................
Variable expenses:
Variable cost of goods sold:
Beginning inventory .......................
Add variable manufacturing costs
(25,000 units × $20 per unit) ......
Goods available for sale .................
Less ending inventory (3,500 units
× $20 per unit)...........................
Variable cost of goods sold* .............
Variable selling and administrative
(21,500 units × $4 per unit) ..........
Contribution margin ............................
Fixed expenses:
Fixed manufacturing overhead ..........
Fixed selling and administrative ........
Operating profit..................................
$752,500
$
0
500,000
500,000
70,000
430,000
86,000
75,000
110,000
516,000
236,500
185,000
$51,500
* The variable cost of goods sold could be computed more simply as:
21,500 units sold × $20 per unit = $430,000.
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Solutions Manual, Chapter 8
13
Exercise 8-5 (continued)
3. The break-even point in units sold can be computed using the contribution margin per unit as follows:
Selling price per unit .....................
Variable product cost per unit........
Variable selling and admin cost per
unit………………………………………..
Contribution margin per unit .........
Break-even unit sales =
=
$35
20
4
$ 11
Fixed expenses
Unit contribution margin
$185,000
$11 per unit
= 16,819 units
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14
Managerial Accounting, 11th Canadian Edition
Exercise 8-6 (20 minutes)
1. Under absorption costing, all manufacturing costs (variable and fixed)
are included in product costs.
Direct materials ....................................
Direct labour ........................................
Variable manufacturing overhead ..........
Fixed manufacturing overhead
($75,000 ÷ 25,000 units) ...................
Unit product cost ..................................
$ 8
10
2
3
$23
2. The absorption costing income statement appears below:
Sales (21,500 units × $35 per unit) .........
Cost of goods sold:
Beginning inventory .............................
Add cost of goods manufactured
(25,000 units × $23 per unit).............
Goods available for sale ........................
Less ending inventory
(3,500 units × $23 per unit) ..............
Gross margin..........................................
Selling and administrative expenses:
Variable selling and administrative
(21,500 units × $4 per unit) ..............
Fixed selling and administrative ............
Operating income ...................................
$752,500
$
0
575,000
575,000
80,500
86,000
110,000
494,500
258,000
196,000
$ 62,000
Note: Operating income is larger under absorption costing because the
company holds back $10,500 ($3 x 3,500 units) worth of fixed costs in
ending inventory.
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Solutions Manual, Chapter 8
15
Exercise 8-7 (30 minutes)
1. a. The unit product cost under absorption costing would be:
Direct materials ................................................................
Direct labour ....................................................................
Variable manufacturing overhead ......................................
Total variable manufacturing costs .....................................
Fixed manufacturing overhead ($200,000 ÷ 25,000 units) ..
Unit product cost ..............................................................
$25
12
3
40
8
$48
b. The absorption costing income statement:
Sales (21,000 units × $65 per unit) ............
Cost of goods sold:
Beginning inventory (first year of operations)...................................................
Add cost of goods manufactured
(25,000 units × $48 per unit)................
Goods available for sale ...........................
Less ending inventory
(4,000 units × $48 per unit) .................
Gross margin.............................................
Selling and administrative expenses ............
Operating income ......................................
$1,365,000
$
0
1,200,000
1,200,000
192,000
1,008,000
357,000
215,000 *
$ 142,000
*(21,000 units × $5 per unit) + $110,000 = $215,000.
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16
Managerial Accounting, 11th Canadian Edition
Exercise 8-7 (continued)
2. a. The unit product cost under variable costing would be:
Direct materials ..............................................................
$25
Direct labour ..................................................................
12
Variable manufacturing overhead ....................................
3
Unit product cost ............................................................
$40
b. The variable costing income statement:
Sales (21,000 units × $65 per unit) ................................. $1,365,000
Less variable expenses:
Variable cost of goods sold:
Beginning inventory ...................................................
$
0
Add variable manufacturing costs
(25,000 units × $40 per unit) ..................................
1,000,000
Goods available for sale .............................................
1,000,000
Less ending inventory
(4,000 units × $40 per unit) ....................................
160,000
Variable cost of goods sold ...........................................
840,000 *
Variable selling expense
(21,000 units × $5 per unit) ......................................
105,000
945,000
Contribution margin ........................................................
420,000
Less fixed expenses:
Fixed manufacturing overhead ......................................
200,000
Fixed selling and administrative ....................................
110,000
310,000
Operating income ...........................................................
$ 110,000
* The variable cost of goods sold could be computed more simply
as: 21,000 units × $40 per unit = $840,000.
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Solutions Manual, Chapter 8
17
Exercise 8-8 (20 minutes)
1. The company is using variable costing. The computations are:
Direct materials ..............................
Direct labour ..................................
Variable manufacturing overhead ....
Fixed manufacturing overhead
($90,000 ÷ 30,000 units) .............
Unit product cost ............................
Total cost, 5,000 units ....................
Variable
Costing
$10
5
2
—
$17
$85,000
Absorption
Costing
$10
5
2
3
$20
$100,000
2. a. The total cost based on variable costing of $85,000 would be acceptable for tax purposes, but not for external reporting.
b. The finished goods inventory account should be stated at $100,000,
which represents the absorption cost of the 5,000 unsold units. Thus,
the account should be increased by $15,000 for external reporting
purposes. This $15,000 consists of the amount of fixed manufacturing overhead cost that is allocated to the 5,000 unsold units under
absorption costing:
5,000 units × $3 per unit fixed manufacturing overhead cost =
$15,000
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18
Managerial Accounting, 11th Canadian Edition
Exercise 8-9 (20 minutes)
1. Sales (40,000 units × $33.75 per unit)…………
Variable expenses:
Variable cost of goods sold
(40,000 units × $16 per unit*)………………….. $640,000
Variable selling and administrative expenses
(40,000 units × $3 per unit) ………………………
120,000
Contribution margin…………………………………..
Fixed expenses:
Fixed manufacturing overhead…………………….
250,000
Fixed selling and administrative expenses…….. 300,000
Operating income………………………………………
* Direct materials………………………….
Direct labour………………………………
Variable manufacturing overhead…
Total variable manufacturing cost..
$1,350,000
760,000
590,000
550,000
$ 40,000
$10
4
2
$16
2. The difference in operating income can be explained by the $50,000 in
fixed manufacturing overhead deferred in inventory under the absorption costing method:
Variable costing operating income …………………………
$40,000
Add: Fixed manufacturing overhead cost deferred in inventory under absorption costing: 10,000 units × $5 per
unit in fixed manufacturing overhead cost……………….
50,000
Absorption costing operating income………………………
$90,000
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Solutions Manual, Chapter 8
19
Exercise 8-10 (10 minutes)
Sales were above the company’s break-even sales and yet the company
sustained a loss. The apparent contradiction is explained by the fact that
the CVP analysis is based on variable costing, whereas the income reported
to shareholders is prepared using absorption costing. Because sales were
above the break-even point, the variable costing net operating income
would have been positive. However, the absorption costing net operating
income was negative. Ordinarily, this would only happen if inventories decreased and fixed manufacturing overhead deferred in inventories was released to the income statement on the absorption costing income statement. This added fixed manufacturing overhead cost resulted in a loss on
an absorption costing basis even though the company operated at its
break-even point on a variable costing basis.
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20
Managerial Accounting, 11th Canadian Edition
Problem 8-11 (30 minutes)
1. The unit product cost under the variable costing approach would be
computed as follows:
Direct materials ....................................
Direct labour ........................................
Variable manufacturing overhead ..........
Unit product cost ..................................
$ 8
10
2
$20
With this figure, the variable costing income statements can be prepared:
Sales .........................................................
Variable expenses:
Variable cost of goods sold @ $20 per unit
Variable selling and administrative @ $3
per unit ................................................
Total variable expenses ...............................
Contribution margin ....................................
Fixed expenses:
Fixed manufacturing overhead ..................
Fixed selling and administrative ................
Total fixed expenses ...................................
Operating income (loss) ..............................
2. Variable costing operating income (loss) ......
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing (5,000 units × $14 per unit) .........
Deduct: Fixed manufacturing overhead cost
released from inventory under absorption
costing (5,000 units × $14 per unit) .........
Absorption costing operating income ...........
Year 1
Year 2
$1,000,000
$1,500,000
400,000
600,000
60,000
460,000
540,000
90,000
690,000
810,000
350,000
250,000
600,000
$ (60,000) $
350,000
250,000
600,000
210,000
$ (60,000) $ 210,000
70,000
$
10,000
(70,000)
$ 140,000
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Solutions Manual, Chapter 8
21
Problem 8-12 (45 minutes)
1. a. The unit product cost under absorption costing:
Direct materials ....................................
Direct labour ........................................
Variable manufacturing overhead ..........
Fixed manufacturing overhead
(600,000 ÷ 20,000 units) ...................
Unit product cost ..................................
$12
9
5
30
$56
b. The absorption costing income statement follows:
Sales (15,000 units × $80 per unit) .........
Cost of goods sold:
Beginning inventory .............................
Add cost of goods manufactured
(20,000 units × $56 per unit) ............
Goods available for sale .......................
Less ending inventory
(5,000 units × $56 per unit) ..............
Gross margin .........................................
Selling and administrative expenses* .......
Operating loss ........................................
$1,200,000
$
0
1,120,000
1,120,000
280,000
840,000
360,000
565,000
$ (205,000)
*(15,000 units × $6 per unit) + $475,000 = $565,000.
2. a. The unit product cost under variable costing:
Direct materials ....................................
Direct labour ........................................
Variable manufacturing overhead ..........
Unit product cost ..................................
$12
9
5
$26
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22
Managerial Accounting, 11th Canadian Edition
Problem 8-12 (continued)
b. The variable costing income statement follows:
Sales (15,000 units × $80 per unit) ..............
Variable expenses:
Variable cost of goods sold:
Beginning inventory ................................
Add variable manufacturing costs
(20,000 units × $26 per unit) ...............
Goods available for sale ..........................
Less ending inventory
(5,000 units × $26 per unit) .................
Variable cost of goods sold ........................
Variable selling expense
(15,000 units × $6 per unit) ...................
Contribution margin .....................................
Fixed expenses:
Fixed manufacturing overhead ...................
Fixed selling and administrative expense ....
Operating loss .............................................
$1,200,000
$
0
520,000
520,000
130,000
390,000
90,000
600,000
475,000
480,000
720,000
1,075,000
$ (355,000)
3. The difference in the ending inventory relates to a difference in the
handling of fixed manufacturing overhead costs. Under variable costing,
these costs have been expensed in full as period costs. Under absorption costing, these costs have been added to units of product at the rate
of $30 per unit ($600,000 ÷ 20,000 units produced = $30 per unit).
Thus, under absorption costing a portion of the $600,000 fixed manufacturing overhead cost of the month has been added to the inventory
account rather than expensed on the income statement:
Added to the ending inventory
(5,000 units × $30 per unit) ....................................... $ 150,000
Expensed as part of cost of goods sold
(15,000 units × $30 per unit) .....................................
450,000
Total fixed manufacturing overhead cost for the month .. $600,000
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Solutions Manual, Chapter 8
23
Problem 8-12 (continued)
Because $150,000 of fixed manufacturing overhead cost has been deferred in inventory under absorption costing, the operating income
reported under that costing method is $150,000 higher than the operating income under variable costing, as shown in parts (1) and (2) above.
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24
Managerial Accounting, 11th Canadian Edition
Problem 8-13 (45 minutes)
1. a. and b.
Direct materials ....................................
Variable manufacturing overhead ..........
Fixed manufacturing overhead
($340,000 ÷ 4,000 units) ...................
Unit product cost ..................................
Absorption
Costing
Variable
Costing
85
$247
—
$162
$ 152
10
$152
10
2. Absorption costing income statement:
Sales (3,200 units × $400 per unit) ................
Cost of goods sold:
Beginning inventory ....................................
Add cost of goods manufactured
(4,000 units × $247 per unit) ....................
Goods available for sale ...............................
Less ending inventory
(800 units × $247 per unit) ......................
Gross margin.................................................
Selling and administrative expenses
(15% × $1,280,000 + $160,000)..................
Operating income ..........................................
$1,280,000
$
0
988,000
988,000
197,600
790,400
489,600
352,000
$ 137,600
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Solutions Manual, Chapter 8
25
Problem 8-13 (continued)
3. Variable costing income statement:
Sales (3,200 units × $400 per unit) .........
Variable expenses:
Variable cost of goods sold:
Beginning inventory ...........................
Add variable manufacturing costs
(4,000 units × $162 per unit) ..........
Goods available for sale .....................
Less ending inventory
(800 units × $162 per unit) .............
Variable cost of goods sold* .................
Variable selling and administrative expense ($1,280,000 × 15%)................
Contribution margin ................................
Fixed expenses:
Fixed manufacturing overhead ..............
Fixed selling and administrative ............
Operating income ...................................
$1,280,000
$
0
648,000
648,000
129,600
518,400
192,000
340,000
160,000
710,400
569,600
500,000
$ 69,600
* This figure could be computed more simply as:
3,200 units × $162 per unit = $518,400.
4. A manager may prefer to take the statement prepared under the absorption approach in part (2), because it shows a higher profit for the
month. As long as inventory levels are rising, absorption costing will report higher profits than variable costing.
5. Variable costing operating income ...................................... $ 69,600
Add: Fixed manufacturing overhead cost deferred in inventory under absorption costing (800 units × $85 per
unit) ............................................................................... 68,000
Absorption costing operating income ...................................$137,600
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26
Managerial Accounting, 11th Canadian Edition
Problem 8-14 (60 minutes)
1. a. Direct materials ........................................... $1.00
Direct labour ............................................... 0.80
Variable manufacturing overhead ................. 0.20
Fixed manufacturing overhead
($75,000 ÷ 50,000 units) .......................... 1.50
Unit product cost......................................... $3.50
b. Sales (40,000 units) ..................................
$200,000
Cost of goods sold:
Beginning inventory ................................ $
0
Add cost of goods manufactured
(50,000 units × $3.50 per unit) ............ 175,000
Goods available for sale .......................... 175,000
Less ending inventory
(10,000 units × $3.50 per unit) ............
35,000 140,000
Gross margin ............................................
60,000
Selling and administrative expenses*..........
50,000
Operating income ......................................
$ 10,000
*$30,000 variable plus $20,000 fixed = $50,000.
c. Variable costing operating loss .................................. $ (5,000)
Add: Fixed manufacturing overhead cost deferred in
inventory under absorption costing
(10,000 units × $1.50 per unit) ..............................
15,000
Absorption costing operating income ......................... $ 10,000
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Solutions Manual, Chapter 8
27
Problem 8-14 (continued)
2. Under absorption costing, the company did earn a profit for the month.
However, before the question can really be answered, one must first
define what is meant by a “profit.” The central issue here relates to timing
of the release of fixed manufacturing overhead costs to expense. Advocates
of variable costing would argue that all such costs should be expensed
immediately, and that no profit is earned unless the revenues of a period are sufficient to cover the fixed manufacturing overhead costs in full.
From this point of view, then, no profit was earned during the month,
because the fixed costs were not fully covered.
Advocates of absorption costing would argue, however, that fixed manufacturing overhead costs attach to units of product as they are produced, and that such costs do not become expense until the units are
sold. Therefore, if the selling price of a unit is greater than the unit cost
(including a proportionate amount of fixed manufacturing overhead),
then a profit is earned even if some units produced are unsold and carry
some fixed manufacturing overhead with them to the following period. A
difficulty with this argument is that “profits” will vary under absorption
costing depending on how many units are added to or taken out of
inventory. That is, profits will depend not only on sales, but on what happens to inventories. In particular, profits can be consciously manipulated
by increasing or decreasing a company’s inventories.
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Managerial Accounting, 11th Canadian Edition
Problem 8-14 (continued)
3. a. Sales (60,000 units × $5 per unit)..................
Variable expenses:
Variable cost of goods sold
(60,000 units × $2 per unit) .....................
Variable selling and administrative expenses
(60,000 units × $0.75 per unit).................
Contribution margin ......................................
Fixed expenses:
Fixed manufacturing overhead.....................
Fixed selling and administrative expense ......
Operating income ..........................................
$300,000
$120,000
45,000
75,000
20,000
165,000
135,000
95,000
$ 40,000
b. The absorption costing unit product cost will remain at $3.50, the
same as in part (1).
Sales (60,000 units × $5 per unit)................
Cost of goods sold:
Beginning inventory
(10,000 units × $3.50 per unit) ..............
Add cost of goods manufactured
(50,000 units × $3.50 per unit) ..............
Goods available for sale ............................
Less ending inventory ...............................
Gross margin ..............................................
Selling and administrative expenses (60,000
units × $0.75 per unit + $20,000) .............
Operating income ........................................
$300,000
$ 35,000
175,000
210,000
0
c. Variable costing operating income .................................
Deduct: Fixed manufacturing overhead cost released
from inventory under absorption costing (10,000 units
× $1.50 per unit).......................................................
Absorption costing operating income .............................
210,000
90,000
65,000
$ 25,000
$ 40,000
15,000
$ 25,000
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Solutions Manual, Chapter 8
29
Problem 8-15 (45 minutes)
1. a. and b.
Direct materials ....................................
Direct labour ........................................
Variable manufacturing overhead ..........
Fixed manufacturing overhead
($240,000 ÷ 15,000 units) .................
Unit product cost ..................................
2.
Absorption
Costing
$ 12
24
8
Sales (13,000 units, 17,000 units) ................
Less Variable expenses:
Variable cost of goods sold:
Beginning inventory ..................................
Add variable production costs @ $44 per unit
Good available for sale .............................
Less ending inventory ...............................
Variable cost of goods sold
Variable selling and administrative @ $6 per
unit .........................................................
Total variable expenses ...............................
Contribution margin ....................................
Fixed expenses:
Fixed manufacturing overhead ..................
Fixed selling and administrative .................
Total fixed expenses....................................
Operating income (loss) ..............................
Variable
Costing
16
$60
$ 12
24
8
—
$44
May
June
0
660,000
660,000
88,000
572,000
88,000
660,000
748,000
0
748,000
78,000
650,000
390,000
102,000
850,000
510,000
$1,040,000 $1,360,000
240,000
180,000
420,000
$ (30,000) $
240,000
180,000
420,000
90,000
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30
Managerial Accounting, 11th Canadian Edition
Problem 8-15 (continued)
3.
May
Variable costing operating income (loss) ..........................
$ (30,000)
Add: Cost deferred in inventory under absorption costing (2,000 units × $16 per
unit) ...........................................................................
32,000
Deduct: Cost released from inventory under
absorption costing (2,000 units × $16 per
unit) ...........................................................................
Absorption costing operating income ...............................
$
2,000
June
$ 90,000
(32,000)
$ 58,000
4. As shown in the reconciliation in part (3) above, $32,000 of product cost
was deferred in inventory under absorption costing at the end of May,
because $16 of fixed manufacturing overhead cost “attached” to each of
the 2,000 unsold units that went into inventory at the end of that
month. This $32,000 was part of the $420,000 total fixed cost that has
to be covered each month in order for the company to break even. Because the $32,000 was added to the inventory account, and thus did not
appear on the income statement for May as an expense, the company
was able to report a small profit for the month even though it sold less
than the break-even volume of sales. In short, only $388,000 of fixed
cost ($420,000 – $32,000) was expensed for May, rather than the full
$420,000 as contemplated in the break-even analysis. As stated in the
text, this is a major problem with the use of absorption costing internally for management purposes. The method does not harmonize well with
the principles of cost-volume-profit analysis, and can result in data that
are unclear or confusing to management.
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Solutions Manual, Chapter 8
31
Problem 8-16 (30 minutes)
1. Because of soft demand for the New Zealand Division’s product, the inventory should be drawn down to the minimum level of 1,500 units.
Drawing inventory down to the minimum level would require production
as follows during the last quarter:
Desired inventory, December 31 ............
Expected sales, last quarter ..................
Total needs ..........................................
Less inventory, September 30................
Required production .............................
1,500 units
18,000 units
19,500 units
12,000 units
7,500 units
Drawing inventory down to the minimum level would save inventory carrying costs such as storage (rent, insurance), interest, and obsolescence.
The number of units scheduled for production will not affect the reported operating income or loss for the year if variable costing is in use. All
fixed manufacturing overhead cost will be treated as an expense of the
period regardless of the number of units produced. Thus, no fixed manufacturing overhead cost will be shifted between periods through the inventory account and income will be a function of the number of units
sold, rather than a function of the number of units produced.
2. To maximize the New Zealand Division’s operating income, Ms. Hartley
could produce as many units as storage facilities will allow. By building
inventory to the maximum level, Ms. Hartley will be able to defer a portion of the year’s fixed manufacturing overhead costs to future years
through the inventory account, rather than having all of these costs appear as charges on the current year’s income statement. Building inventory to the maximum level of 30,000 units would require production as
follows during the last quarter:
Desired inventory, December 31 ............
Expected sales, last quarter ..................
Total needs ..........................................
Less inventory, September 30................
Required production .............................
30,000
18,000
48,000
12,000
36,000
units
units
units
units
units
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32
Managerial Accounting, 11th Canadian Edition
Problem 8-16 (continued)
Thus, by producing enough units to build inventory to the maximum
level that storage facilities will allow, Ms. Hartley could relieve the current year of fixed manufacturing overhead cost and thereby maximize
the current year’s operating income.
3. By setting a production schedule that will maximize her division’s operating
income—and maximize her own bonus— Ms. Hartley will be acting
against the best interests of the company as a whole. The extra units
aren’t needed and will be expensive to carry in inventory. Moreover,
there is no indication that demand will be any better next year than it
has been in the current year, so the company may be required to carry
the extra units in inventory a long time before they are ultimately sold.
The company’s bonus plan undoubtedly is intended to increase the
company’s profits by increasing sales and controlling expenses. If Ms.
Hartley sets a production schedule as shown in part (2) above, she will
obtain her bonus as a result of producing rather than as a result of selling. Moreover, she will obtain it by creating greater expenses—rather
than fewer expenses—for the company as a whole.
In summary, producing as much as possible so as to maximize the division’s
operating income and the manager’s bonus would be unethical because
it subverts the goals of the overall organization.
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Solutions Manual, Chapter 8
33
Problem 8-17 (45 minutes)
1. The break-even point in units sold can be computed using the contribution margin per unit as follows:
Selling price per unit .....................
Variable cost per unit ....................
Contribution margin per unit .........
$58
38
$20
Break-even unit sales = Fixed expenses ÷ Unit contribution margin
= $1,200,000 ÷ $20 per unit
= 60,000 units
2 a. Under variable costing, only the variable manufacturing costs are included in product costs.
Direct materials ....................................
Direct labor ..........................................
Variable manufacturing overhead ..........
Variable costing unit product cost ..........
Year 1 Year 2 Year 3
$20
12
4
$36
$20
12
4
$36
$20
12
4
$36
Note that selling and administrative expenses are not treated as
product costs; that is, they are not included in the costs that are inventoried. These expenses are always treated as period costs.
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34
Managerial Accounting, 11th Canadian Edition
Problem 8-17 (continued)
2 b. The variable costing income statements appear below:
Sales........................................................................
Variable expenses:
Variable cost of goods sold @ $36 per unit ..............
Variable selling and administrative @ $2 per unit .....
Total variable expenses .............................................
Contribution margin ..................................................
Fixed expenses:
Fixed manufacturing overhead ................................
Fixed selling and administrative...............................
Total fixed expenses .................................................
Net operating income (loss) ......................................
Year 1
$3,480,000
Year 2
Year 3
$2,900,000 $3,770,000
2,160,000
120,000
2,280,000
1,200,000
1,800,000
100,000
1,900,000
1,000,000
2,340,000
130,000
2,470,000
1,300,000
960,000
960,000
960,000
240,000
240,000
240,000
1,200,000
1,200,000 1,200,000
$
0 $ (200,000) $ 100,000
3 a. The unit product costs under absorption costing:
Year 1
Year 2 Year 3
Direct materials ....................................
$20 $20.00
Direct labor ..........................................
12
12.00
Variable manufacturing overhead ..........
4
4.00
Fixed manufacturing overhead ..............
*16 **12.80
Absorption costing unit product cost ......
$52 $48.80
* $960,000 ÷ 60,000 units = $16 per unit.
** $960,000 ÷ 75,000 units = $12.80 per unit.
*** $960,000 ÷ 40,000 units = $24 per unit.
$20
12
4
***24
$60
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Solutions Manual, Chapter 8
35
Problem 8-17 (continued)
3 b. The absorption costing income statements appears below:
Year 1
Year 2
Year 3
Sales ..................................................... $3,480,000 $2,900,000 $3,770,000
Cost of goods sold.................................. 3,120,000 2,440,000 3,620,000
Gross margin .........................................
360,000
460,000
150,000
Selling and administrative expenses ........
360,000
340,000
370,000
Net operating income (loss) .................... $
0 $ 120,000 $ (220,000)
Cost
Year
Year
Year
of goods sold computations:
1: 60,000 units × $52 per unit = $3,120,000
2: 50,000 units × $48.80 per unit = $2,440,000
3: (25,000 × $48.80 per unit) + (40,000 × $60 per unit) = $3,620,000
4.
Units sold ...........................................................
Break-even point in units .....................................
Units above (below) break-even point ..................
Variable costing net operating income (loss) .........
Absorption costing net operating income (loss) .....
Year 1
60,000
60,000
0
Year 2
50,000
60,000
(10,000)
Year 3
65,000
60,000
5,000
$0 $(200,000) $ 100,000
$0 $ 120,000 $(220,000)
The absorption costing net operating incomes in years 2 and 3 are counter-intuitive. In year 2, the
number of units sold is below the break-even point; however, absorption costing reports a net operating income greater than zero. In year 3, the number of units sold is above the break-even
point; however, absorption costing reports a net operating income less than zero.
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36
Managerial Accounting, 11th Canadian Edition
Problem 8-18 (75 minutes)
1.
Year 1
Year 2
Year 3
Sales .......................................... $1,000,000 $ 800,000 $1,000,000
Variable expenses:
Variable cost of goods sold @
$4 per unit.............................
200,000
160,000
200,000
Variable selling and administrative @ $2 per unit ..................
100,000
80,000
100,000
Total variable expenses ................
300,000
240,000
300,000
Contribution margin.....................
700,000
560,000
700,000
Fixed expenses:
Fixed manufacturing overhead ...
600,000
600,000
600,000
Fixed selling and administrative .
70,000
70,000
70,000
Total fixed expenses ....................
670,000
670,000
670,000
Operating income (loss) ............... $ 30,000 $(110,000) $ 30,000
2. a.
Variable manufacturing cost ............
Fixed manufacturing cost:
$600,000 ÷ 50,000 units..............
$600,000 ÷ 60,000 units..............
$600,000 ÷ 40,000 units..............
Unit product cost............................
Year 1
$ 4
12
$16
Year 2
$ 4
10
$14
Year 3
$ 4
15
$19
b. Variable costing operating
income (loss) ................................ $30,000 $(110,000) $ 30,000
Add (Deduct): Fixed manufacturing
overhead cost deferred in inventory from Year 2 to Year 3 under absorption costing (20,000 units ×
$10 per unit) .................................
200,000 (200,000)
Add: Fixed manufacturing overhead
cost deferred in inventory from
Year 3 to the future under absorption costing (10,000 units × $15
per unit) .......................................
150,000
Absorption costing operating
income (loss) ................................ $30,000 $ 90,000 $(20,000)
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Solutions Manual, Chapter 8
37
Problem 8-18 (continued)
3. Production went up sharply in Year 2 thereby reducing the unit product
cost, as shown in (2a). This reduction in cost, combined with the large
amount of fixed manufacturing overhead cost deferred in inventory for
the year, more than offset the loss of revenue. The net result is that the
company’s operating income rose even though sales were down.
4. The fixed manufacturing overhead cost deferred in inventory from Year
2 was charged against Year 3 operations, as shown in the reconciliation
in (2b). This added charge against Year 3 operations was offset somewhat by the fact that part of Year 3’s fixed manufacturing overhead
costs was deferred in inventory to future years [again see (2b)]. Overall,
the added costs charged against Year 3 were greater than the costs deferred to future years, so the company reported less income for the year
even though the same number of units was sold as in Year 1.
5. a. With lean production, production would have been geared to sales in
each year so that little or no inventory of finished goods would have
been built up in either Year 2 or Year 3.
b. If lean production had been in use, the operating income under
absorption costing would have been the same as under variable costing in all three years. With production geared to sales, there would
have been no ending inventory on hand, and therefore there would
have been no fixed manufacturing overhead costs deferred in inventory to other years. Assuming that the company expected to sell
50,000 units in each year and that unit product costs were set on the
basis of that level of expected activity, the income statements under
absorption costing would have appeared as shown on the next page.
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38
Managerial Accounting, 11th Canadian Edition
Problem 8-18(continued)
Year 1
Sales ......................................... $1,000,000
Cost of goods sold:
Cost of goods manufactured
@ $16 per unit .....................
800,000
Add underapplied overhead .....
Cost of goods sold ................
800,000
Gross margin .............................
200,000
Selling and administrative expenses....................................
170,000
Operating income (loss) ............. $ 30,000
Year 2
$ 800,000
640,000 *
120,000 **
760,000
40,000
150,000
$(110,000)
Year 3
$1,000,000
800,000
800,000
200,000
170,000
$ 30,000
* 40,000 units × $16 per unit = $640,000.
** 10,000 units not produced × $12 per unit fixed manufacturing overhead cost = $120,000 fixed manufacturing overhead cost not applied
to products.
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Solutions Manual, Chapter 8
39
Case 8-20 (60 minutes)
Memo
To: Mr. Hugh Richards, President
From: CFO, Ajax Inc.
RE: Current year’s Income Statements
The following information is provided in response to your question about
the unusual increase in current year net income. This difference was
caused by the way we account for manufacturing costs in our income
statements. Generally Accepted Accounting Principles require us to use absorption costing to calculate the Cost of Goods Sold and the value of ending inventories at the end of the fiscal year. Under absorption costing,
some of our fixed manufacturing overhead is attached to the units in ending inventory. Therefore, these costs do not get recognized in the current
year since the goods related to these costs have not been sold. Instead,
we hold these costs in the value of ending inventory on the Balance Sheet
until they are sold. Given we normally produce only as much as we sell, the
use of absorption costing has not affected the amount of net income we
have reported in the past. This year was unusual since we decided to produce 10,000 more units than we could actually sell so that we could stockpile inventory against the risk of a strike at our major raw materials supplier.
To avoid the problem of strange variations in operating income, we could
adopt variable costing for internal reporting purposes. Under variable costing, we would recognize the same amount of fixed manufacturing costs on
the income statement each year (assuming no change in the manufacturing process) regardless of the level of sales. While this method of costing
cannot be used for external reporting purposes, it may allow us to better
manage internally. To give you a better feeling for the differences caused
by the choice of costing method, I have prepared Schedule 1 and 2 below.
In Schedule 1, I compare the unit product cost calculated under absorption
and variable costing. In Schedule 3, I provide a new version of the income
statement prepared under variable costs. In addition, I provide a reconciliation of operating income under variable and absorption costing.
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40
Managerial Accounting, 11th Canadian Edition
Case 8-20 (continued)
Schedule 1: Unit costs
Variable manufacturing costs ..............
Fixed manufacturing overhead costs:
$600,000 ÷ 40,000 units ..................
$600,000 ÷ 50,000 units ..................
Unit product cost ................................
Absorption Costing
Variable Costing
Year 1
Year 2
Year 1
Year 2
$6
15
$21
$6
12
$18
$6
—
$6
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Solutions Manual, Chapter 8
$6
—
$6
Case 8-20 (continued)
Schedule 2:
Variable costing income statement
Sales ..............................................................
Variable expenses:
Variable cost of goods sold:
Beginning inventory ...................................
Add variable manufacturing costs ................
Goods available for sale ..............................
Less ending inventory .................................
Variable cost of goods sold ............................
Variable selling and administrative expenses
(40,000 units × $2 per unit) .......................
Contribution margin.........................................
Fixed expenses:
Fixed manufacturing overhead .......................
Fixed selling and administrative expenses.......
Operating income ............................................
Reconciliation:
Variable costing operating income ...........
Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing (10,000 units × $12 per unit) ...
Absorption costing operating income .......
Year 1
$1,250,000
$
0
240,000
240,000
0
240,000
80,000
600,000
270,000
Year 1
$1,250,000
$
0
300,000
300,000
60,000
240,000
320,000
930,000
870,000
$ 60,000
Year 2
$ 60,000
$ 60,000
—
$ 60,000
120,000
$180,000
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42
Year 2
Managerial Accounting, 11th Canadian Edition
80,000
600,000
270,000
320,000
930,000
870,000
$ 60,000
Case 8-20(continued)
Notice that the increase in production in Year 2, in the face of level sales,
caused a build-up of inventory and a deferral of a portion of Year 2’s fixed
manufacturing overhead costs to the next year. This deferral of cost relieved Year 2 of $120,000 (10,000 units × $12 per unit) of fixed manufacturing overhead cost that it otherwise would have borne. Thus, operating
income was $120,000 higher in Year 2 than in Year 1, even though the
same number of units was sold each year. In summary, by increasing production and building up inventory, profits increased without any increase
sales or reduction in costs. This is a major criticism of the absorption costing approach.
Many organizations use the variable costing method for internal reporting
purposes and absorption costing for external reporting (i.e. to prepare financial statements presented to shareholders, creditors etc.). These organizations find variable costing useful internally for the following reasons:
1. Data can be taken directly from variable costing statements for use in
cost-volume-profit (CVP) analysis used in short-term planning
2. Profit for the period is not affected by levels of ending inventory
3. The impact of fixed costs on profit is much more apparent under variable costing income statements and therefore, managers will tend to
pay more attention and manage them better.
4. Variable costing operation income is closer to net cash flow than absorption costing operating income and therefore, we might be able to
use the variable cost information more easily when considering affects of our decisions on cash flows.
Given all of these advantages, I would recommend we prepare variable
costing income statements for internal use each month in addition to any
absorption costing based statements we may need to provide externally.
The cost to prepare them would be relatively small given the quality of our
information systems and the potential benefits are large. I would be happy
to provide training to our managers to help them understand the advantages and potential uses of this new information.
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Solutions Manual, Chapter 8
43
Case 8-20 (continued)
Finally, I would like to discuss the issue of changes in production for next
year. It is highly likely that we will first draw down any inventory and then
produce enough new products to meet normal sales levels next year.
Therefore, I anticipate operating income reported under absorption costing
will be closer to the levels of 2014. We need to be prepared with an explanation for our shareholders and creditors. While there is a temptation to
continue to overproduce to boost net income, over time, our inventory
holding costs (including storage, retrieval and potential damage incurred)
will build and will potentially exceed the boost to operating income that
may result. Overproducing is just not good management. Instead, since we
have excess capacity, my recommendation would be to try to find new customers to boost sales, spread the fixed costs over a greater number of
units thereby providing a “real” boost to net income that is sustainable over
the longer term.
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44
Managerial Accounting, 11th Canadian Edition
Case 8-21 (40 minutes)
Memo
To: Ms. Jane Jones, Plant Manager
From: Plant Accountant, Acme Electric Fan Co.
RE: Production beyond the planned 20,000 fans this year
I have prepared this memo in response to your question concerning the effect of producing an extra 500 fans this year. As indicated at our recent
meeting, the obvious issue when producing units beyond what can be sold
is the cost of holding the extra units in inventory. We have determined that
the extra inventory holding costs related to the 500 fans would be negligible so let’s move on to the effect of incurring the extra production costs
without also realizing sales revenues related to these units before the end
of the year. You expressed concern that this decision might have a negative
effect on plant profitability. To help you to make this decision, I provide the
following analysis:
Assume you decided to make the extra 500 fans:
Sales (20,000 units x $12)
Cost of goods sold:
Beginning inventory
$240,000
-0-
Add cost of goods manufactured:
20,500 units x ($3+2+1+ 3*)
Less: Ending inventory (500 x $9)
Cost of goods sold
Gross margin
Less Variable selling costs
($1 x 20,000)
Net income
184,500
(4,500)
180,000
60,000
20,000
$40,000
*$3 = $61,500 fixed costs ÷ 20,500 units produced
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Solutions Manual, Chapter 8
45
Case 8-21 (continued)
Without the additional 500 fans, net income would be as follows:
Sales (20,000 units x $12)
Cost of goods sold:
Beginning inventory
$240,000
-0-
Add cost of goods manufactured:
Variable manufacturing costs:
20,000 units x ($3+2+1)
Fixed manufacturing costs
Less: Ending inventory
Cost of goods sold
Gross margin
Less Variable selling costs
($1 x 20,000)
Net income
$120,000
61,500
-0181,500
58,500
20,000
$38,500
* Note the $61,500 fixed costs are spread over fewer units in this scenario
so that the cost per unit increases to $3.08 ($61,500 ÷ 20,000 units produced)
As you can see from this analysis, profits are actually higher when the extra 500 fans are produced. This can be explained by our use of an absorption costing system. This system is designed to match costs with revenues
generated; therefore, the $1500 in fixed costs related to producing the extra fans is held back in the Ending Inventory account (an asset on the Balance Sheet) until next period when the fans are sold. At that point, the
costs will move out of ending inventory and will be included in cost of
goods sold.
Based on my analysis of the effect on profits, the fact that holding costs
are negligible and that unexpected orders that would otherwise upset the
production schedule are sometimes issued by customers, I would recommend that you produce and hold in inventory the additional 500 fans.
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46
Managerial Accounting, 11th Canadian Edition
Connecting Concepts: Section 2 (30 minutes)
1. Cost of each job using traditional overhead allocation method:
Cost of subcontracted work
Direct in-house staff costs
Overhead*
Total cost per job
Smith and Valens
$45,000
12,500
78,200
$135,700
Walker and Chen
$85,000
5,000
27,600
$117,600
*Overhead application rate = $115,000/625 hrs = $184/hr
Smith and Valens: $184 x 425 hrs = $78,200
Walker and Chen: $184 x 150 hrs = $27,600
Cost of each job using ABC to allocate overhead costs
Cost of subcontracted work
Direct in-house staff costs
Technical support*
Administration**
Total cost per job
Smith and Valens
$45,000
12,500
22,500
36,125
$116,125
Walker and Chen
$85,000
5,000
42,500
12,750
$145,250
*Smith and Valens: $0.50 x $45,000
Walker and Chen: $0.50 x $85,000
**Smith and Valens : $85 x 425 hrs
Walker and Chen : $85 x 150 hrs
The cost of the two jobs differ under different cost allocation methods because, under the traditional method, overhead costs are allocated based on
the number of direct in-house staff hours worked, whether these activities
drive the overhead costs or not. Every direct in-staff hour attracts an equal
portion of the overhead costs. The ABC system recognizes that jobs that
require more subcontracted labour cause more technical support costs to
be generated. Therefore, more of the total overhead incurred is allocated
to the Walker and Chen job than to the Smith and Valens job given the
Walker and Chen job requires more subcontracted work. In addition, the
ABC system recognizes that more administrative activity is likely needed to
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Solutions Manual, Chapter 8
47
oversee a greater number of in-house hours worked. Thus, more of this
type of overhead cost is allocated to the Smith and Valens job than to the
Walker and Chen job since more in-house direct hours are required there.
2. The CEO should be aware that some jobs may have been over-costed
while others were likely under-costed under the old system. This suggests that rolling out the ABC system to other departments where several different activities drive overhead costs could improve the company’s ability to estimate cost more accurately. This would allow the
company to better understand and manage those costs as well as to
set prices with more confidence. Even so, performing initial and continuing activity analyses is costly and the firm must ensure to only implement an ABC system in areas where the benefits exceed the cost of
implementation.
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48
Managerial Accounting, 11th Canadian Edition
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