Chapter 7, Problem 23P

Absorption and Variable Costing; Production Constant, Sales Fluctuate L07—1, L07—2, L07—3
Tami Tyler opened Tami’s Creations; Inc., a small manufacturing company, at the beginning of the year. Getting the company through its first quarter of operations placed a considerable strain on Ms. Tyler s personal finances. The following income statement for the first quarter was prepared by a friend who has just completed a course in managerial accounting at State University.

Ms. Tyler is discouraged over the loss shown for the quarter, particularly because she had planned to use the statement as support for a bank loan. Another friend, a CPA; insists that the company should be using absorption costing rather than variable costing and argues that if absorption costing had been used the company probably would have reported at least some profit for the quarter.
At this point; Ms. Tyler is manufacturing only one product—a swimsuit. Production and cost data relating to the swimsuit for the first quarter follow:

Required:
1. Complete the following:
a. Compute the unit product cost under absorption costing.
b. What is the company’s absorption costing net operating income (loss) for the quarter?
c. Reconcile the variable and absorption costing net operating income (loss) figures.
2. Was the CPA correct in suggesting that the company really earned a “profit” for the quarter? Explain.
3. During the second quarter of operations, the company again produced 30,000 units but sold 32,000 units. (Assume no change in total fixed costs.)
a. What is the company’s variable costing net operating income (loss) for the second quarter?
b. What is the company’s absorption costing net operating income (loss) for the second quarter?
c. Reconcile the variable costing and absorption costing net operating incomes for the second quarter.

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 Net Operating Income for the quarter.

Answer to Problem 23P

Solution (a):

Computation of Unit Product Cost under Absorption Costing
	Cost per unit
Direct Material	$ 3.5
Direct Labor	$ 12.0
Variable Manufacturing Overhead	$ 1.0
Fixed Manufacturing Overhead	$ 10.0
Total Product Cost	$ 26.5

Explanation of Solution

• Given:

Direct Material, Direct Labor and Variable Manufacturing Overhead are given in the question

• Formula:

  $\text{Fixed Cost per unit = }\frac{\text{Fixed Manufacturing Cost of a period }}{\text{Total production quantity of the same period}}$

$\begin{array}{l}\text{Unit Product Cost = Direct Material + Direct}\text{}\text{labour + Variable Manufacturing Overhead}\\ \text{ + Fixed Manufacturing Overhead}\end{array}$

• Calculation:

  $\text{Fixed Cost per unit = }\frac{\text{\$ 300,000}}{\text{30,000 units}}=\$10\text{ per unit}$

$\text{Total Unit Product Cost = \$ 3}\text{.50 + \$ 12 + \$ 1 + \$ 10 = \$ 26}\text{.50}$

Conclusion

The unit product cost under absorption costing is $ 26.50

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 Net Operating Income for the quarter.

Answer to Problem 23P

Solution (b):

Income Statement (Contribution Format) under Absorption Costing
	Quarter 1
Sales	$1,120,000
Cost of Goods Sold	$ 742,000
Gross Margin	$ 378,000
Selling & Administrative Expenses	$ 368,000
Net Operating Income	$ 10,000

Explanation of Solution

The income statement under this method requires following computations:

Sales − Cost of Goods Sold = Gross Margin

Gross Margin − Total Selling Cost = Net Operating Income

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 are given as $ 1,120,000

• Formula:

1. $\text{Cost of Goods Sold = Opening Stock + Production - Closing Stock}$
2. $\text{Production Amount = Production Quantity X Unit Product Cost}$
3. $\text{Closing Stock = Production + Opening Stock - Sales }$
4. $\text{Amount of Closing Stock = Closing Stock Quantity X Unit product Cost}$
5. $\begin{array}{l}\text{Selling and Administrative Expenses = Fixed Selling Expenses + (Sales Quantity}\\ \text{ X Variable Selling Expense per unit)}\end{array}$

• Calculation:

Opening Stock = Nil

$\text{Production Amount = 30,000 units X \$ 26}\text{.50 per unit = \$ 795,000}$

$\text{Closing Stock = 30,000 units + Nil - 28,000 units = 2,000 units}$

$\text{Amount of Closing Stock = 2,000 units X \$ 26}\text{.50 per unit = \$ 53,000}$

$\text{Cost of Goods Sold = Nil + \$ 795,000 - \$ 53,000 = \$ 742,000}$

Fixed selling expenses = $ 200,000

$\text{Variable Selling Expenses = 28,000 units }\times \text{ \$ 6 per unit = \$ 168,000}$

$\text{Selling \& Administrative Expenses = \$ 200,000 + \$ 168,000 = \$ 368,000}$

Conclusion

Net Operating Income is $ 10,000

To determine

Reconciliation between Variable costing and Absorption Costing

Answer to Problem 23P

Solution:

Reconciliation
	Quarter 1
Net Operating Income as per Variable Costing	$ (10,000)
Closing Stock	2,000
Opening Stock	-
Difference in Stock (Closing - Opening)	2,000
Fixed Overhead per unit	$ 10
Fixed Overhead on Difference Stock	20,000
Profit as per Absorption Costing	$ 10,000

Explanation of Solution

Reconciliation is done between Net Operating Income as per Variable Costing and that as per Absorption Costing.

The difference between the two net operating income figures would be on account of fixed cost element on inventory.

1. Net operating income under variable costing is taken as a base;
2. Difference of stock quantity is computed as closing stock less opening stock
3. This difference in stock is multiplied with fixed overhead per unit (as computed in Unit product cost). This will the amount of fixed overhead which has been deferred over to the next period;
4. Adding this fixed overhead amount to Net Operating Income as per Variable Costing will give Net Operating Income as per Absorption Costing.

• Given

Opening stock is given as Nil.

• Formula

  $\begin{array}{l}\text{Net Operating Income as per Absorption Costing = Net Operating Income as per Variable Costing }\\ \text{+ Difference in Stock X Fixed Overhead per unit}\end{array}$

Conclusion

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

To determine

Whether company earned profit for the quarter under review

Explanation of Solution

As per CPA the Company did earn profit under absorption costing. However, under absorption costing the fixed expenses get deferred to next period due to absorption in closing stock even though they have actually been incurred.

Conclusion

Though absorption costing shows profit, this is not real profit.

To determine

Reconciliation between Variable costing and Absorption Costing

Answer to Problem 23P

3:

Solution (a):

Tami Tyler's Creations Inc Income Statement (Contribution Format) under Absorption Costing
	Quarter 2
Sales	$1,280,000
Cost of Goods Sold	$ 848,000
Gross Margin	$ 432,000
Selling & Administrative Expenses	$ 392,000
Net Operating Income	$ 40,000

Explanation of Solution

• Formula:

1. $\text{Sales = Sales Quantity X Selling Price per unit}$
2. $\text{Cost of Goods Sold = Opening Stock + Production - Closing Stock}$
3. $\text{Production Amount = Production Quantity X Unit Product Cost}$
4. $\text{Closing Stock = Production + Opening Stock - Sales }$
5. $\begin{array}{l}\text{Selling and Administrative Expenses = Fixed Selling Expenses + (Sales Quantity}\\ \times \text{ Variable Selling Expense per unit)}\end{array}$

Calculation:

$\text{Sales = 32,000 units }\times \text{ \$ 40 per unit = \$ 1,280,000}$

$\text{Cost of Goods Sold = \$ 53,000 + \$ 795,000 }-\text{ Nil = \$ 848,000}$

Value of Opening Stock = $ 53,000

$\text{Production Amount = 30,000 units }\times \text{ \$ 26}\text{.50 per unit = \$ 795,000}$

$\text{Closing Stock = 30,000 units + 2,000 units }-\text{ 32,000 units = Nil}$

$\text{Selling and Administrative Expenses = \$ 200,000 + \$ 168,000 = \$ 368,000}$

Fixed selling expenses = $ 200,000

$\text{Variable Selling Expenses = 32,000 units }\times \text{ \$ 6 per unit = \$ 192,000}$

To determine

Reconciliation between Variable costing and Absorption Costing

Answer to Problem 23P

Solution (b):

Tami Tyler's Creations Inc Income Statement (Contribution Format) under Variable Costing
	Quarter 2
Sales	$1,280,000
Cost of Goods Sold	$ 528,000
Variable selling and administrative expenses	$ 192,000
Contribution Margin	$ 560,000
Fixed Expenses (Manufacturing + Selling)	$ 500,000
Net Operating Income	$ 60,000

Explanation:

Formula:

1. $\text{Sales = Sales Quantity }\times \text{ Selling Price per unit}$
2. $\text{Cost of Goods Sold = Opening Stock + Production - Closing Stock}$
3. $\text{Production Amount = Production Quantity }\times \text{ Unit Product Cost}$
4. $\text{Closing Stock = Production + Opening Stock }-\text{ Sales }$

Calculation:

$\text{Sales = 32,000 units X \$ 40 per unit = \$ 1,280,000}$

$\text{Cost of Goods Sold = \$ 33,000 + \$ 495,000 }-\text{ Nil = \$ 528,000}$

Opening Stock = 2000 units

$\text{Value of Opening Stock = 2,000 units }\times \text{ \$ 16}\text{.50 per unit = \$ 33,000}$

$\text{Production Amount = 30,000 units }\times \text{ \$ 16}\text{.50 per unit = \$ 495,000}$

$\text{Closing Stock = 30,000 units + 2,000 units }-\text{ 32,000 units = Nil}$

Working Notes:

	Quarter 1	Quarter 2
Sales Quantity	28000	32000	(as given in question)
Production Quantity	30000	30000	(as given in question)
Opening Stock	0	2000	(Closing Stock of previous year)
Closing Stock	2000	0	(Opening Stock + Production - Sales)
Selling Price per unit	40	40	(Sales Value $ 1,120,000/ 28,000 units)
Fixed Manufacturing Cost	300000	300000
Fixed Manufacturing Cost per unit	10	10	(Fixed manufacturing cost / Production Qty)
Variable Selling cost per unit	6	6	(as given in question)
Fixed Selling Expenses	200000	200000	(as given in question)
Unit Product Cost under Variable Costing	Quarter 1	Quarter 2
Direct Material	3.5	3.5
Direct Labour	12	12
Variable Manufacturing Overhead	1	1
	16.5	16.5

Explanation of Solution

Formula:

1. $\text{Sales = Sales Quantity }\times \text{ Selling Price per unit}$
2. $\text{Cost of Goods Sold = Opening Stock + Production - Closing Stock}$
3. $\text{Production Amount = Production Quantity }\times \text{ Unit Product Cost}$
4. $\text{Closing Stock = Production + Opening Stock }-\text{ Sales }$

Calculation:

$\text{Sales = 32,000 units X \$ 40 per unit = \$ 1,280,000}$

$\text{Cost of Goods Sold = \$ 33,000 + \$ 495,000 }-\text{ Nil = \$ 528,000}$

Opening Stock = 2000 units

$\text{Value of Opening Stock = 2,000 units }\times \text{ \$ 16}\text{.50 per unit = \$ 33,000}$

$\text{Production Amount = 30,000 units }\times \text{ \$ 16}\text{.50 per unit = \$ 495,000}$

$\text{Closing Stock = 30,000 units + 2,000 units }-\text{ 32,000 units = Nil}$

Working Notes:

	Quarter 1	Quarter 2
Sales Quantity	28000	32000	(as given in question)
Production Quantity	30000	30000	(as given in question)
Opening Stock	0	2000	(Closing Stock of previous year)
Closing Stock	2000	0	(Opening Stock + Production - Sales)
Selling Price per unit	40	40	(Sales Value $ 1,120,000/ 28,000 units)
Fixed Manufacturing Cost	300000	300000
Fixed Manufacturing Cost per unit	10	10	(Fixed manufacturing cost / Production Qty)
Variable Selling cost per unit	6	6	(as given in question)
Fixed Selling Expenses	200000	200000	(as given in question)
Unit Product Cost under Variable Costing	Quarter 1	Quarter 2
Direct Material	3.5	3.5
Direct Labour	12	12
Variable Manufacturing Overhead	1	1
	16.5	16.5

Conclusion

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

To determine

Reconciliation between Variable costing and Absorption Costing

Answer to Problem 23P

Solution:

Reconciliation
	Quarter 1
Net Operating Income as per Variable Costing	$ 60,000
Closing Stock	-
Opening Stock	2,000
Difference in Stock (Closing - Opening)	(2,000)
Fixed Overhead per unit	$ 10
Fixed Overhead on Difference Stock	(20,000)
Profit as per Absorption Costing	$ 40,000

Explanation of Solution

Reconciliation is done between Net Operating Income as per Variable Costing and that as per Absorption Costing.

The difference between the two net operating income figures would be on account of fixed cost element on inventory.

1. Net operating income under variable costing is taken as a base;
2. Difference of stock quantity is computed as closing stock less opening stock
3. This difference in stock is multiplied with fixed overhead per unit (as computed in Unit product cost). This will the amount of fixed overhead which has been deferred over to the next period;
4. Adding this fixed overhead amount to Net Operating Income as per Variable Costing will give Net Operating Income as per Absorption Costing.

• Given

Opening stock is calculated as 2,000 units from previous solutions.

Closing stock is available as Nil

• Formula

  $\begin{array}{l}\text{Net Operating Income as per Absorption Costing = Net Operating Income as per Variable Costing }\\ \text{+ Difference in Stock }\times \text{ Fixed Overhead per unit}\end{array}$

Conclusion

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