Problem 6 - 21: Prepare & Reconcile Variable Costing Statements

Given:Linden Company manufactures and sells a single product. Cost data for the product follow:

Variable costs per unit:Direct materials $6.00 Direct labor 12.00 Variable factory overhead 4.00 Variable selling & administrative 3.00

Total variable costs per unit $25.00

Fixed costs per month:Fixed manufacturing overhead $240,000 Fixed selling & administrative 180,000

Total fixed cost per month $420,000

of operations, are as follows; $40.00

Units UnitsProduced Sold

May 30,000 26,000 June 30,000 34,000

presented below:May June

Sales $1,040,000 $1,360,000 Cost of goods sold

Beginning inventory $0 $120,000 $120,000Add cost of goods manufactured 900,000 900,000 $900,000Goods available for sale $900,000 $1,020,000 Less ending inventory 120,000 0 $120,000 Cost of goods sold $780,000 $1,020,000

Gross margin $260,000 $340,000 Selling & administrative expenses 258,000 282,000 $258,000 $282,000Operating income $2,000 $58,000

Required:1. Determine the unit product cost under:

a. Absorption costingb. Variable costing

Absorption VariableCosting Costing

Direct materials $6.00 $6.00 Direct labor 12.00 12.00 Variable manufacturing overhead 4.00 4.00 Fixed manufacturing overhead ($240,000/30,000) 8.00

The product sells for $40 per unit. Production and sales data for May and June, the first two months

Income statements prepared by the Accounting department, using absorption costing, are

$30.00 $22.00

2. Prepare variable costing income statements for May and June using thecontribution approach.

Linden CompanyVariable Costing Income StatementsFor the Months of May and June

May JuneSales (26,000 X $40; 34,000 X $40) $1,040,000 $1,360,000 Variable expenses:

Variable cost of goods sold $572,000 $748,000 Variable selling & administrative 78,000 102,000 Total variable expenses $650,000 $850,000

Contribution margin $390,000 $510,000 Fixed expenses:

Fixed manufacturing overhead $240,000 $240,000 Fixed selling & administrative 180,000 180,000 Total fixed expenses $420,000 $420,000

Operating income (loss) ($30,000) $90,000

3. Reconcile the variable costing and absorption costing net operating income figuresMay June

Operating variable costing income (loss) ($30,000) $90,000 Adjustment for Change in inventory during May

Production 30,000 Sales 26,000 Increase in inventory 4,000 Fixed MOH rate $8.00 Fixed $ deferred in inventory $32,000 32,000

Operating absorption costing income (loss) $2,000 Adjustment for Change in inventory during June

Production 30,000 Sales 34,000 Decrease in inventory (4,000)Fixed MOH rate $8.00 Fixed $ released from inventory ($32,000) (32,000)

Operating absorption costing income (loss) $58,000

4. The company's Accounting Department has determined the break-even point to be

Upon receiving this figure, the president commented, "There's something peculiar here.The controller says that the break-even point is 28,000 per month. Yet we sold only

Which figure do we believe?" Prepare a brief explanation of what happened on the Mayincome statement.

28,000 units per month, computed as follows:

Fixed cost per month/Unit contribution margin = $420,000/$15 per unit = 28,000 units

26,000 units in May, and the income statement we received showed a $2,000 profit.

The break-even analysis above assumes that all of Linden Company's $420,000 of monthly fixedcosts will be recognized as expenses each month in its monthly income statements. If LindenCompany uses a variable costing approach to measuring operating income, then this assumption will hold true. However, if the absorption costing approach is used to measure operating income,this assumption will hold true only when production is equal to sales. In May, production wasgreater than sales by 4,000 units. Therefore, $32,000 (4,000 X $8) of fixed MOH costs was deferred in ending inventory to future periods. This $32,000 of deferred fixed MOH costs will berecognized in future periods as expense items when the inventory units to which these costs areassigned are sold. Fewer units need to be sold to B/E since recognized fixed costs are $32,000less.

Current sales 26,000.00 B/E = ($420,000 - $32,000)/$15 = 25,866.67 Sales greater than B/E 133.33 CM per unit sold $15.00 Operating income -- 26,000 sales $2,000.00

Thus, both are correct depending on underlying assumptions.

Normal B/E analysis assumes production = sales. This assumption equates operating incomemeasured under variable costing with operating income measured under absorption costing.Since production is greater than sales during May, operating income is greater when measuredusing an absorption costing approach than when using a variable costing approach.

Problem 6 - 25: Prepare and Interpret Statements; Changes in both Sales and Production; Lean Production

Given:Memotec, Inc. manufactures and sells a unique electronic part. Operating results for the firstthree years of activity were as follows (absorption costing basis):

Absorption Costing Year 1 Year 2 Year 3Sales $1,000,000 $800,000 $1,000,000 Cost of goods sold

Beginning inventory $0 $0 $280,000 Add: Cost of goods manufactured 800,000 840,000 760,000 Cost of goods available for sale $800,000 $840,000 $1,040,000 Less: Ending Inventories 0 280,000 190,000 Cost of goods sold $800,000 $560,000 $850,000

Gross margin $200,000 $240,000 $150,000 Selling and administrative expenses 170,000 150,000 170,000 Net operating income (Loss) $30,000 $90,000 ($20,000)

of Year 3, management could see that spurts in demand were unlikely and that the inventory wasexcessive. To work off the excessive inventories, Memotec cut back production during Year 3, asshown below:

Total Year 1 Year 2 Year 3Production in units 150,000 50,000 60,000 40,000 Sales in units 140,000 50,000 40,000 50,000

P>S P=S P>S P<S

Additional information about the company follows:a. The company's plant is highly automated. Variable manufacturing costs (direct materials, direct

per year.

b. FMOH costs are applied to units of product on the basis of each year's production. (That is, a newFMOH rate is computed each year).

c.

d. The company uses a FIFO inventory flow assumption

Memotec's management can't understand why profits tripled during Year 2 when sales dropped by20%, and why a loss was incurred during Year 3 when sales recovered to previous levels.

Required:1. Prepare a contribution format income statement for each year using variable costing.

Unit Sales 50,000 40,000 50,000

Variable Costing Year 1 Year 2 Year 3Sales $20 $1,000,000 $800,000 $1,000,000

Sales dropped by 20% during Year 2 due to the entry of several foreign competitors into the market.Memotec had expected sales to remain constant at 50,000 units for the year; production was set at60,000 units in order to build a buffer of protection against unexpected spurts in demand. By the start

labor, and variable manufacturing overhead) total only $4 per unit, and FMOH costs total $600,000

Variable selling and administrative expenses are $2 per unit sold. Fixed selling & administrativeexpenses total $70,000

Variable expenses:$4 $200,000 $160,000 $200,000 $2 100,000 80,000 100,000

Total variable expenses $300,000 $240,000 $300,000 Contribution margin $14 $700,000 $560,000 $700,000 Fixed expenses:

Manufacturing overhead $600,000 $600,000 $600,000 Selling and administrative expenses 70,000 70,000 70,000 Total fixed expenses $670,000 $670,000 $670,000

Net operating income (Loss) $30,000 ($110,000) $30,000

2. Refer to the absorption costing income statements above.a. Compute the unit product cost in each year under absorption costing.

Calculation of unit product costs Year 1 Year 2 Year 3Variable cost of goods sold $4 $4 $4 Fixed manufacturing costs 12 10 15 Unit product costs $16 $14 $19

b. Reconcile the variable costing and absorption costing NOI figure for each year.P=S P>S P<S

Year 1 Year 2 Year 3$30,000 ($110,000) $30,000

Change in inventory Year 2Production 60,000 Sales 40,000 Inventory increase 20,000 FMOH rate Year 2 $10 Deferred FMOH Costs $200,000 200,000

Change in inventory Year 3Fifo Cost FlowReleased from EI Y2 20,000 FMOH rate Year 2 $10 (200,000)

BI Y3 Units 20,000 Production 40,000 Sales (50,000)EI Y3 Units 10,000 FMOH Rate Year 3 $15 Deferred FMOH Year 3 $150,000 150,000

NOI -- Absorption Costing $30,000 $90,000 ($20,000)NOI -- Absorption Costing $30,000 $90,000 ($20,000)

OK OK OK

3. Refer again to the absorption costing income statements. Explain why NOI was higherin Year 2 than it was in Year 1 under the absorption approach, in light of the fact that fewer units were sold in Year 2 than in Year 1.

Cost of goods sold ($4 per unit sold)Selling & administrative ($2/unit sold)

NOI -- Variable Costing

Decrease in CM in Year 2 (real change) ($140,000) ($140,000)FMOH costs deferred in inventory (accounting change) 200,000 Increase in NOI $60,000

4. Refer again to the absorption costing income statements. Explain why the companysuffered a loss in Year 3 but reported a profit in Year 1, although the same number ofunits were sold in each year.

Based on a FIFO inventory flow assumption:FMOH costs from Year 2 released from Year 3 BI to COGM (20,000 X $10) $200,000 FMOH costs from Year 3 deferred in EI of Year 3 (10,000 X $15) 150,000 Differences in NOI (Year 1 compared with Year 3) $50,000

5. a. Explain how operations would have differed in Year 2 and Year 3 if the companyhad been using Lean Production with the result that ending inventory was zero.

With Lean Production, production would have been geared to sales in each year so thatlittle 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 during Year 2 and Year 3, what would the company's net operating income (or loss) have been in each year under absorption

?? costing? Explain the reason for any differences between these income figures andthe figures reported by the company in the statements above.

If Lean Production had been in use, the NOI under absorption costing would have been thesame as under variable costing in all three years. With production geared to sales, therewould have been no ending inventory on hand, and therefore there would have been noFMOH 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 levelof expected activity, the income statements under absorption costing would have been

Year 1 Year 2 Year 3Sales in units 50,000 40,000 50,000Production (matched to sales) 50,000 40,000 50,000

Absorption Costing Year 1 Year 2 Year 3Sales $1,000,000 $800,000 $1,000,000 Cost of goods sold Beginning inventory $0 $0 $0 New mfg. costs added: Variable manufacturing costs ($4) 200,000 160,000 200,000 Fixed mfg. costs applied ($12) 600,000 480,000 600,000 Underapplied overhead 120,000 Cost of goods available for sale $800,000 $760,000 $800,000 Ending Inventories 0 0 0 Cost of goods sold $800,000 $760,000 $800,000 Gross margin $200,000 $40,000 $200,000 Selling and administrative expenses 170,000 150,000 170,000 Net operating income (Loss) $30,000 ($110,000) $30,000 Note: Same as Variable Costing

Variable Costing NOI $30,000 ($110,000) $30,000

Problem 7 - 16: Variable Costing Income Statements; Sales Constant; Production Varies

Given:"Can someone explain to me what's wrong with these statements?" asked Cheri Reynolds, president of Milex Corporation. "They just don't make sense. We sold the same number ofunits this year as we did last year, yet our profits have tripled! Who messed up thecalculations?"

below:Units Units

Sales 40,000 40,000Production 40,000 50,000Var. mfg. $/unit $6 $6 Var. S&A $/unit $2 $2 FMOH $ $600,000 $600,000 FMOH $/unit $15 $12

Year 1 Year 2Sales (40,000 units each year) $31.25 $1,250,000 $1,250,000 $31.25 Cost of goods sold $840,000 840,000 720,000 $720,000 Gross margin $410,000 $530,000 Selling & administrative expense $80,000 350,000 350,000 $80,000 $270,000 Net operating income $60,000 $180,000

Milex Corporation applies FMOH costs to its only product on the basis of each year's production.

Required:1. Compute the unit product cost for each year under:

a. Absorption costingb. Variable costing

Year 1 Year 2 Year 1 Year 2Absorption Absorption Variable Variable

Costing Costing Costing CostingVariable mfg. $6.00 $6.00 $6.00 $6.00 Fixed MOH 15.00 12.00 N/A N/A

$21.00 $18.00 $6.00 $6.00

2. Prepare a contribution format income statement for each year using variable costing

Milex CorporationVariable Costing Contribution Format Income StatementFor Year 1 and Year 2

Sales $1,250,000 $1,250,000 Variable expenses:

Cost of goods sold $240,000 $240,000 Selling & Administrative 80,000 80,000

Total variable expenses $320,000 $320,000 Contribution margin $930,000 $930,000

The absorption costing income statements to which Ms. Reynolds was referring are shown

Fixed expenses:Fixed manufacturing overhead $600,000 $600,000 Fixed selling & administrative 270,000 270,000

Total fixed expenses $870,000 $870,000 Net operating income $60,000 $60,000

3. Reconcile the variable costing and absorption costing net operating income figuresfor each year.

Year 1 Year 2Operating variable costing income $60,000 $60,000 Adjustment for Change in inventory during Year

Production 40,000 50,000 Sales 40,000 40,000 Increase in inventory 0 10,000 Fixed MOH rate $15.00 $12.00 Fixed $ deferred in inventory $0 0 $120,000 120,000

Operating absorption costing income $60,000 $180,000

4. Explain to the president why the net operating income for Year 2 was higher than for Year 1 under absorption costing, although the same number of units was sold in eachyear.

Year 2 production was greater than Year 2 sales (P>S). The excess production resulted ininventory increasing by 10,000 units. Each of these inventory units has FMOH costs of $12 assigned to them under absorption costing. Thus $120,000 (10,000 X $12) of FMOH incurredin Year 2 was capitalized as inventory costs. These deferred costs will not be expensed until these units are sold. In Year 1, production was equal to sales (P=S). No inventory increase resulted to defer some of the FMOH costs incurred in Year 1 to future years. Thus, all$600,000 of FMOH costs incurred in Year 1 are expensed in Year 1. In Year 2, FMOH costsincurred also totaled $600,000. But, only $480,000 of these costs are expensed in Year 2. The remaining $120,000 are deferred in inventory to future time periods.

This strange result occurs because under the traditional absorption costing approach, NOI is afunction of both production and sales. Managers may manipulate NOI by adjusting production up (higher NOI) or down (lower NOI)

A variable costing approach to income determination results in all FMOH costs being expensedin the year of occurrence; net operating income is a function of sales and can not be manipulatedby merely increasing or decreasing production. Hence, managers prefer absorption costing forexternal reporting.

5. a. Explain how operations would have differed in Year 2 if the company had been using LeanProduction and inventories had been "eliminated."

Production must equal sales for there to be no inventory increases or decreases. When P = S,direct costing and absorption costing result in identical measures of NOI. If production is geared to sales estimates and sales estimates are correct, then inventories are minimal. Thus, Lean Production strategy would eliminate major inventories, and differences between NOI

calculated using absorption costing and variable costing would be minimal. In addition, costsassociated with carrying inventories would be minimal resulting in more efficient operations.

However, the risk of stock outs must not be overlooked.

5. b. If Lean Production had been in use during Year 2 and ending inventories were zero, what would the company's NOI have been under absorption costing?

NOI would have been $60,000, the same as Year 1. There would have been no inventory build up andtherefore no deferral of FMOH cost to a later time period. NOI reported would be $60,000 in both years under both costing methods (absorption costing, variable costing).

Problem 6-24: Incentives Created by Absorption Costing; Ethics and the Manager

Given:Aristotle Constantinos, the manager of DuraProducts' Australian Division, is trying to set the production

the following activity had been reported:Units

Inventory, January 1 0Production 72,000Sales 60,000Inventory, September 30 12,000

Due to the nature of the division's operations, fixed manufacturing overhead is a major element of productcost.

Required:1. Assume that the division is using variable costing. How many units should be scheduled

for production during the last quarter of the year? (The basic formula for computing therequired production for a period in a company is: Expected sales + Desired endinginventory - Beginning inventory = Required production.) Show computations and explainyour answer. Will the number of units scheduled for production affect the division'sreported profit for the year? Explain.

Expected sales for the last quarter of the year 18,000 Desired minimum inventory 1,500

Total units needed for sales and desired EI 19,500 **Less: Current inventory on hand -- September 30 12,000Desired production for the 4th quarter 7,500 ***

** Inventory should be drawn down to save inventory carrying costs such as storage (rent, insurance),interest, and obsolescence.

*** Production exceeds 6,000 units needed to "retain a nucleus of key employees"

The number of units scheduled for production will not affect the reported operating income orloss for the year if variable costing is in use. All fixed MOH costs will be treated as an expenseof the period regardless of the number of units produced. Thus, no fixed MOH cost will be shiftedbetween periods through the inventory account, and income will be a function of the number of unitssold, rather than a function of the number of units produced and sold.

2. Assume that the division is using absorption costing and that the divisional manager is given anannual bonus based on the division's net operating income. If Mr. Constantinos wants to

schedule for the last quarter of the year. The Australian Division had planned to sell 100,000 unitsduring the year, but current projections indicate sales will be only 78,000 units in total. By September 30

Demand has been soft, and the sales forecast for the last quarter is only 18,000 units.

The division can rent warehouse space to store up to 30,000 units. The division should maintain a minimum inventory level of at least 1,500 units. Mr. Constantinos is aware that production must beat least 6,000 units per quarter in order to retain a nucleus of key employees. Maximum productioncapacity is 45,000 units per quarter.

maximize his division's net operating income for the year, how many units should be scheduledfor production during the last quarter? Explain.

Expected sales for the last quarter of the year 18,000 Maximum inventory storage facilities available 30,000 **

Total units needed for sales and desired EI 48,000 Less: Current inventory on hand -- September 30 12,000 Desired production for the 4th quarter 36,000 ***

** Storage capacity for 30,000 units can be rented.*** Does not exceed the 45,000 quarterly production capacity

By building inventory to maximum levels, Mr. Constantinos will be able to defer a portion of the year's fixedMOH to future years through the inventory account, rather than having all of these costs appear as charges on the current year's income statement.

Thus, by producing enough units to build inventory to the maximum level that storage facilities will allow,Mr. Constantinos could relieve the current year of FMOH cost and thereby maximize the current year's netoperating income (and his bonus).

3. Identify the ethical issues involved in the decision Mr. Constantinos must make about the levelof production for the last quarter of the year

Production options:1. Production schedule designed to draw down inventory 7,500 2. Production schedule designed to maximize divisional manager's annual bonus 36,000

By setting a production schedule that will maximize his division's net operating income -- and maximizehis own bonus -- Mr. Constantinos 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 indicationthat demand will be any better next year than it has been in the current year, so the company may berequired 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 salesand controlling expenses. If Mr. Constantinos sets a production schedule as shown in part (2) above, hewill obtain his bonus as a result of sales and production rather than as a result of sales. Moreover, he will obtain it by creating greater expenses --rather than fewer expenses -- for the company as a whole.

Producing as much as possible so as to maximize the division's net operating income and the manager'sbonus would be unethical because it subverts the goals of the overall organization.

Exercise 6-14: Working with a Segmented Income StatementGiven:Marple Associates is a consulting firm that specializes in information systems forconstruction and landscaping companies. The firm has two offices -- one in Houstonand one in Dallas. The firm classifies the direct costs of consulting jobs as variable costs. A segmented contribution format income statement for the company's mostrecent year is given below:

OfficeTotal Company Houston Dallas

Sales $750,000 100.00% $150,000 100.00% $600,000 100.00%Variable expenses 405,000 54.00% 45,000 30.00% 360,000 60.00%Contribution margin $345,000 46.00% $105,000 70.00% $240,000 40.00%Traceable fixed expenses 168,000 22.40% 78,000 52.00% 90,000 15.00%Market segment margin $177,000 23.60% $27,000 18.00% $150,000 25.00%Common fixed expenses(not traceable to offices) 120,000 16.00%Net operating income $57,000 7.60%

Required:1. By how much would the company's net operating income increase if Dallas

increased its sales by $75,000 per year? Assume no change in cost behaviorpatterns.

Increase in Dallas sale $75,000 Contribution margin ratio 40.00%Increase in Company's NOI $30,000

2. Refer to the original data. Assume that sales in Houston increased by $50,000next year and that sales in Dallas remain unchanged. Assume no change infixed costs.a. Prepare a new segmented income statement for the company using the above

format. Show both amounts and percentages.

OfficeTotal Company Houston Dallas

Sales $800,000 100.00% $200,000 100.00% $600,000 100.00%Variable expenses 420,000 52.50% 60,000 30.00% 360,000 60.00%Contribution margin $380,000 47.50% $140,000 70.00% $240,000 40.00%Traceable fixed expenses 168,000 21.00% 78,000 39.00% 90,000 15.00%Market segment margin $212,000 26.50% $62,000 31.00% $150,000 25.00%Common fixed expenses(not traceable to offices) 120,000 15.00%Net operating income $92,000 11.50%

b. Observe from the income statement you have prepared that the CM ratio forHouston has remained unchanged at 70% (the same as in the above data) butthat the segment margin ratio has changed. How do you explain the change in the segment margin ratio?

The traceable fixed expenses are spread over a larger base as sales increase.Therefore, the segment margin ratio increase from 18% to 31%.

The contribution margin ratio remains stable at 70% because there is noinformation to suggest that the selling price per unit or the variable cost perunit have changed.

Exercise 6-15: Working with a Segmented Income Statement Given:Refer to the data in Exercise 12-11. Assume that Dallas' sales by major marketare as follows:

Dallas: Market ClientsDallas Office Construction Landscaping

Sales $600,000 100.00% $400,000 100.00% $200,000 100.00%Variable expenses 360,000 60.00% 260,000 65.00% 100,000 50.00%Contribution margin $240,000 40.00% $140,000 35.00% $100,000 50.00%Traceable fixed expenses 72,000 12.00% 20,000 5.00% 52,000 26.00%Market segment margin $168,000 28.00% $120,000 30.00% $48,000 24.00%Common fixed expenses(not traceable to markets) 18,000 3.00%Net operating income $150,000 25.00%

The company would like to initiate an intensive advertising campaign in one of the

studies indicate that such a campaign would increase sales in the construction

Required:1. In which of the markets would you recommend that the company focus its

advertising campaign?

The company should focus its campaign on Landscaping Clients.

Construction LandscapingClients Clients

Increased sales from campaign $70,000 $60,000 CM ratio for market client 35.00% 50.00%Increase in contribution margin $24,500 $30,000 Less cost of the campaign 8,000 8,000Increased segment margin & NOI $16,500 $22,000

2. In Exercise 6-14, Dallas shows $90,000 in traceable fixed expenses. Whathappened to the $90,000 in this exercise?

The $90,000 of traceable fixed cost to Dallas has been accounted for as follows:

Construction LandscapingDallas Clients Clients

two markets during the next month. The campaign would cost $8,000. Marketing

market by $70,000 or increase sales in the landscaping market by $60,000.

Traceable fixed costs $72,000 $20,000 $52,000 Common fixed expenses(not traceable to markets) 18,000 Total $90,000