9-16 (30 min.) Variable and absorption costing, explaining operating income differences.

1. Key inputs for income statement computations are:

April MayBeginning inventoryProductionGoods available for saleUnits soldEnding inventory

0500 500350 150

150400 550520 30

The unit fixed and total manufacturing costs per unit under absorption costing are:

April May(a) Fixed manufacturing costs(b) Units produced(c)=(a)÷(b) Unit fixed manufacturing costs(d) Unit variable manufacturing costs(e)=(c)+(d) Unit total manufacturing costs

$2,000,000500

$4,000$10,000$14,000

$2,000,000400

$5,000$10,000$15,000

9-1

9-16 (Cont'd.)

(a) Variable costing

April 19_7 May 19_7Revenuesa $8,400,000 $12,480,000Variable costs

Beginning inventoryVariable cost of goods manufacturedb

Cost of goods available for saleEnding inventoryc

Variable manufacturing cost of goods soldVariable marketing costs Total variable costs

Contribution marginFixed costs

Fixed manufacturing costsFixed marketing costs Total fixed costs

Operating income

$ 0 5,000,000 5,000,000

1,500,000 3,500,000

1,050,000

2,000,000 600,000

4,550,000 3,850,000

2,600,000 $1,250,000

$1,500,000 4,000,000 5,500,000 300,000 5,200,000

1,560,000

2,000,000 600,000

6,760,000 5,720,000

2,600,000 $3,120,000

a $24,000 × 350; 520b $10,000 × 500; 400c $10,000 × 150; 30

9-2

9-16 (Cont'd.)

(b) Absorption costing

April 19_7 May 19_7Revenuesa $8,400,000 $12,480,000Cost of goods sold

Beginning inventoryVariable manufacturing costsb

0$5,000,000

$2,100,0004,000,000

Fixed manufacturing costsc 2,000,000 2,000,000 Cost of goods available for saleEnding inventoryd

7,000,000 2,100,000

8,100,000 450,000

Cost of goods soldGross marginMarketing costs

4,900,000 3,500,000

7,650,000 4,830,000

Variable marketing costse 1,050,000 1,560,000Fixed marketing costs Total marketing costs

Operating income

600,000 1,650,000$1,850,000

600,000 2,160,000 $ 2,670,000

a $24,000 × 350; 520b $10,000 × 500; 400c ($4,000 × 500); ($5,000 ×400)d ($14,000 × 150; $15,000 × 30)e ($3,000 × 350; $3,000 × 520)

9-3

9-16 (Cont’d.)

2. – = –

April:

$1,850,000 – $1,250,000 = ($4,000 × 150) – ($0)$600,000 = $600,000

May:

$2,670,000 – $3,120,000 = ($5,000 × 30) – ($4,000 × 150) – $450,000 = $150,000 – $600,000 – $450,000 = – $450,000

The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into inventories as inventories increase (as in April) and out of inventories as they decrease (as in May).

9-4

9-17 (20 min.) Throughput costing (continuation of Exercise 9-16).

1. April 19_7 May 19_7Revenuesa $8,400,000 $12,480,000Variable direct materials costs

Beginning inventoryDirect materials in goods manufacturedb

$ 0 3,350,000

$1,005,000 2,680,000

Cost of goods available for saleEnding inventoryc

3,350,000 1,005,000

3,685,000 201,000

Total variable direct materials costsThroughput contributionOther costs

2,345,000 6,055,000

3,484,000 8,996,000

Manufacturing 3,650,000d 3,320,000e

Marketing 1,650,000 f 2,160,000 g

Total other costsOperating income

5,300,000 $ 755,000

5,480,000 $3,516,000

a $24,000 × 350; 520 e ($3,300 × 400) + $2,000,000 = $3,320,000b $6,700 × 500, 400 f ($3,000 × 350) + $600,000c $6,700 × 150, 30 g($3,000 × 520) + $600,000d($3,300 × 500) + $2,000,000 = $3,650,000

9-5

9-17 (Cont'd.)

2. Operating income under:April May

Absorption costingVariable costingThroughput costing

$1,850,0001,250,000

755,000

$2,670,0003,120,0003,516,000

Throughput costing puts greater emphasis on sales as the source of operating income than does either absorption or variable costing.

3. Throughput costing puts a penalty on producing without a corresponding sale in the same period. Costs other than direct materials that are variable with respect to production are expensed to that period, whereas under variable costing they would be capitalized.

9-18 (40 min.) Variable and absorption costing, explaining operatingincome differences.

1. Key inputs for income statement computations are:

January February MarchBeginning inventoryProductionGoods available for saleUnits soldEnding inventory

0 1,0001,000 700 300

300 8001,100 800 300

300 1,2501,550

1,500 50

The unit fixed and total manufacturing costs per unit under absorption costing are:January February March

(a) Fixed manufacturing costs(b) Units produced(c)=(a)÷(b) Unit fixed manufacturing costs(d) Unit variable manufacturing costs(e)=(c)+(d) Unit total manufacturing costs

$400,0001,000$400$900

$1,300

$400,000800

$500$900

$1,400

$400,0001,250$320$900

$1,220

9-6

9-18 (Cont'd.)

(a) Variable CostingJanuary 19_8 February 19_8 March 19_8

Revenuesa $1,750,000 $2,000,000 $3,750,000Variable costs

Beginning inventoryb $ 0 $270,000 $ 270,000Variable cost of goods manufacturedc 900,000 720,000 1,125,000 Cost of goods available for saleEnding inventoryd

900,000 270,000

990,000 270,000

1,395,000 45,000

Variable manufacturing cost of goods soldVariable marketing costse

Total variable costs

630,000 420,000

1,050,000

720,000 480,000

1,200,000

1,350,000 900,000

2,250,000 Contribution marginFixed costs

Fixed manufacturing costsFixed marketing costs Total fixed costs

Operating income

400,000 140,000

700,000

540,000 $ 160,000

400,000 140,000

800,000

540,000 $ 260,000

400,000 140,000

1,500,000

540,000 $ 960,000

a $2,500 × 700; 800; 1,500b $? × 0; $900 × 300; $900 × 300c $900 × 1,000; 800; 1,250d $900 × 300; 300; 50e $600 × 700; 800; 1,500

9-7

9-18 (Cont'd.)

(b) Absorption CostingJanuary 19_8 February 19_8 March 19_8

Revenuesa

Cost of goods soldBeginning inventoryb $ 0

$1,750,000

$ 390,000

$2,000,000

$ 420,000

$3,750,000

Variable manufacturing costsc: 900,000 720,000 1,125,000Fixed manufacturing costsd: 400,000 400,000 400,000 Cost of goods available for saleEnding inventorye

Cost of goods soldGross marginMarketing costs

Variable marketing costsf

Fixed marketing costs Total marketing costs

Operating income

1,300,000 390,000

420,000 140,000

910,000 840,000

560,000 $ 280,000

1,510,000 420,000

480,000 140,000

1,090,000 910,000

620,000 $ 290,000

1,945,000 61,000

900,000 140,000

1,884,000 1,866,000

1,040,000 $ 826,000

a $2,500 × 700; 800; 1,500b ($?× 0; $1,300 × 300; $1,400 × 300)c $900 × 1,000, 800, 1,250d ($400 × 1,000); ($500 × 800); ($320 × 1,250)e ($1,300 × 300); ($1,400 × 300); ($1,220 × 50)f $600 × 700; 800; 1,500

9-8

9-18 (Cont’d.)

2. – = –

January: $280,000 – $160,000 = $120,000 – $0$120,000 = $120,000

February: $290,000 – $260,000 = $150,000 – $120,000$30,000 = $30,000

March: $826,000 – $960,000 = $16,000 – $150,000– $134,000 = – $134,000

The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into inventories as inventories increase (as in January) and out of inventories as they decrease (as in March).

9-9

9-19 (20–30 min.) Throughput costing (continuation of Exercise 9-18).

1.January February March

Revenuesa

Variable direct materials costsBeginning inventoryb $ 0

$1,750,000

$150,000

$2,000,000

$ 150,000

$3,750,000

Direct materials in goods manufacturedc

Cost of goods available for saleEnding inventoryd

Total variable direct materials costs

500,000 500,000

150,000 350,000

400,000 550,000

150,000 400,000

625,000 775,000

25,000 750,000

Throughput contribution 1,400,000 1,600,000 3,000,000Other costs

Manufacturinge

Marketingf

Total other costsOperating income

800,000 560,000

1,360,000 $ 40,000

720,000 620,000

1,340,000 $ 260,000

900,000 1,040,000

1,940,000 $1,060,000

a $2,500 × 700; 800; 1,500b ($? × 0; $500 × 300; $500 × 300)c $500 × 1,000; 800; 1,250d $500 × 300; 300; 50e ($400 × 1,000) + $400,000 ($400 × 800) + $400,000 ($400 × 1,250) + $400,000f ($600 × 700) + $140,000 ($600 × 800) + $140,000 ($600 × 1,500) + $140,000

9-10

9-19 (Cont'd.)

2. Operating income under:January February March

Absorption costingVariable costingThroughput costing

$280,000160,00040,000

$290,000260,000260,000

$826,000960,000

1,060,000

Throughput costing puts greater emphasis on sales as the source of operating income than does absorption or variable costing.

3. Throughput costing puts a penalty on producing without a corresponding sale in the same period. Costs other than direct materials that are variable with respect to production are expensed to that period, whereas under variable costing they would be capitalized as an inventoriable cost.

9-11

9-20 (40 min) Variable vs. absorption costing.

1.

Beginning inventory, January 1, 2001 85,000 unitsEnding inventory, December 31, 2001 34,500 unitsSales 345,400 unitsSelling price (to distributor) $22.00 per unitVariable manufacturing cost per unit $5.10Variable marketing cost per unit sold $1.10 per unit soldFixed manufacturing overhead $1,440,000 Denominator level machine hours 6,000 machine hours Standard production rate 50 units per machine-hourFixed marketing and SG&A costs $1,080,000

Income Statement for the Zwatch Company, Variable Costingfor the year ended December, 31, 2001

Revenues: $22 × 345,400 $7,598,800Variable costs Beginning inventory: $5.10 × 85,000 $ 433,500 Variable manufacturing costs: $5.10 × 294,900 1,503,990 Cost of good available for sale 1,937,490 Ending inventory: $5.10 × 34,500 175,950 Variable cost of goods sold 1,761,540 Variable marketing and SG&A costs: $1.10 × 345,400 379,940 Total variable costs (at standard costs) 2,141,480 Adjustment for variances 0 Total variable costs 2,141,480Contribution Margin 5,457,320

Fixed Costs Fixed manufacturing overhead costs 1,440,000 Fixed marketing and SG&A costs 1,080,000 Adjustment for variances 0 Total fixed costs 2,520,000Operating income $2,937,320

9-12

9-20 (Cont’d.)

Absorption Costing Data

Fixed manufacturing overhead allocation rate = Fixed manufacturing overhead/Denominator level machine hours = $1,440,000/6,000 = $240 per machine hour

Fixed manufacturing overhead allocation rate per unit = Fixed manufacturing overhead allocation rate/standard production rate = $240/50 = $4.80 per unit

Income Statement for the Zwatch Company, Absorption CostingFor the year ended December 31, 2001Revenues: $22 × 345,400 $7,598,800Cost of goods sold Beginning inventory ($5.10 + $4.80) × 85,000 $ 841,500 Variable manuf. costs: $5.10 × 294,900 1,503,990 Fixed manuf. costs: $4.80 × 294,900 1,415,520 Cost of goods available for sale $3,761,010 Ending inventory: ($5.10 + $4.80) × 34,500 341,550 Adjust for manuf. variances ($4.80 × 5,100)a 24,480 Cost of goods sold 3,443,940 Gross margin 4,154,860Operating costs Variable marketing costs: $1.10 × 345,400 $ 379,940 Fixed marketing costs 1,080,000 Adjust for operating cost variances 0 Total operating costs 1,459,940 Operating income $2,694,920 a Production volume variance

= [(6,000 hours × 50) – 294,900) × $4.80= (300,000 – 294,900) × $4.80= $24,480

2. Zwatch’s pre-tax profit margins –

Under variable costing: Revenues $7,598,800 Operating income 2,937,320 Pre-tax profit margin 38.7%

Under absorption costing: Revenues $7,598,800 Operating income 2,694,920 Pre-tax profit margin 35.5%

9-13

9-14

9-20 (Cont’d.)

3. Operating income using variable costing is about nine percent higher than operating income calculated using absorption costing.

Variable costing operating income – Absorption costing operating income =$2,937,320 – $2,694,920 = $242,400

Fixed manufacturing costs in beginning inventory under absorption costing – Fi×ed manufacturing costs in ending inventory under absorption costing =

($4.80 × 85,000) – ($4.80 × 34,500) = $242,400

4. The factors the CFO should consider include:(a) Effect on managerial behavior, and(b) Effect on external users of financial statements.

Absorption costing has many critics. However, the dysfunctional aspects associated with absorption costing can be reduced by:

Careful budgeting and inventory planning, Adding a capital charge to reduce the incentives to build up inventory, and Monitoring nonfinancial performance measures.

9-15

9-21 (10 min.) Absorption and variable costing.

The answers are 1(a) and 2(c). Computations:

1. Absorption Costing:

Revenuesa

Cost of goods sold:Variable manufacturing costsb

Fixed manufacturing costsc

Gross margin

$2,400,000 360,000

$4,800,000

2,760,000 2,040,000

Marketing and administrative costs:Variable marketing and administratived Fixed marketing and administrative

Operating income

1,200,000 400,000 1,600,000

$ 440,000

a $40 × 120,000b $20 × 120,000c Fixed manufacturing rate = $600,000 ÷ 200,000

= $3 per output unit Fixed manufacturing costs = $3 × 120,000

d $10 × 120,000

2. Variable Costing:

Revenuesa

Variable costs:Variable manufacturing costs of goods soldb Variable marketing and administrative costsc

Contribution marginFixed costs:

Fixed manufacturing costsFixed marketing and administrative costs

Operating income

$2,400,000 1,200,000

600,000 400,000

$4,800,000

3,600,000 1,200,000

1,000,000 $ 200,000

a $40 × 120,000b $20 × 120,000c $10 × 120,000

9-16

9-22 (40 min) Absorption vs. variable costing.

1. The number of Mimic pills sold in 2001 is:44,800 × 365 × 3 = 49,056,000 pills

Ending inventory on December 31, 2000 is 5,694,000 pills:Unit data Beginning inventory 0 Production 54,750,000 Sales 49,056,000 Ending inventory 5,694,000

Variable cost data Manufacturing costs per pill produced Direct materials $0.05 Direct manufacturing labor 0.04 Manufacturing overhead 0 .11 Total variable manufacturing costs $0 .20

Fixed cost data Manufacturing costs $ 7,358,400 R&D 4,905,600 SG&A 19,622,400

Wholesale selling price per pill $1.20

Fixed manufacturing costs allocation rate per pill $0.15

2. Variable costing:

Revenues: $1.20 × 49,056,000 $58,867,200

Variable costs Beginning inventory $ 0 Variable manuf. cost: $0.20 × 54,750,000 10,950,000 Cost of goods available for sale 10,950,000 Ending inventory: $0.20 × 5,694,000 1,138,800 Variable cost of goods sold 9,811,200 Variable marketing costs: $0.07 × 49,056,000 3,433,920 Adjust for variable-cost variance 0 Total variable cost 13,245,120 Contribution margin 45,622,080Fixed costs Fixed manufacturing costs 7,358,400 Fixed R&D 4,905,600 Fixed marketing 19,622,400

9-17

Total fixed costs 31,886,400 Operating income $13,735,680 Absorption costing:922 (Cont’d.)

Absorption costing:

Revenues: $1.20 × 49,056,000 $58,867,200 Costs of goods sold Beginning inventory $ 0 Variable manuf. cost: $0.20 × 54,750,000 10,950,000 Fixed manuf. costs: $0.15 × 54,750,000 8,212,500 Cost of goods available for sale 19,162,500 Ending inventory: $0.35 × 5,694,000 1,992,900 Adjust for manuf. variances 854,100 Cost of goods sold 16,315,500 Gross margin 42,551,700Operating costs Variable marketing costs: $0.07 × 49,056,000 3,433,920 Fixed R&D 4,905,600 Fixed marketing 19,622,400 Adjustment for operating cost variances 0 Total operating costs 27,961,920 Operating income $14,589,780

3. The difference of $854,100 is due to:

=

= ($0.15 × 5,694,000) $0= $854,100

9-18

9-23 (20 min.) Throughput costing (continuation of E×ercise 9-22).

1.

Revenues: $1.20 × 49,056,000 $58,867,200Variable direct materials cost of goods sold Beginning inventory $ 0 Direct materials: $0.05 × 54,750,000 2,737,500 Cost of goods available for sale 2,737,500 Ending inventory: $0.05 × 5,694,000 284,700 Total variable direct materials COGS 2,452,800 Adjustment for variances 0 Total variable direct materials costs 2,452,800 Throughput contribution 56,414,400Other costs Variable manuf.: $0.15 × 54,750,000 8,212,500 Variable marketing: $0.07 × 49,056,000 3,433,920 Fixed manufacturing 7,358,400 Fixed R&D 4,905,600 Fixed marketing 19,622,400 Total other costs 43,532,820 Operating income $12,881,580

2. Use of throughput costing reduces incentives to transfer costs from period to period by producing for inventory. A manager under throughput costing cannot increase operating income by building for inventory as is possible with absorption costing.

9-19

9-24 (20-30 min.) Comparison of actual-costing methods.

The numbers are simplified to ease computations. This problem avoids standard costing and its complications.

1. Variable-costing income statements:

2000 2001Sales

Production1,000 units1,400 units

SalesProduction

1,200 units1,000 units

Revenues ($3 per unit)Variable costs:

Beginning inventoryVariable cost of goods manufacturedCost of goods available for saleEnding inventorya

$ 0 700

700 200

$3,000

$ 200 500

700 100

$3,600

Variable manuf. cost of goods soldVariable marketing and admin. costs Variable costs:

Contribution marginFixed costs

Fixed manufacturing costsFixed marketing and admin. costs Fixed costs

Operating income

500 1,000

700 400

1,500 1,500

1,100 $ 400

600 1,200

700 400

1,800 1,800

1,100 $ 700

a Unit inventoriable costs:Year 1: $700 ÷ 1,400 = $0.50 per unitYear 2: $500 ÷ 1,000 = $0.50 per unit

9-20

9-24 (Cont'd.)

2. Absorption-costing income statements:

2000 2001Sales

Production1,000 units1,400 units

SalesProduction

1,200 units1,000 units

Revenues ($3 per unit)Cost of goods sold:

Beginning inventoryVariable manufacturing costsFixed manufacturing costsa

Cost of goods available for saleEnding inventoryb

$ 0 700

700 1,400 400

$3,000

$ 400500

700 1,600

240

$3,600

Cost of goods soldGross marginMarketing and administrative costs:

Variable marketing and admin. costsFixed marketing and admin. costs

Marketing and admin. costsOperating income

1,000 400

1,000 2,000

1,400 $ 600

1,200 400

1,360 2,240

1,600 $ 640

a Fixed manufacturing costs:Year 1: $700 ÷ 1,400 = $0.50 per unitYear 2: $700 ÷ 1,000 = $0.70 per unit

b Unit inventoriable costs:Year 1: $1,400 ÷ 1,400 = $1.00 per unitYear 2: $1,200 ÷ 1,000 = $1.20 per unit

9-21

9-24 (Cont'd.)

3. 2000 2001Variable Costing:

Operating income $400 $700Ending inventory 200 100

Absorption Costing:Operating income $600 $640Ending inventory 400 240Fixed manuf. overhead

• in beginning inventory 0 200• in ending inventory 200 140

=

Year 1: $600 – $400 = $200 – $0= $200

Year 2: $640 – $700 = $140 – $200= –$60

The difference in reported operating income is due the amount of fixed manufacturing overhead in the beginning and ending inventories. In Year I, absorption costing has a higher operating income of $200 due to ending inventory having $200 more in fixed manufacturing overhead than does beginning inventory. In Year 2, variable costing has a higher operating income of $60 due to ending inventory having $60 less in fixed manufacturing overhead than does ending inventory.

4. a.Absorption costing is more likely to lead to inventory build-ups than variable costing. Under absorption costing, operating income in a given accounting period is increased, because some fixed manufacturing costs are accounted for as an asset (inventory) instead of a cost of the current period.

b. Although variable costing will counteract undesirable inventory build-ups, other measures can be used without abandoning absorption costing. Examples include budget targets and nonfinancial measures of performance such as maintaining specific inventory levels, inventory turnovers, delivery schedules, and equipment maintenance schedules.

9-22

9-25 (25 min.) Denominator-level problem

1. Budgeted fixed manufacturing overhead costs rates:

DenominatorLevel

Concept

Budgeted Fixed

ManufacturingOverhead per

Period

BudgetedDenominator

Level

Budgeted Fixed

ManufacturingOverhead Cost

RateTheoretical $ 3,800,000 2,880 $ 1,319.44Practical 3,800,000 1,800 2,111.11Normal 3,800,000 1,000 3,800.00Master-budget 3,800,000 1,200 3,166.67

The rates are different because of varying denominator-level concepts. Theoretical and practical capacity levels are driven by supply-side concepts, i.e. “how much can I produce?” Normal and Master-budget capacity levels are driven by demand-side concepts, i.e. “how much can I sell?” (or “how much should I produce?”)

2. In order to incorporate fixed manufacturing costs into unit product costs, fixed manufacturing costs have to be unitized for inventory costing. Absorption costing is the method used for tax reporting to the IRS and for financial reporting using generally accepted accounting principles.

The choice of a denominator level becomes relevant under absorption costing because fixed costs are accounted for along with variable costs at the individual product level. Variable and throughput costing account for fixed costs as a lump sum, expensed in the period incurred.

3. The variances that arise from use of the theoretical or practical level concepts will signal that there is a divergence between the supply of capacity and the demand for capacity. This is useful input to managers. As a general rule, however, it is important not to place undue reliance on the production volume variance as a measure of the economic costs of unused capacity.

4. Under a cost-based pricing system, the choice of a master-budget level denominator will lead to high prices when demand is low (more fixed costs allocated to the individual product level), further eroding demand; conversely it will lead to low prices when demand is high, forgoing profits. This has been referred to as the downward demand spiral—the continuing reduction in demand that occurs when the prices of competitors are not met and demand drops, resulting in even higher unit costs and even more reluctance to meet the prices of competitors.

9-23

9-26 (30 min.) Variable and absorption costing and breakeven points.

1. Production = Sales + Ending Inventory - Beginning Inventory= 242,400 + 24,800 32,600= 234,600

2. Breakeven point in cases:a. Variable Costing:

QT =

QT =

QT =

QT = 224,400 cases

b. Absorption costing:

QT =

QT =

QT =

QT =

46 QT 16 QT = $6,568,800

30 QT = $6,568,800

QT = 218,960 cases.

9-24

926 (Cont’d.)

3. If grape prices increase by 25%, the cost of grapes per case will increase from $16 in 2001 to $20 in 2002. This will decrease the unit contribution margin from $46 in 2001 to $42 in 2002.

a. Variable Costing:

QT =

= 245,772 cases

b. Absorption Costing:

QT =

$42 QT = $6,568,800 + $16 QT

$26 QT = $6,568,800

QT = 252,647 cases

9-25

9-27 (40 min.) Variable costing versus absorption costing.

1. Absorption Costing:Mavis Company Income Statements For the Year 2001

Revenues (540,000 × $5.00)$2,700,000

Cost of goods sold:Beginning inventory (30,000 × $3.70a) $ 111,000Variable manufacturing costs (550,000 × $3.00) 1,650,000Fixed manuf. overhead costs (550,000 × $0.70) 385,000Cost of goods available for sale 2,146,000Ending inventory (40,000 × $3.70) 148,000 Cost of goods sold (at std. costs) 1,998,000

Gross margin (at standard costs) 702,000Adjustment for variances (50,000b × $0.70) 35,000

Gross margin 667,000Marketing and administrative costs:

Variable marketing and admin. costs (540,000 × $1) 540,000Fixed marketing and admin. costs 120,000Adjustment for variances 0 Marketing and administrative costs 660,000

Operating income $ 7,000

a $3.00 + ($7.00 ÷ 10) = $3.00 + $0.70 = $3.70b [(10 × 60,000) – 550,000)] = 50,000 units

9-26

9-27 (Cont'd.)

2. Variable Costing: Mavis Company Income Statement For the Year 2001

Revenues $2,700,000Variable costs:

Beginning inventory (30,000 × $3.00) $ 90,000Variable cost of goods manufactured (550,000 × $3.00) 1,650,000Cost of goods available for sale 1,740,000 Ending inventory (40,000 × $3.00) 120,000Variable manufacturing cost of goods sold 1,620,000Variable marketing and administrative costs 540,000 Total variable costs (at std. cost) 2,160,000Adjustment for variances 0 Total variable costs 2,160,000

Contribution margin 540,000Fixed costs:

Fixed manufacturing overhead costs 420,000Fixed marketing and administrative costs 120,000Adjustment for variances 0 Total fixed costs 540,000

Operating income $ 0

3. The difference in operating income between the two costing methods is:

=

$7,000 – $0 = [(40,000 × $0.70) – (30,000 × $0.70)]$7,000 = $28,000 – $21,000$7,000 = $7,000

The absorption-costing operating income exceeds the variable costing figure by $7,000 because of the increase of $7,000 during 2001 of the amount of fixed manufacturing costs in ending inventory vis-a-vis beginning inventory.

9-27

9-27 (Cont'd.)

4.

5. Absorption costing is more likely to lead to buildups of inventory than does variable costing. Absorption costing enables managers to increase reported operating income by building up inventory which reduces the amount of fixed manufacturing overhead included in the current period's cost of goods sold.

Ways to reduce this incentive include:(a) Careful budgeting and inventory planning,(b) Change the accounting system to variable costing or throughput costing,(c) Incorporate a carrying charge for carrying inventory,(d) Use a longer time period to evaluate performance than a quarter or a year, and(e) Include nonfinancial as well as financial measures when evaluating management

performance.

9-28

9-28 (10-20 min.) Breakeven under absorption costing (continuation of Problem 9-27).

1. The unit contribution margin is $5 – $3 – $1 = $1. Total fixed costs ($540,000) divided by the unit contribution margin ($1.00) equals 540,000 units. Therefore, under variable costing 540,000 units must be sold to break even.

2. If there are no changes in inventory levels, the breakeven point can be the same, 540,000 units, under both variable costing and absorption costing. However, as the preceding problem demonstrates, under absorption costing, the breakeven point is not unique; operating income is a function of both sales and production. Some fixed overhead is "held back" when inventories rise (10,000 units × $0.70 = $7,000), so operating income is positive even though sales are at the breakeven level as commonly conceived.

=

Let N = Breakeven sales in units

N =

N =

$0.30N = $155,000

N = 516,667 units (rounded)

Therefore, under absorption costing, when 550,000 units are produced, 516,667 units must be sold for the income statement to report zero operating income.

Proof of 2001 breakeven point:

Gross margin, 516,667 units × ($5.00 – $3.70) $671,667Output level MOH variance, as before $ 35,000Marketing and administrative costs: Variable, 516,667 units × $1.00 516,667 Fixed 120,000 671,667Operating income $ 0

9-29

9-28 (Cont'd.)

3. If no units are sold, variable costing will show an operating loss equal to the fixed manufacturing costs, $420,000 in this instance. In contrast, the company would break even under absorption costing, although nothing was sold to customers. This is an extreme example of what has been called "selling fixed manufacturing overhead to inventory."

A final note: We find it helpful to place the following comparisons on the board, keyed to the three parts of this problem:

1. Breakeven = f (sales)2. Breakeven = f (sales and production)3. Breakeven = f (0 units sold and 540,000 units produced), an extreme case

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9-29 (40 min.) The All-Fixed Company in 2001.

This problem always generates active classroom discussion.

1. The treatment of fi×ed manufacturing overhead in absorption costing is affected primarily by what denominator level is selected as a base for allocating fixed manufacturing costs to units produced. In this case, is 10,000 tons per year, 20,000 tons, or some other denominator level the most appropriate base?

We usually place the following possibilities on the board or overhead projector and then ask the students to indicate by vote how many used one denominator level versus another. Incidentally, discussion tends to move more clearly if variable-costing income statements are discussed first, because there is little disagreement as to computations under variable costing.

a.Variable-Costing Income Statement:

2000 2001 TogetherRevenues (and contribution margin) $300,000 $300,000 $600,000Fixed costs:Manufacturing costs $280,000Marketing and administrative cost 40,000 320,000 320,000 640,000Operating income $(20,000) $(20,000) $(40,000)

b. Absorption-Costing Income Statement:

The ambiguity about the 10,000- or 20,000-unit denominator level is intentional. IF YOU WISH, THE AMBIGUITY MAY BE AVOIDED BY GIVING THE STUDENTS A SPECIFIC DENOMINATOR LEVEL IN ADVANCE.

Alternative 1. Use 20,000 units as a denominator; fi×ed manufacturing overhead per unit is $280,000 20,000 = $14.

2000 2001  TogetherRevenues $300,000 $ 300,000 $600,000 Manufacturing costs @ $14 280,000 -- 280,000Deduct ending inventory 140,000 --   -- Cost of goods sold 140,000 140,000* 280,000Underallocated manuf. overhead-- output level variance -- 280,000 280,000Marketing and administrative costs 40,000 40,000 80,000 Total costs 180,000 460,000 640,000 Operating income $120,000 $(160,000 ) $( 40,000 )

* Inventory carried forward from 2000 and sold in 2001.

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9-29 (Cont'd.)

Alternative 2. Use 10,000 units as a denominator; fi×ed manufacturing overhead per unit is $280,000 10,000 = $28.

2000 2001  TogetherRevenues $300,000 $300,000 $600,000 Manufacturing costs @ $28 560,000 -- 560,000Deduct ending inventory 280,000 -- -- Cost of goods sold 280,000 280,000* 560,000Underallocated manuf. overhead-- output level variance -- 280,000 --Overallocated manuf. overhead -- output level variance (280,000) -- --Marketing and administrative costs 40,000 40,000 80,000 Total costs 40,000 600,000 640,000Operating income $260,000 $(300,000) $ (40,000)

*Inventory carried forward from 2000 and sold in 2001.

Note that operating income under variable costing follows sales and is not affected by inventory changes.

Note also that students will understand the variable-costing presentation much more easily than the alternatives presented under absorption costing.

2. = =

= 10,667 tons per year or 21,333 for two years.

If the company could sell 667 more tons per year at $30 each, it could get the extra $20,000 contribution margin needed to break even.

Most students will say that the breakeven point is 10,667 tons per year under both absorption costing and variable costing. The logical question to ask a student who answers 10,667 tons for variable costing is: "What operating income do you show for 2000 under absorption costing?" If a student answers $120,000 (alternative 1 above), or $260,000 (alternative 2 above), ask: "But you say your breakeven point is 10,667 tons. How can you show an operating income on only 10,000 tons sold during 2000?"

The answer to the above dilemma lies in the fact that operating income is affected by both sales and production under absorption costing.

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9-29 (Cont'd.)

Optional: Given that sales would be 10,000 tons in 2000, solve for the production level that will provide a breakeven level of zero operating income. Using the formula in the chapter, sales of 10,000 units, and a fixed manufacturing overhead rate of $14 (based on $280,000 ÷ 20,000 units denominator level = $14):

Let P = Production level

=

10,000 tons =

$300,000 = $320,000 + $140,000 – $14P$14P = $160,000 P = 11,429 units (rounded)

Proof:Gross margin, 10,000 × ($30 – $14) $160,000Output level variance, (20,000 – 11,429) × $14 $120,000Marketing and administrative costs 40,000 160,000Operating income $ 0

Given that production would be 20,000 tons in 2000, solve for the breakeven unit sales level. Using the formula in the chapter and a fi×ed manufacturing overhead rate of $14 (based on a denominator level of 20,000 units):

Let N = Breakeven sales in units

N =

N =

$30N = $320,000 + $14N – $280,000$16N = $40,000N = 2,500 units

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9-29 (Cont'd.)

Proof:Gross margin, 2,500 × ($30 – $14) $40,000Output level MOH variance $ 0Marketing and administrative costs 40,000 40,000Operating income $ 0

We find it helpful to put the following comparisons on the board:

Variable costing breakeven = f(sales)= 10,667 tons

Absorption-costing breakeven = f(sales and production)= f(10,000 and 11,429)= f(2,500 and 20,000)

3. Absorption costing inventory cost: Either $140,000 or $280,000 at the end of 2000 and zero at the end of 2001.

Variable costing: Zero at all times. This is a major criticism of variable costing and focuses on the issue of the definition of an asset.

4. Operating income is affected by both production and sales under absorption costing. Hence, most managers would prefer absorption costing because their performance in any given reporting period, at least in the short run, is influenced by how much production is scheduled near the end of a period.

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