Measuring and Assigning Costs for Income Statements

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1 117 Chapter 15 Measuring and Assigning Costs for Income Statements LEARNING OBJECTIVES Chapter 15 addresses the following objectives: LO1 Prepare absorption and variable costing income statements and reconcile the resulting net incomes. LO2 Discuss the factors that affect the choice of production volume measures for allocating fixed overhead. LO3 Prepare absorption and variable costing income statements considering beginning inventory balances, and evaluate the impact of inventory on income. LO4 Prepare throughput costing income statement and evaluate absorption, variable, and throughput costing income. These learning objectives (LO1 through LO4) are cross-referenced in the textbook to individual exercises and problems. 212 John Wiley and Sons Canada, Ltd.

2 118 Cost Management QUESTIONS 15.1 The three methods are similar because they assign some costs to inventory as product costs, and expense other costs as period costs. The three methods differ in the categories that are used for product and period costs. Details of these categorizations follow. Absorption costing allocates all production costs, both fixed and variable, to units as product costs so cost of goods sold and inventory on the balance sheet include fixed manufacturing costs. Cost of goods sold is subtracted from revenue to arrive at gross margin, and then other nonmanufacturing expenses are subtracted to arrive at operating income. Variable costing assigns direct costs (direct labour and direct materials) and variable overhead costs to inventory and variable cost of goods sold. Variable cost of goods sold and all other non-manufacturing variable costs are subtracted from revenue to arrive at contribution margin. All fixed costs, both manufacturing and non-manufacturing, are then subtracted from contribution margin to arrive at operating income. Throughput costing assigns only direct materials costs to inventory and throughput cost of goods sold. Throughput cost of goods sold is subtracted from revenue to arrive at throughput margin. All other costs are considered period costs and deducted from throughput margin to arrive at operating income. Uses of the three methods are different, also. Absorption costing income statements meet GAAP and are used by shareholders and other external stakeholders. Variable costing income statements generally do not meet GAAP and are only available for internal reporting. Information from these reports is used in decision-making. Throughput accounting income statements provide information for very short-term decisions and are especially helpful when capacity constraints exist The allocated fixed manufacturing overhead that is added (if production is greater than sales) or subtracted (if production is less than sales) from finished goods is the reconciliation amount between variable versus absorption costing The volume variance arises because of differences between actual volumes and budgeted volumes used to allocate fixed manufacturing overhead. Under variable costing all fixed manufacturing overhead is treated as a period expense; there are no allocations of fixed manufacturing overhead to inventory or variable cost of goods sold. Hence, there will be no volume variances Under variable costing, all fixed manufacturing overhead is treated as an expense of the period, regardless of how many units were produced or sold; income will vary only with the number of units sold, the level of production has no effect. Under absorption costing, fixed manufacturing overhead is first assigned to product; the amount of fixed overhead that appears on the income statement depends on unit sales. Income depends upon both the level of production and the level of sales. 212 John Wiley and Sons Canada, Ltd.

3 Eventually all of the units are sold under either method, so eventually all of the fixed manufacturing cost will be expensed under either method. Under variable costing, it is expensed during the period it is incurred, whereas under absorption costing, a portion of fixed manufacturing cost is inventoried and expensed when the inventory is sold rather than during the period it was incurred A variable cost increases proportionately with volume. Variable costing is a method of calculating income Unless the organization is not-for-profit, none. For most on-going, profit-seeking firms, denominator volume should exceed breakeven volume because the firm plans to be operating at volumes greater than breakeven The fixed manufacturing overhead of the current period will be shown in its entirety as an expense if variable costing is used. If absorption costing is used, some of it will be assigned to the units added to inventory, so that the fixed manufacturing overhead included in cost of goods sold will be less than the total fixed manufacturing overhead that is expensed on the variable costing income statement Both IFRS and GAAP require absorption costing to match production-related expenses to revenues This can be accomplished through the use of an adjusting journal entry at the end of the period. The objective is to distribute or allocate the fixed manufacturing overhead of the period between inventories on hand (WIP and FG) and cost of goods sold A joint cost may be either fixed or variable and a separable cost may be either fixed or variable. Both variable and absorption costing can be applied to joint product situations. Under variable costing, the joint costs are first categorized as fixed or variable and then listed on the income statement under the headings of variable or fixed production costs. Under absorption costing, the common and separable costs are considered product costs and assigned to inventory Under absorption costing, managers could manipulate earnings during a period by producing more inventory than is sold. As inventory on the balance sheet increases, the amount of fixed overhead expense allocated to the units in inventory also increases, while expense for cost of goods sold decreases because the fixed overhead is spread across and increasingly large number of units, some of which are not sold Supply-based capacity levels measure the amount of capacity that is available for production. Theoretical capacity and practical capacity are supply based. Demand-based capacity levels measure the amount of capacity needed to meet sales volumes. Normal capacity and budgeted capacity are demand based Theoretical capacity is the maximum number of units that would be produced under continuous, uninterrupted production over 365 days per year. Practical capacity is the upper capacity limit taking into account regularly scheduled times for production and 212 John Wiley and Sons Canada, Ltd.

4 12 Cost Management planned downtimes for holidays, maintenance, and any other scheduled interruptions in production. Normal capacity is an average use of capacity across time under normal circumstances. Budgeted or expected capacity is the planned use of capacity in the next period. Theoretical capacity and practical capacity are supply-based capacity levels that depend on the amount of capacity available for production. Normal capacity and budgeted or expected capacity are demand-based capacity levels that measure the amount of capacity needed to meet sales volumes In the financial statements, volume variances that are immaterial are allocated to cost of goods sold. When the volume variance is large and favorable, the variance is prorated among cost of goods sold and ending inventory. If production is below normal capacity, the volume variance is closed to cost of goods sold to avoid increasing the amount of fixed cost in inventory on the balance sheet. 212 John Wiley and Sons Canada, Ltd.

5 121 MULTIPLE-CHOICE QUESTIONS The following information pertains to Questions and 15.17: Vintage Co. made 4, units of a product during its first year of operations and sold 3, units for $6,. There was no ending work-in-process inventory. Total costs were $6,: Direct materials and direct labour $25, Manufacturing overhead (5% fixed) $2, Marketing and administrative costs (1% variable) $15, The cost of the 1, units of finished goods ending inventory under variable costing is: a) $15, b) $125, c) $112,5 d) $87,5 e) $62,5 Ans: D ( $25, + ($2, *5%) )/4 * 1 = $87, The cost of the 1, units of finished goods ending inventory under absorption costing is: a) $15, b) $125, c) $112,5 d) $62,5 e) $25, Ans: C ( $25, + $2, )/4 * 1 = $112, In Company LL, the fixed factory overhead per unit is $5, and the fixed selling administration charges are $11. This year, the company produced and sold 1, units of product. The company uses the LIFO method of accounting for its inventory. What would be the difference in income reported by the company if it used variable costing instead of absorption costing? a) $ b) $ 5, c) $1,1, d) $1,6, Ans: A Since there is no ending inventory all fixed costs are reported on the income statement under both methods. 212 John Wiley and Sons Canada, Ltd.

6 122 Cost Management How does the accounting treatment of selling and administration costs differ between absorption and variable costing if more units are produced than are sold? a) The variable portion is added to the cost of ending inventory based on a pro rata portion of units produced to those sold. b) The fixed portion is added to the costs of ending inventory based on a pro rata portion of units produced to those sold. c) There is no difference in the treatment. d) Both fixed and variable portions are added to the cost of ending inventory based on a prorata portion of units produced to those sold. Ans: C 15.2 Which of the following statements is true about the variable cost method? a) It is always inappropriate for performing a profitability analysis. b) It is useful for determining the price of a product for a special order. c) It is always useful when fixing the price for a long period. d) It is helpful for performing target costing. Ans: B 212 John Wiley and Sons Canada, Ltd.

7 123 EXERCISES Absorption and Variable Income - Famous Desk Company A and B. First list all pertinent information: Revenue = 22 desks * $3 = $66, Variable production costs = 22 desks * $8 = $17,6 Variable selling and administrative costs = 22 desks * $3 = $6,6 Fixed selling and administrative = $6, Fixed overhead absorbed into inventory under normal production Beginning Inventory 1 units with variable cost of $8 per desk and absorption cost of $ per desk $ $8 = $66.67 fixed costs per desk Fixed overhead volume variance = $1, (2 desks x $66.67) = $3,334 overapplied, which is closed to COGS Variable Costing Revenue Variable costs: Production Selling Contribution Margin Fixed costs: Production Admin and Sales $66, (17,6) (6,6) 41,8 (1,) (6,) $25,8 Absorption Costing Revenue $66, Cost of goods sold 22 desks x ($8 + $66.67) (32,267) Volume variance 3,334 Gross Margin 37,67 Selling and administrative ($6,6 + $6,) (12,6) $24,467 Double-check calculations: Difference in operating income = 2 units x $66.67 = $1,333 (fixed overhead brought into income statement under absorption costing from units produced in prior periods) Difference in operating income = $25,8 - $24,467 = $1, John Wiley and Sons Canada, Ltd.

8 124 Cost Management Absorption and Variable Income, Reconcile Incomes - Rock Crusher Corp. A sample spreadsheet showing the calculations for this problem is available on the Instructor s web site for the textbook (available at A. Variable costing income statement VARIABLE COSTING Variable cost per unit produced A1 A3 Revenue Variable costs: Production: A1 A3 Selling Contribution margin Fixed costs: Production: Selling and administrative $5. $2.5 $24, $15, 1, (25,) (35,) 18, (1,) (6,) $2, Computation details for variable production cost per unit: A1: $2,/4, tons = $5 per ton A3: $15,/6, tons = $2.5 per ton B. Absorption costing income statement: ABSORPTION COSTING Fixed production cost per ton Total production cost per ton: A1 A3 Revenue Cost of goods sold: A1 A3 Gross margin Selling and administrative: Variable Fixed 212 John Wiley and Sons Canada, Ltd. $1. $15. $12.5 $24, $45, 5, $35, 6, (95,) 145, (95,) $5,

9 125 Calculation details for cost of goods sold: Fixed production cost per ton = $1,/1, tons = $1 per ton Variable production cost per ton was calculated in Part A Cost of goods sold: A1 [($1+$5) x 3,] $45, A3 [($1+$2.5) x 4,] 5, Total $95, C. The difference in income resides in inventory. There was no beginning inventory, but there were 3, tons (1, tons produced 7, tons sold) with $1 of fixed production cost per ton absorbed into inventory on the balance sheet under absorption costing. The difference in income = $5, - $2, = $3,, and the fixed production cost in inventory is 3, x $1 = $3, Absorption and Variable Inventory and Income, Reconciliation - Start-Up Firm A and B. Units in ending inventory: Units beginning inventory Units produced Units sold Units ending inventory 1, (85) 15 Variable Costing Revenue (85 units $89) $75,65 Variable costs: Production (85 units $4) (34,) Selling (85 units $9) (7,65) Contribution Margin 34, Absorption Costing Revenue (85 units $89) $75,65 Cost of goods sold 85 units ($4 + $1) (42,5) Fixed costs: Production Selling and administrative Operating Income (Loss) Selling and administrative ($25, + $9 85 units) (32,65) Operating Income $ Ending inventory ($4 15 units) 212 John Wiley and Sons Canada, Ltd. (1,) (25,) $(1,) Gross Margin 33,15 5 Ending inventory $6, [$4+($1,/1,)] 15 units $7,5

10 126 Cost Management C. With no beginning inventory, the reconciliation of variable costing to absorption costing income is affected by only ending inventory: Variable costing operating income (loss) Fixed manufacturing overhead added to ending inventory under absorption costing [(15 units ($1,/1, units)] Absorption costing operating income $(1,) 1,5 $ Absorption and Variable Inventory and Income, Reconciliation Calculations for both costing methods: Selling price: $2, revenue last year / 5, units sold last year = $4 per unit Variable manufacturing cost: $4,/5, units produced = $8 per unit Units in ending inventory = 5, units produced 4,5 units sold = 5 units Variable selling and administration cost: $3,/5, units sold last year = $6 per unit A. Variable costing (1) Ending inventory: $8 variable manufacturing cost per unit * 5 units = $4, (2) Variable costing income statement Revenue ($4 *4,5 units) Variable costs: Manufacturing costs ($8 * 4,5 units) Selling and administration($6 * 4,5 units) Contribution margin Fixed costs: Manufacturing costs Selling and administration Operating Income $18, 36, 27, 117, 6, 5, $ 7, B. Absorption costing Fixed production cost allocation rate: $6,/5, units = $12 per unit Absorption cost per unit = $8 variable manufacturing cost per unit + $12 fixed manufacturing cost per unit = $2 per unit Note: No information is provided about any capacity levels other than actual production volume, so these calculations assume that actual costing is used. (1) Ending inventory: $2 absorption cost per unit 5 units = $1, (2) Absorption Costing Income Statement Revenue ($4 *4,5 units) Cost of goods sold ($2 * 4,5 units) Gross margin Selling and administration[$5, + ($6 * 4,5 units)] Operating Income 212 John Wiley and Sons Canada, Ltd. $18, 9, 9, 77, $ 13,

11 127 C. With no beginning inventory, the reconciliation of variable costing to absorption costing income is affected by only ending inventory: Variable costing operating income Fixed manufacturing overhead added to ending inventory under absorption costing ($12 5 units) Absorption costing operating income $ 7, 6, $13, Absorption and Variable Income Vintage Co. A. Total variable manufacturing costs = $25, + $19,(.55) = $354,5 Variable manufacturing cost per unit = $354,5/4, = $ Cost of ending finished goods inventory = 1, $ = $88,625 B. Under absorption costing, fixed manufacturing overhead would be included in ending finished goods inventory, but it would not be included under variable costing. Therefore, net profit would increase by the following amount: Variable manufacturing overhead / total units produced * ending inventory =($19, * 45%)/4, * 1, = $21,375 decrease in COGS under absorption costing = $21,375 increase in operating income Alternative calculation: Net profit under absorption costing: Revenue [Total production costs / units produced * units sold] selling and administrative = $6, - [($25, + $19,) /4, * 3,] - $15, = $6, - $33, - $15, = $12, Net profit under variable costing: Revenue [Variable production costs/units produced * units sold fixed production costs selling and administrative = $6, - [($25,+($19,*55%)]/4,*3,] - ($19,*45%) - $15, = $6, - $265,875 - $85,5 - $15, = $98,625 Difference = $12, - $98,625 = $21,375 increase 212 John Wiley and Sons Canada, Ltd.

12 128 Cost Management Absorption and Variable Income The Wye Co. Ltd. A. Which income statement was prepared using actual absorption costing? Under actual absorption costing, cost of goods sold is calculated as the actual rate * actual inputs used for both direct and indirect costs. Therefore, no variances would be calculated and the income statement is E. B. Which income statement was prepared using standard variable costing? Under standard variable costing, cost of goods sold is calculated as the standard variable cost * the standard inputs allowed for actual outputs. Therefore, there may be variable cost variances but no fixed cost variances and the income statement is B. C. How many units of product RGW were actually produced during the year? statement D includes all variance therefore it is standard absorption costing. COGS $378, / $42 = 9, units statement B (i.e. standard variable costing) $514, statement D (i.e. standard absorption costing) 58, Fixed overhead in ending inventory $6, $6, / $6 standard fixed overhead per unit = 1, ending inventory units Number of units sold 9, Number of units produced 1, Absorption and Variable Costing Income Hamilton Limited A. Variable costs = $9 + $12 + $15 + $6 = $42 Profit/loss = 7, units* ($72 - $42) - $1,8, - $6, = $2,1, - $2,4, = $3, loss B. 1, units sold - 7, units produced = 3, units in inventory Inventory under absorption costing includes a portion of fixed manufacturing costs, whereas no fixed manufacturing costs are inventoried under variable costing. Therefore, income would be 3, * $18 = $54, higher under absorption costing than under variable costing. ($3,) + $54, = $24, 212 John Wiley and Sons Canada, Ltd.

13 Throughput Inventory and Income, Reconciliation Continuation of A. Throughput costing Direct cost per unit: $25,/5, units produced = $5 per unit Other variable manufacturing costs per unit: ($4, $25,) /5, units produced = $3 per unit (1) Ending inventory: $5 direct cost per unit 5 units = $2,5 (2) Throughput Costing Income Statement Revenue ($4 4,5 units) Direct material costs ($5 4,5 units) Throughput contribution Other costs: Manufacturing costs [$6, + ($3 *5, units)] Selling and administration[$5, + ($6 * 4,5 units)] Operating Income $18, 22,5 157,5 75, 77, $ 5,5 B. With no beginning inventory, the reconciliation of throughput costing to variable costing is affected by only ending inventory: Throughput costing operating income Non-material variable manufacturing costs added to ending inventory under variable costing ($3 5 units) Absorption costing operating income $5,5 1,5 $7, Absorption and Variable Inventory and Income - Plains Irrigation A. The value of inventory is higher when absorption costing is used because some fixed manufacturing overhead is allocated to inventory to match revenue with expense at the time of sale. If there is fixed manufacturing overhead, the value of inventory under absorption costing will always be higher than under variable costing. B. To identify the costing method that would result in higher income, first calculate the change in inventory during October under both methods: October inventory added under absorption costing ($2,598-$1,346) October inventory added under variable costing ($1, ) Difference $1, $ 459 Because $459 more cost was assigned to inventory under absorption costing, operating income during October would be higher by $459 under absorption than under variable costing. 212 John Wiley and Sons Canada, Ltd.

14 13 Cost Management 15.3 Absorption, Variable, and Throughput Inventory and Income - Asian Iron A. 1. Under variable costing: Total variable production cost = (NT$2,3 + 3,3 + 2,8) = NT$8,4 Variable cost per unit = NT$8,4/1,5 = NT$.8 per unit Units in ending inventory = 1,5 9,4 = 1,1 units Ending inventory = NT$.8 x 1,1 units = NT$88 2. Under absorption costing: Fixed manufacturing overhead = NT$8,25/1,5 units = NT$.7857 per unit Total cost per unit = NT$.8 + NT$.7857 = NT$ Ending inventory = NT$ x 1,1 units = NT$1, Under throughput costing: Total direct materials cost per unit = NT$2,3/1,5 units = NT$.2195 Ending inventory = NT$.2195 x 1,1 units = NT$241 C. 1, 2, 3 Variable Costing Absorption Costing Throughput Costing Revenue NT$32,9 Variable costs: Production (NT$.8 x 9,4) (7,52) Selling (94) Contribution margin 24,44 Fixed costs: Production (8,25) Selling and admin. (14,56) NT$ 1,63 Revenue NT$32,9 Cost of goods sold (NT$ x 9,4) (14,96) Gross margin 17,994 Selling and admin. (NT$ ,56) (15,5) NT$ 2,494 Revenue NT$32,9 Direct materials (NT$.2195 x 9,4) (2,59) Throughput margin 3,841 Operating expenses (a) (29,85) NT$ 991 (a) NT$(3,3 + 2, , ,56) = NT$29,85 Double-check computations for absorption versus variable costing: There were no beginning inventories. Therefore, the change in inventory is equal to the ending inventory (calculated in Part A). Inventory under absorption costing NT$1,744 Inventory under variable costing 88 Difference in inventory NT$ 864 Difference in operating income - NT$2,494 - NT$1, John Wiley and Sons Canada, Ltd. NT$ 864

15 131 Double-check computations for absorption versus throughput costing: Inventory under absorption costing NT$1,744 Inventory under throughput costing 241 Difference in inventory NT$1,53 Difference in operating income - NT$2,494 - NT$991 NT$1,53 C. It is first necessary to calculate the revenue and variable costs per unit: Revenue per unit = NT$32,9/9,4 = NT$3.5 Variable production cost per unit = NT$.8 Variable selling cost per unit = NT$94/9,4 = NT$.1 Revenue (12,11 x $3.5) Variable costs: Production (12,11 x NT$.8) Selling (12,11 x NT$.1) Contribution margin Fixed costs: Production Selling and administrative NT$42,385 (9,688) (1,211) 31,486 (8,25) (14,56) NT$ 8, Calculations Using Balance Sheet Data A Manufacturing Firm A. Balance Sheet 2 has higher unit costs in inventory, so it must be an absorption costing statement. B. Assuming that costs per unit did not decrease, the decrease in total cost of inventory from January 1 to January 31 indicates that more units were sold than produced. C. Difference between variable costing income and absorption costing income: Fixed costs in beginning absorption inventory ($38, $17,) $21, Fixed costs in ending absorption inventory ($19, $8,) 11, Variable costing income higher than absorption costing income $1, Calculations Using Income Statement Data A. Absorption costing will have the larger cost per unit for cost of goods sold, so Income Statement 2 must be the absorption costing statement and Income Statement 1 must be the variable costing statement. B. Absorption costing income is higher than variable costing income, so the quantity of units in inventory must have increased during the period. Thus, production exceeded sales. 212 John Wiley and Sons Canada, Ltd.

16 132 Cost Management C. The difference between the two income statements is the treatment of fixed manufacturing overhead costs. Under absorption costing, manufacturing overhead cost per unit is included in cost of goods sold. Under variable costing, the total amount of manufacturing overhead costs incurred during the current period is included in other expenses. Thus, the total amount of fixed overhead can be calculated from the difference in other expenses shown on the two income statements: $4,18 $3,1 = $1,8 Note that fixed overhead cannot be derived by comparing cost of goods sold because some of the fixed overhead will be deferred into ending inventory under absorption costing. The amount deferred this period is: $1,8 ($4,32 3,) = $ Absorption, Variable, and Throughput Income, Reconcile Incomes - Happy Bikers Motorcycle Company A, B, C. Variable Costing Revenue (a) Variable costs: Production (b) Selling (c) Contribution margin Fixed costs: Production Selling and admin. $15, (45,) (3,75) 11,25 Absorption Costing Revenue (a) Cost of goods sold (d) Volume variance (e) Gross margin Selling and admin. (f) $15, (15,) 26,667 71,667 (43,75) $ 27,917 Throughput Costing Revenue (a) Raw materials (g) Throughput margin Operating expenses (h) $15, (3,) 12, (11,75) $ 18,25 (4,) (4,) $ 21,25 Calculation details: (a) Revenue = 15 motorcycles * $1, = $15, (b) Variable production costs = 15 motorcycles * ($2, + $1,) = $45, (c) Variable selling and administrative costs = 15 motorcycles * $25 = $3,75 (d) Absorption cost of goods sold: Normal capacity = 1 motorcycles per month Estimated fixed overhead per motorcycle = $4,/1 = $4, Total fixed and variable production cost per unit = $4, + $2, + $1, = $7, Cost of goods sold = 15 motorcycles* $7, = $15, (e) Volume variance: Fixed production overhead $ 4, Allocated overhead (18 motorcycles * $4,) 72, Overapplied overhead $(32,) Because the volume variance is material relative to actual production costs, it will be prorated between cost of goods sold and ending inventory. The portion allocated to cost of goods sold is: $32, * (15/18 motorcycles) $(26,667) (f) Total selling and administrative expense = $4, + 15 motorcycles * $25 = $43, John Wiley and Sons Canada, Ltd.

17 (g) Total raw materials = 15 motorcycles * $2, = $3, (h) Total operating expenses: Direct labour and variable overhead (18 motorcycles * $1,) Fixed production costs Variable selling and administrative (15 motorcycles * $25) Fixed selling and administrative Total 133 $ 18, 4, 3,75 4, $11,75 D. Here is a schedule to reconcile the three income statements. Recall that inventory increased during the month by 3 units (18 motorcycles manufactured 15 motorcycles sold). Throughput costing operating income $18,25 Direct labour and variable overhead costs added to ending variable costing inventory (3 motorcycles * $1,) 3, Variable costing operating income 21,25 Fixed overhead costs allocated to ending absorption costing income (after the volume variance adjustment, this is equal to actual fixed overhead cost per unit) [3 motorcycles x ($4,/18)] 6,667 Absorption costing operating income $27, Variable and Absorption Costing, Multiyear Analysis LeFiell Manufacturing A sample spreadsheet showing the calculations for this problem is available on the Instructor s web site for the textbook (available at A. and B. Below are the income statements produced using the spreadsheet Units Sold 14, 15, 16, Units Produced 15, 15, 15, $5, Fixed Production Costs $5, $5, 7 Variable production costs per unit Selling price per unit 2 2 Fixed selling and administrative expenses 1, 1, 1, Absorption Costing Revenue (a) Cost of Goods Sold (b) Gross Margin 212 John Wiley and Sons Canada, Ltd. 21 $2,8, 1,516,66 7 $1,283,3 211 $3,, 1,625, $1,375, 212 $3,2, 1,733,33 3 $1,466,6

18 134 Cost Management Selling and Administrative Operating Income 212 John Wiley and Sons Canada, Ltd. 33 1, $1,183,3 33 1, $1,275, 67 1, $1,366,6 67

19 Variable Costing Revenue (a) Variable Production Costs (c) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income 21 $2,8, 1,5, $1,75, 211 $3,, 1,125, $1,875, 212 $3,2, 1,2, $2,, 5, 1, $1,15, 5, 1, $1,275, 5, 1, $1,4, Calculations Details: (a) Revenue = units sold x $2 (b) Absorption Cost of Goods Sold: * Fixed Production Cost per unit = $5, / 15, units= Total Production Cost per unit = $75 + $ = Absorption cost of Goods Sold = $18.33 x units sold (c ) Variable Production Costs = $75 x units sold $ $ *Since fixed overhead costs and production were constant each month the fixed overhead production cost per unit was calculated using the 15, units produced each month. Ending Inventory Value: Absorption Costing $ x units remaining in inventory 21 = 1, units 21 C. 212 John Wiley and Sons Canada, Ltd. 212 $18, $18, = 1, units 212 = units Variable Costing $75 x units remaining in inventory 211 $ $75,. $75,. $ 135

20 136 Cost Management Difference in Operating Income Absorption Costing Income Variable Costing Income Difference in Operating Income Difference in Change in Inventory Absorption costing: Ending Inventory Beginning Inventory Increase (decrease) 212 John Wiley and Sons Canada, Ltd. 21 $1,183,3 33 1,15, 33,333 $18, , $1,275, $1,366,66 7 1,275, 1,4, (33,333) $18,333 $.33 18, , (18, )

21 137 Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference $75,. 75,. 33, $75,. $ 75,. 75,. (75,. ) (33, ) The net income under the absorption costing method is higher in 21 because a portion of the fixed production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 212 the net income was lower under absorption costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 211 the net incomes were the same because production and sales were equal and the higher inventory costs carried over to the balance sheet again. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $ 3,825, under both methods Throughput Costing, Multiyear Approach LeFiell Manufacturing (Continued) A sample spreadsheet showing the calculations for this problem is available on the Instructor s web site for the textbook (available at A and B: Below is the income statement produced using the spreadsheet , 15, 16, Units Sold 15, 15, 15, Units Produced Fixed Production Costs $5, $5, $5, Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Direct materials per unit Throughput Costing Revenue (a) 212 John Wiley and Sons Canada, Ltd , 5 $2,8, , , 5 $3,, $3,2,

22 138 Cost Management Direct material costs (b) Throughput contribution Other costs: Other production costs (c) Selling and administrative expenses (d) Operating Income 212 John Wiley and Sons Canada, Ltd. 7, $2,1, 75, 8, $2,25, $2,4, 875, 1, $1,125, 875, 875, 1, 1, $1,275, $1,425,

23 Calculations Details (a) Revenue = units sold x $2 (b) Direct material costs = units sold x $5 (c ) Other Production Costs = [($75-5) x units produced] + $5, (d) Selling and administrative expenses = $1, Ending Inventory Value: Throughput Costing Direct materials per unit x units remaining in inventory $5,. 21 = 1, units $5,. 211 = 1, units 212 = units Difference in Operating Income Throughput Costing Income Variable Costing Income (15.34) Difference in Operating Income Difference in Change in Inventory Throughput costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference 212 John Wiley and Sons Canada, Ltd $1,125, 1,15, (25, ) 211 $1,275, 1,275, 5,. 5,. 5,. 5,. 75,. 75,. (25,. - 75,. 75, $1,425, 1,4, 25, 5,. (5,. ) 75,. (75,. ) 25,. 139

24 14 Cost Management ) - The net income under the variablecosting method is higher in 21 because a portion of the variable production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 212 the net income was lower under variable costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 211 the net incomes were the same because production and sales were equal and the higher inventory costs carried over to the balance sheet again. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $ 3,825, under both methods Variable and Absorption Costing, Multi-year Approach MacHine Company A sample spreadsheet showing the calculations for this problem is available on the Instructor s web site for the textbook (available at A. and B. 21 Units Sold 5, Units Produced 5,5 Fixed Production Costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Absorption Costing Revenue (a) Cost of Goods Sold (b) Gross Margin Selling and Administrative Operating Income 212 John Wiley and Sons Canada, Ltd. $2, , 21 $875,. 456, $418, ,. $368, , 5 6, $2, 212 6, 5, $2, , 175 5, 211 $962,5. 487, $475, $1,5,. 5,. $425, , $486, ,. $436,

25 Variable Costing Revenue (a) Variable Production Costs (c) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income 21 $875,. 275,. $6,. 211 $962,5. 32,5. $66,. 2,. 5,. $35,. 2,. 2,. 5,. $41,. 5,. $47,. Calculations Details: (a) Revenue = units sold x $175 (b) Absorption Cost of Goods Sold: *Fixed Production Cost per unit (allocated based on actual production) = $2, / actual production each year Total Production Cost per unit = $55 + fixed prod cost per unit **Absorption cost of Goods Sold 21 = units sold x Total prod cost/unit 211 = 5 u (end inv in 27) x $ , u x $ = 1, u (end inv in 28) x $ , u x $95 (c) Variable Production Costs = $55 x units sold $1,5,. 33,. $72, , , , *Since fixed overhead costs and production were not constant each month the fixed overhead production cost per unit was calculated using the actual units produced each month. Alternatively the average could have been calculated based on a normal capacity but this information was not given in the question. **Since the production costs are not the same each year, the cost of goods sold must take into account that the ending inventory from the prior year has a different cost than the current year production. Since the company uses a FIFO costing system the assumption was 212 John Wiley and Sons Canada, Ltd.

26 142 Cost Management made that the beginning inventories were sold first at last year s cost and then the remaining units sold were from current year s production. Ending Inventory Value: Absorption Costing = total production cost / unit x units remaining in inventory $45, = 5 units x $ $88, = 1, units x $ = units Variable Costing $55 x units remaining in inventory C. Difference in Operating Income Absorption Costing Income Variable Costing Income Difference in Operating Income Difference in Change in Inventory Absorption costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory $27,5. $55,. 21 $368, ,. 211 $425, ,. 18, $45, , $88, , , , ,5. 55,. 27,5. Increase (decrease) 27,5. 27,5. Difference 18, , John Wiley and Sons Canada, Ltd. 212 $ $ 212 $436, ,. (33, ) $ 88, (88, ) 55,. (55,. ) (33, )

27 143 The net income under the absorption costing method is higher in 21 and 211 because a portion of the fixed production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 212 the net income was lower under absorption costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 212 the net income was lower using absorption costing by an amount equal to the two previous years when the net income was higher using absorption costing. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $1,23, under both methods Throughput Costing, Multiyear Approach MacHine Company (Continued) A sample spreadsheet showing the calculations for this problem is available on the Instructor s web site for the textbook (available at A. and B. Units Sold Units Produced Fixed Production Costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Direct materials per unit 21 5, 5,5 $2, 211 5,5 6, $2, 212 6, 5, $2, , , , Throughput Costing Revenue (a) Cost of Materials (b) Throughput Margin Other Production Costs (c) Selling and Administrative Operating Income 212 John Wiley and Sons Canada, Ltd. $875,. 1,. $775,. 392,5. 5,. $332,5 $962,5. $1,5,. 11,. 12,. $852,5. $93,. 41,. 375,. 5,. 5,. $392,5 $55,

28 144 Cost Management... Variable Costing (15.36) Revenue (a) Variable Production Costs (d) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income $875,. 275,. $6,. $962,5. 32,5. $66,. $1,5,. 33,. $72,. 2,. 5,. $35,. 2,. 5,. $41,. 2,. 5,. $47,. Calculations Details (a) Revenue = units sold x selling price per unit (b) Throughput Cost of Materials = $2 x units sold (c) Throughput Other Production Costs Fixed Production Cost + (Variable cost per unit - direct materials per unit) x units produced (d ) Variable Production Costs = $55 x units sold Ending Inventory Value: Throughput Costing = materials cost per unit x units remaining in inventory $1,. 21 = 5 units x $2 $2,. 211 = 1, units x $2 212 = units - Variable Costing $55 x units remaining in inventory $27,5. $55,. - Difference in Operating Income Throughput Costing Income 21 $332, $392, $55,. 212 John Wiley and Sons Canada, Ltd.

29 Variable Costing Income Difference in Operating Income Difference in Change in Inventory Throughput costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference 35,. (17,5. ) 41,. (17,5. ) 47,. 35,. 1,. 2,. 1,. 1,. 2,. (2,. ) 55,. 27,5. 27,5. (17,5. ) 55,. (55,. ) 35,. 1,. 27,5. 27,5. (17,5. ) 145 The net income under the variable costing method is higher in 21 and 211 because a portion of the direct materials production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 212 the net income was lower under variable costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 212 the net income was lower using variable costing by an amount equal to the two previous years when the net income was higher using variable costing. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $1,23, under both methods. 212 John Wiley and Sons Canada, Ltd.

30 146 Cost Management PROBLEMS Absorption and Variable Costing Income Statements, Reconciliation of Net Incomes Okanagan Company It is useful to set out the given information in the following format prior to addressing the requirements (there are no WIP inventories). Absorption Costing Sales $9, COGS Beginning FG + COGM Ending FG COGS Gross margin SG&A (all fixed) Operating profit $186, Variable Costing $9, Sales???? $162, 42, $12, Variable costs Manufacturing + SG&A = Total variable costs Contribution margin Fixed costs manufacturing Fixed costs SG&A Operating profit?? 36, 132, 42, A. 1) From the information given in the variable costing income statement, total variable cost of goods sold = Sales CM = $9, 36, = $54,. There are no variable SG&A expenses. Given that unit variable manufacturing cost is $6, total units sold are: $54, / 6 = 9,. 2) From the absorption costing income statement: COGS = Sales Gross margin = $9, $162, = $738,. Since 9, units were sold, the product cost per unit is $738, / 9, = $8.2 3) Unit fixed costs are $8.2 $6 = $2.2. Since total fixed costs are $132, in 29, production must be $132, / 2.2 = 6, units. B. and C. Production and sales quantities are provided for this part. The product cost of manufacturing can thus be determined and the income statements constructed. (b) Absorption Costing Sales (c) Variable Costing $9, Sales $9, COGS Beginning FG (A1) + COGM 2 246, 492,1 212 John Wiley and Sons Canada, Ltd. Variable costs Manufacturing + SG&A 54,

31 3 738, (A2) $162, 42, $12, Ending FG COGS Gross margin SG&A (all fixed) Operating profit = Total variable costs Contribution margin Fixed costs manufacturing Fixed costs SG&A Operating profit , 36, 132, 42, $186, Notes: 1 COGM = 6, * $8.2 = $492,. See A3 and A2 above 2 Beginning FG = COGS COGM = $738, $492, = $246, represents the difference between beginning FG and ending FG. Thus Units in beginning inventory Units in ending inventory = $246, / $8.2 = 3, units 3 Ending FG = 3, beginning inventory units + 6, units produced 9, units sold = units D. Reconciliation Absorption costing operating profit $12, + FC released from beginning inventory (3, * $2.2) 66, FC held back in ending inventory ( * $2.2 = Variable costing operating profit $186, Absorption and Variable Costing Income Statements, Reconciliation of Net Incomes Hermione Corporation A. Absorption costing income statement HERMIONE CORPORTATION Pro-forma Income Statement Absorption Costing Basis Year Ended December 31, 212 Sales (96, * $12.) Costs of goods sold Beginning inventory (4, * $5.) Variable manufacturing cost (1, * $7.5) $75, Fixed overhead, manufacturing 8, Cost of goods manufactured Cost of goods available for sale Ending inventory [8, * ($7.5+($8,/1,)] Cost of goods sold Gross margin Variable selling and administrative (96, * $1.) Fixed selling and administrative Total selling and administrative Net income 212 John Wiley and Sons Canada, Ltd. $1,152, $ 2, 83, $85, (66,4) 783,6 368,4 $ 96, 55, 151, $ 217,4

32 148 Cost Management Variable costing income statement HERMIONE CORPORTATION Pro-forma Income Statement Variable Costing Basis Year ended December 31, 212 Sales $1,152, Costs of goods sold Beginning inventory $ 2, Variable manufacturing cost 75, Variable manufacturing cost of goods available for sale 77, Variable cost of manufacturing in ending inventory (6,) Variable cost of goods sold $71, Variable selling and administrative 96, Total variable cost 86, Contribution margin $ 346, Fixed overhead, manufacturing $8, Fixed selling and administrative 55, Total fixed costs 135, Net income $ 211, Calculations Ending inventory 4, purchased units + 1, manufactured units 96, sold units 8, units Reconciliation Absorption costing net income (NI) Variable costing NI = Fixed cost in ending inventory Fixed cost in beginning inventory $217,4 - $211, = $6,4 8, units x.8 = $6,4 Note: Fixed manufacturing costs per unit = $8,/1, = $.8 There are no fixed costs in beginning inventory since it was purchased from an outside supplier. Those units were not manufactured. 212 John Wiley and Sons Canada, Ltd.

33 Absorption and Variable Costing Income Statements KopyKat Company A. The following calculations will be used in the solution. i) Units in beginning and ending inventory Beginning inventory Production Good available for sale Sales Ending inventory October November 1, units 25, 35, 15, 2, 2, units ---2, 2, ii) Product cost per unit Variable manufacturing Fixed manufacturing September October November $ 18 $ 11 $ 28 $ 18 $ 122 $ 3 $ 18 N/A3 $ 18 1 Total product of beginning inventory is given in the question: $28, / 1, units = $28 per unit total product cost. $28 - $18 variable costs = $1 fixed costs allocated to beginning inventory. 2 Total fixed manufacturing cost/production = $3, = $12 25, 3 Since there is no production in November, fixed costs for the period cannot be unitized. Absorption Format Income Statement October Sales1 Cost of goods sold Beginning inventory2 Costs of goods manufactured3 Ending inventory4 Cost of goods sold Gross margin Selling and administration costs Variable5 Fixed Total selling and administrative costs Net income 212 John Wiley and Sons Canada, Ltd. November $ 75, $1,, 28, 75, (6,) $43, $ 32, 6, 3, ( ) $ 9, $ 1, 45, 26, $ 35, $ 15, 6, 26, $ 32, $ (22,)

34 15 Cost Management 1 October: 15, * $5 November: 2, * $5 2 October: Given November: Same as October ending inventory 3 October: 25, * $3 November: This is the fixed manufacturing cost; no production occurred, thus no variable costs were incurred. 4 October: 2, * $3 November: 5 October: 15, * $3 November: 2, * $3 B. Absorption costing net income Plus fixed cost in beginning inventory1 Minus fixed cost in ending inventory2 Equals variable costing net income October November $ 15, $ 1, $ 24, $(125,) $ (22,) $ 24, $ 2, 1 October: Unit fixed cost * Units in inventory = $1 * 1, = $1, November: Unit fixed cost * Units in inventory = $12 * 2, = $24, 2 October: Unit fixed cost * Units in inventory = $12 * 2, = $24, November: Unit fixed cost * Units in inventory = $12 * = $ C. The CEO s confusion stems from the fact that in November the sales were filled entirely from inventory, and thus the costs in inventory that were deferred in October flow to the income statement as a cost in November. Additionally, since there is no production in November, the company must still cover the fixed manufacturing costs from the sales. Thus the cost of goods sold is $9,. With no excess production in November to absorb the fixed costs, all of this cost is expensed and net income is affected negatively. 212 John Wiley and Sons Canada, Ltd.

35 Absorption and Variable Inventory and Income, Reconcile Incomes - Wild Bird Feeders A sample spreadsheet showing the calculations for this problem is available on the Instructor s web site for the textbook (available at A and B. Absorption and variable costing ending inventory The problem states the 212 actual costs for direct materials, direct labour, and variable manufacturing overhead are the same as the planned costs (i.e., $3,12,/13, units = $24. for direct materials, $2,34,/13, units = $18. for direct labour, and $52,/13,=$4. for variable manufacturing overhead). The problem also states that all over- or underapplied overhead is assigned directly to cost of goods sold. Therefore, the 212 overhead costs assigned to inventory are the same as the planned costs. Thus, the prior year inventory costs are the same as the current year inventory costs, and it does not matter which cost flow assumption the company uses. COST OF ENDING INVENTORY Production cost per unit: Direct materials (actual) Direct labour (actual) Variable manufacturing overhead (allocated=actual) Fixed manufacturing overhead (allocated) Total Units: Beginning inventory Production Sales Ending inventory 211 Absorption Variable Costing Costing $24. $ $51. $ Absorption Variable Costing Costing $24. $ $51. $46. 3, 13, (125,) 5, 35, Cost of ending inventory $1,785, $1,61, C. Manufacturing and total contribution margin VARIABLE COSTING Revenue Variable production costs Manufacturing contribution margin Other variable costs: Variable selling Variable administrative Total contribution margin Fixed costs: Manufacturing overhead Selling Administrative $12,375, (5,75,) 6,625, $1,75, 125, $71, 98, 85, (1,875,) 4,75, (2,54,) $2,21, D. This question asks for the total fixed costs on the income statement and then proceeds to develop that cost in steps as follows. 1. Fixed selling and administration = ($98, + $85,) = $1,83, 212 John Wiley and Sons Canada, Ltd.

36 152 Cost Management 2. Fixed manufacturing overhead allocated to COGS: Fixed overhead at given allocation rate (125, x $5) $625, 3. As noted in the answer to Parts A and B, the cost per unit during 211 was the same as the cost per unit assigned to inventory during 212. Therefore, the cost per unit assigned to cost of goods sold and to inventory is not affected by whether the company s inventory levels increased or decreased during 212. In other words, sales of units that were produced last year do not need to be considered. 4. Calculation of overapplied (underapplied) overhead: Overhead allocated to production Actual overhead (Underapplied) overhead $625, 71, $ (85,) 5. Total fixed costs on income statement = $1,83, + $625, + $85, (because the underapplied overhead is closed to COGS) = $2,54,. E. Variable costs on variable costing income statement (see the solution to Part C): $5,75, + $1,875, = $7,625,. F. Absorption income would be higher than variable income because the company produced more units that it sold, and the units remaining in ending inventories include an allocation of fixed manufacturing overhead cost under absorption costing. Therefore, total overhead expense on the income statement is less under absorption than under variable costing, where the total fixed cost for the period is expensed. G. There are two ways to answer this question. The first method is to calculate the amount of fixed overhead added to inventory under absorption costing. The fixed overhead allocation rate is $5 per unit, and 5, units were added to inventory. Therefore, absorption costing income should be $25, higher than variable costing income. The second method is to prepare the two income statements and compare the results. The difference in income is (income statements are available on the sample spreadsheet for this problem): Absorption costing operating income $2,235, Variable costing operating income 2,21, Difference $ 25, Differences in Income, Choice of Absorption and Variable Costing Nova Scotia Lobsters Company A. Absorption income statements assign all direct production costs and allocate all indirect production costs to inventory. At the time of sale, per unit revenue is matched with per unit expense on the income statement. Variable income statements categorize costs into fixed and variable, and production related and non-production related costs. 212 John Wiley and Sons Canada, Ltd.

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