Chapter 7, Problem 20P

Variable and Absorption Costing Unit Product Costs and Income Statements; Explanation of Difference in Net Operating Income L07—1, L07—2, L07—3
High Country, Inc., produces and sells many recreational products. The company has just opened a new plant to produce a folding camp cotthat will be marketed throughout the United States. The following cost and revenue data relate to May, the first month of the plant’s operation:

Management is anxious to assess the profitability of the new camp cot during the month of May.
Required:
Assume that the company uses absorption costing.
a. Determine the unit product cost.
b. Prepare an income statement for May.
Assume that the company uses variable costing.
a. Determine the unit product cost.
b. Prepare a contribution format income statement for May.
Explain the reason for any difference in the ending inventory balances under the two costing methods and the impact of this differenceon reported net operating income.

To determine

Absorption Costing: is also known as Full costing method. In this method, those costs which vary directly with production are considered in product cost. Also, fixed Manufacturing Expenses are treated as product cost only. Selling Expenses (since they do not vary with production), both variable and fixed, are charged off completely in the period in which the expenses get incurred.

Unit product Cost and Income statement for May.

Answer to Problem 20P

Solution:

Computation of Unit Product Cost under Absorption Costing
Particulars	Per unit cost
Direct Material	$ 20
Direct Labour	$ 8
Variable Manufacturing Overhead	$ 2
Fixed Manufacturing Overhead	$ 27
Total Product Cost	$ 57

Income Statement under Absorption Costing
		May
A	Sales(Sales Volume X Sales Price)	$ 600,000
B	Less: Cost of Goods Sold
C	Beginning Inventory Opening Inventory Quantity X Unit Product Cost of previous year	$ -
D	Add: Cost of Goods Manufactured Production Quantity X Unit Product Cost	570,000
E	Less: Closing Inventory Closing Inventory Quantity X Unit Product Cost of current year	$ 114,000
B	Cost of Goods Sold (C+D-E)	$ 456,000
F	Gross Margin (A - B)	$ 144,000
G	Variable Selling & Admin Expenses (Sales quantity X Variable selling cost per unit)	$ 48,000
H	Fixed Selling Overhead	$ 130,000
I	Net Operating Income (F - G - H)	$ (34,000)

Working Notes:
	May	Remarks
Sales Volume	8,000	(as given in question)
Production Volume	10,000	(as given in question)
Opening Stock	-	(Closing Stock of previous period)
Closing Stock	2,000	(Opening Stock + Production - Sales)
Selling Price per unit	$ 75	(as given in question)
Fixed Manufacturing Cost	$ 270,000
Fixed Manufacturing Cost per unit	$ 27	(Fixed manufacturing cost / Production Qty)
Variable Selling Cost	$ 6

Explanation of Solution

1. In absorption costing, direct material, direct labour, variable manufacturing expenses and fixed manufacturing cost per unit are considered for unit product cost;
2. The income statement under this method requires following computations:

  $\begin{array}{l}\text{Sales - Cost of Goods Sold = Gross Margin}\\ \text{Gross Margin - Total Selling Cost = Net Operating Income}\end{array}$

Cost of Goods Sold comprises of variable as well as fixed manufacturing cost

Total selling expenses comprise of variable as well as fixed selling cost

Given:

Sales volume, production volume and selling price per unit are given in the question.

Formulas:

Cost of Goods Sold:

  $\begin{array}{l}\text{Beginning Inventory Quantity X Variable Production Cost of previous period + }\\ \text{Current Production Quantity X Variable Production cost of current period -}\\ \text{Closing Inventory Quantity X Variable Production Cost of current period}\end{array}$

  $\text{Variable Selling \& Admin Expenses = Sales Quantity X Variable Selling Expenses per unit}$

  $\text{Fixed Manufacturing Cost per unit = }\frac{\text{Fixed manufacturing cost of a period}}{\text{Production Quantity of the same period}}$

Note: Unit product cost here is unit cost computed as per absorption costing.

To determine

Variable Costing: is also known as Direct costing method. In this method, those costs which vary directly with production are considered in product cost. Fixed Manufacturing Expenses are treated as period cost and not product cost. Selling Expenses (since they do not vary with production), both variable and fixed, are charged off completely in the period in which the expenses get incurred.

Unit product Cost and Income statement May

Answer to Problem 20P

Solution:

Computation of Unit Product Cost under Variable Costing
Direct Material	$ 20
Direct Labour	$ 8
Variable Manufacturing Overhead	$ 2
Total Product Cost	$ 30

Income Statement under Variable Costing
		May
A	Sales(Sales Volume X Sales Price)	600,000
B	Less: Cost of Goods Sold
C	Beginning Inventory Opening Inventory Quantity X Unit Product Cost of previous year	$ -
D	Add: Variable Manufacturing Cost Production Quantity X Unit Product Cost	300,000
E	Less: Closing Inventory Closing Inventory Quantity X Unit Product Cost of current year	$ 60,000
B	Cost of Goods Sold (C+D-E)	$ 240,000
F	Variable Selling & Admin Expenses(Sales quantity X Variable selling cost per unit)	$ 48,000
G	Contribution Margin (A-B-F)	$ 312,000
	Sales Value - (Cost of Goods Sold + Variable selling expenses)
H	Fixed Manufacturing Overhead	$ 270,000
I	Fixed Selling Overhead	$ 130,000
J	Net Operating Income	$ (88,000)

Working Notes:
	May	Remarks
Sales Volume	8,000	(as given in question)
Production Volume	10,000	(as given in question)
Opening Stock	-	(as given in question)
Closing Stock	2,000	(Opening Stock + Production - Sales)
Selling Price per unit	$75	(as given in question)
Variable Selling Cost per unit	$6

Explanation of Solution

1. In variable costing, direct material, direct labour and variable manufacturing expenses are considered for unit product cost;
2. The income statement under this method requires following computations:

  $\begin{array}{l}\text{Sales - Variable Cost = Contribution}\\ \text{Contribution - Fixed Cost = Net Operating Income}\end{array}$

Variable cost comprises of variable cost of goods sold and variable selling expenses

Fixed cost comprises of fixed manufacturing cost and fixed selling cost

Given:

Sales volume, production volume, opening stock and selling price per unit are given in the question.

Formulas:

Variable Cost of Goods Sold:

  $\begin{array}{l}\text{Beginning Inventory Quantity X Unit Product Cost of previous period + }\\ \text{Current Production Quantity X Unit Product cost of current period -}\\ \text{Closing Inventory Quantity X Unit Product Cost of current period}\end{array}$

  $\text{Variable Selling \& Admin Expenses = Sales Quantity X Variable Selling Expenses per unit}$

  $\text{Contribution Margin = Sales Value - (Cost of Goods Sold + variable Selling Expenses)}$

Note: Unit product cost here is unit cost computed as per variable costing.

To determine

The difference between the ending inventory values under two costing methods would be on account of fixed cost element on inventory.

Under Variable costing, the inventory is valued at Unit product cost as per variable costing method which is direct material plus direct labour plus variable manufacturing expenses.

Whereas

Under Absorption costing, the inventory is valued at Unit product cost as per absorption costing method which is direct material plus direct labour plus variable manufacturing expenses plus fixed cost per unit.

Due to the inclusion of fixed cost in inventory in absorption costing, following is the impact:

1. Opening inventory is higher resulting in decrease in profit
2. Closing inventory is higher resulting in increase in profit

Reasons for differences in ending inventory

Explanation of Solution

Ending inventory value under absorption costing	$ 114,000
Ending inventory value under variable costing	$ 60,000
Difference in inventory values	$ 54,000
Closing Stock Quantity	2,000 units
Fixed manufacturing cost per unit (considered in unit product cost in absorption costing method)	$ 27
Fixed manufacturing cost absorbed on closing stock (2,000 units X $ 27 per unit)	54,000

Profit under absorption costing	$ (34,000)
Profit under variable costing	$ (88,000)
Difference	$ 54,000

Conclusion

As clear from above, the amount of Fixed manufacturing cost absorbed on closing stock is equal to the difference between inventory values under two costing methods.

Also, since closing stock is higher under absorption costing, as a result, loss is also less by

$ 54,000 as compared to variable costing.