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
Direct labor
Variable factory overhead
Variable selling & administrative
Total variable costs per unit
Fixed costs per month:
Fixed manufacturing overhead
Fixed selling & administrative
Total fixed cost per month

$6.00
12.00
4.00
3.00
$25.00

$240,000
180,000
$420,000

$22.00

$8
$30.00

The product sells for $40 per unit. Production and sales data for May and June, the first two months
of operations, are as follows;
$40.00

May
June

Units
Produced
30,000
30,000

Units
Sold
26,000
34,000

Income statements prepared by the Accounting department, using absorption costing, are
presented below:
May
June
Sales
$1,040,000 $1,360,000
Cost of goods sold
Beginning inventory
$0
$120,000 $120,000
Add cost of goods manufactured
900,000
900,000 $900,000 $900,000
Goods 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 $282,000
Operating income
$2,000
$58,000
Required:
1. Determine the unit product cost under:
a. Absorption costing
b. Variable costing

Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead ($240,000/30,000)

Absorption
Costing
$6.00
12.00
4.00
8.00

Variable
Costing
$6.00
12.00
4.00

$30.00

$22.00

2. Prepare variable costing income statements for May and June using the
contribution approach.
Linden Company
Variable Costing Income Statements
For the Months of May and June
Sales (26,000 X $40; 34,000 X $40)
Variable expenses:
Variable cost of goods sold
Variable selling & administrative
Total variable expenses
Contribution margin
Fixed expenses:
Fixed manufacturing overhead
Fixed selling & administrative
Total fixed expenses
Operating income (loss)

572000
78000
15

May
$1,040,000

June
$1,360,000

$572,000
78,000
$650,000
$390,000

$748,000
102,000
$850,000
$510,000

$240,000
180,000
$420,000
($30,000)

$240,000
180,000
$420,000
$90,000

748000
102000

3. Reconcile the variable costing and absorption costing net operating income figures
May
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
28,000 units per month, computed as follows:
Fixed cost per month/Unit contribution margin = $420,000/$15 per unit = 28,000 units
($40 - $25) = $15

Upon receiving this figure, the president commented, "There's something strange here.
The controller says that the break-even point is 28,000 per month. Yet we sold only
26,000 units in May, and the income statement we received showed a $2,000 profit.
Which figure do we believe?" Prepare a brief explanation of what happened on the May
income statement.

The break-even analysis above assumes that all of Linden Company's $420,000 of monthly fixed
costs will be recognized as expenses each month in its monthly income statements. If Linden
Company 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 was
greater 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 be
recognized in future periods as expense items when the inventory units to which these costs are
assigned are sold. Fewer units need to be sold to B/E since recognized fixed costs are $32,000
less.
Current sales
B/E = ($420,000 - $32,000)/$15 =
Sales greater than B/E
CM per unit sold
Operating income -- 26,000 sales

26,000.00
25,866.67
133.33
$15.00
$2,000.00

Thus, both are correct depending on underlying assumptions.

Normal B/E analysis assumes production = sales. This assumption equates operating income
measured under variable costing with operating income measured under absorption costing.
Since production is greater than sales during May, operating income is greater when measured
using 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 first
three years of activity were as follows (absorption costing basis):
Absorption Costing
Sales
Cost of goods sold
Beginning inventory
Add: Cost of goods manufactured
Cost of goods available for sale
Less: Ending Inventories
Cost of goods sold
Gross margin
Selling and administrative expenses
Net operating income (Loss)

Year 1
$1,000,000

Year 2
$800,000

Year 3
$1,000,000

$0
800,000
$800,000
0
$800,000
$200,000
170,000
$30,000

$0
840,000
$840,000
280,000
$560,000
$240,000
150,000
$90,000

$280,000
760,000
$1,040,000
190,000
$850,000
$150,000
170,000
($20,000)

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 at
60,000 units in order to build a buffer of protection against unexpected spurts in demand. By the start
of Year 3, management could see that spurts in demand were unlikely and that the inventory was
excessive. To work off the excessive inventories, Memotec cut back production during Year 3, as
shown below:
Total
Year 1
Year 2
Year 3
Production 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
labor, and variable manufacturing overhead) total only $4 per unit, and FMOH costs total $600,000
per year.
b. FMOH costs are applied to units of product on the basis of each year's production. (That is, a new
FMOH rate is computed each year).

c. Variable selling and administrative expenses are $2 per unit sold. Fixed selling & administrative
expenses total $70,000
d. The company uses a FIFO inventory flow assumption
Memotec's management can't understand why profits tripled during Year 2 when sales dropped by
20%, 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

Variable Costing
Sales
Variable expenses:
Cost of goods sold ($4 per unit sold)
Selling & administrative ($2/unit sold)
Total variable expenses
Contribution margin
Fixed expenses:
Manufacturing overhead
Selling and administrative expenses
Total fixed expenses
Net operating income (Loss)

$20
$4
$2
$14

50,000

40,000

50,000

Year 1
$1,000,000

Year 2
$800,000

Year 3
$1,000,000

$200,000
100,000
$300,000
$700,000

$160,000
80,000
$240,000
$560,000

$200,000
100,000
$300,000
$700,000

$600,000
70,000
$670,000
$30,000

$600,000
70,000
$670,000
($110,000)

$600,000
70,000
$670,000
$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
Variable cost of goods sold
Fixed manufacturing costs
Unit product costs

Year 1
$4
12
$16

Year 2
$4
10
$14

Year 3
$4
15
$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

NOI -- Variable Costing

Change in inventory Year 2
Production
Sales
Inventory increase
FMOH rate Year 2
Deferred FMOH Costs
Change in inventory Year 3
Fifo Cost Flow
Released from EI Y2
FMOH rate Year 2
BI Y3 Units
Production
Sales
EI Y3 Units
FMOH Rate Year 3
Deferred FMOH Year 3
NOI -- Absorption Costing
NOI -- Absorption Costing

$30,000
60,000
40,000
20,000
$10
$200,000

($110,000)

$30,000

200,000

20,000
$10

(200,000)

20,000
40,000
(50,000)
10,000
$15
$150,000
$30,000
$30,000
OK

$90,000
$90,000
OK

150,000
($20,000)
($20,000)
OK

3. Refer again to the absorption costing income statements. Explain why NOI was higher
in 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.
Decrease in CM in Year 2 (real change)
FMOH costs deferred in inventory (accounting change)
Increase in NOI

($140,000)
200,000
$60,000

($140,000)

4. Refer again to the absorption costing income statements. Explain why the company
suffered a loss in Year 3 but reported a profit in Year 1, although the same number of
units 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)
FMOH costs from Year 3 deferred in EI of Year 3 (10,000 X $15)
Differences in NOI (Year 1 compared with Year 3)

$200,000
150,000
$50,000

5. a. Explain how operations would have differed in Year 2 and Year 3 if the company
had 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 that
little 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 and
the figures reported by the company in the statements above.
If Lean Production had been in use, the NOI under absorption costing would have been the
same as under variable costing in all three years. With production geared to sales, there
would have been no ending inventory on hand, and therefore there would have been no
FMOH 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 level
of expected activity, the income statements under absorption costing would have been

Sales in units
Production (matched to sales)
Absorption Costing
Sales
Cost of goods sold
Beginning inventory
New mfg. costs added:
Variable manufacturing costs ($4)
Fixed mfg. costs applied ($12)
Underapplied overhead
Cost of goods available for sale
Ending Inventories

Year 1
50,000
50,000
Year 1
$1,000,000

Year 2
40,000
40,000
Year 2
$800,000

Year 3
50,000
50,000
Year 3
$1,000,000

$0

$0

$0

200,000
600,000

160,000
480,000
120,000
$760,000
0

200,000
600,000

$800,000
0

$800,000
0

Cost of goods sold

Gross margin
Selling and administrative expenses
Net operating income (Loss)
Note: Same as Variable Costing
Variable Costing NOI

$800,000
$200,000
170,000
$30,000

$760,000
$40,000
150,000
($110,000)

$800,000
$200,000
170,000
$30,000

$30,000

($110,000)

$30,000

Year 1
BI
P
Total

0
50000
50000

DC$

AC$
0

Year 2
0

0
60000
60000

DC$

AC$
0

Year 3
20000
40000
60000

DC$
$80,000

$200,000

AC$
$280,000

S
50000
EI
0
Deferred FC Under AC

40000
20000

$80,000

$280,000
$200,000

50000
10000

$40,000

$190,000
$150,000

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 of
units this year as we did last year, yet our profits have tripled! Who messed up the
calculations?"
The absorption costing income statements to which Ms. Reynolds was referring are shown
below:
Units
Units
40,000
40,000
Sales
40,000
50,000
Production
$6
$6
Var. mfg. $/unit
$2
$2
Var. S&A $/unit
$600,000
$600,000
FMOH $
$15
$12
FMOH $/unit
Year 1
Year 2
Sales (40,000 units each year)
$1,250,000 $1,250,000
$31.25
Cost of goods sold
840,000
720,000
$840,000
Gross margin
$410,000
$530,000
Selling & administrative expense
350,000
350,000
$80,000
Net operating income
$60,000
$180,000

$31.25
$720,000
$80,000

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 costing
b. Variable costing
Year 1
Year 2
Year 1
Absorption Absorption
Variable
Costing
Costing
Costing
Variable mfg.
$6.00
$6.00
$6.00
Fixed MOH
15.00
12.00
N/A
$21.00
$18.00
$6.00

Year 2
Variable
Costing
$6.00
N/A
$6.00

2. Prepare a contribution format income statement for each year using variable costing
Milex Corporation
Variable Costing Contribution Format Income Statement
For Year 1 and Year 2
Sales
Variable expenses:
Cost of goods sold
Selling & Administrative
Total variable expenses
Contribution margin

$1,250,000

$1,250,000

$240,000
80,000
$320,000
$930,000

$240,000
80,000
$320,000
$930,000

$270,000

Fixed expenses:
Fixed manufacturing overhead
Fixed selling & administrative
Total fixed expenses
Net operating income

$600,000
270,000
$870,000
$60,000

$600,000
270,000
$870,000
$60,000

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

Operating variable costing income

Adjustment for Change in inventory during Year
Production
Sales
Increase in inventory
Fixed MOH rate
Fixed $ deferred in inventory
Operating absorption costing income

Year 1
$60,000
40,000
40,000
0
$15.00
$0

0
$60,000

Year 2
$60,000
50,000
40,000
10,000
$12.00
$120,000

120,000
$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 each
year.
Year 2 production was greater than Year 2 sales (P>S). The excess production resulted in
inventory 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 incurred
in 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 costs
incurred 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 a
function 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 expensed
in the year of occurrence; net operating income is a function of sales and can not be manipulated
by merely increasing or decreasing production. Hence, managers prefer absorption costing for
external reporting.
5. a. Explain how operations would have differed in Year 2 if the company had been using Lean
Production 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, costs
associated 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 and
therefore 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
schedule for the last quarter of the year. The Australian Division had planned to sell 100,000 units
during the year, but current projections indicate sales will be only 78,000 units in total. By September 30
the following activity had been reported:
Units
Inventory, January 1
0
Production
72,000
Sales
60,000
Inventory, September 30
12,000
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 be
at least 6,000 units per quarter in order to retain a nucleus of key employees. Maximum production
capacity is 45,000 units per quarter.
Due to the nature of the division's operations, fixed manufacturing overhead is a major element of product
cost.
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 the
required production for a period in a company is: Expected sales + Desired ending
inventory - Beginning inventory = Required production.) Show computations and explain
your answer. Will the number of units scheduled for production affect the division's
reported profit for the year? Explain.
Expected sales for the last quarter of the year
Desired minimum inventory
Total units needed for sales and desired EI
Less: Current inventory on hand -- September 30
Desired production for the 4th quarter

18,000
1,500 **
19,500
12,000
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 or
loss for the year if variable costing is in use. All fixed MOH costs will be treated as an expense
of the period regardless of the number of units produced. Thus, no fixed MOH cost will be shifted
between periods through the inventory account, and income will be a function of the number of units
sold, 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 an
annual bonus based on the division's net operating income. If Mr. Constantinos wants to

maximize his division's net operating income for the year, how many units should be scheduled
for production during the last quarter? Explain.
Expected sales for the last quarter of the year
Maximum inventory storage facilities available
Total units needed for sales and desired EI
Less: Current inventory on hand -- September 30
Desired production for the 4th quarter

18,000
30,000 **
48,000
12,000
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 fixed
MOH 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 net
operating income (and his bonus).
3. Identify the ethical issues involved in the decision Mr. Constantinos must make about the level
of production for the last quarter of the year
Production options:
1. Production schedule designed to draw down inventory
2. Production schedule designed to maximize divisional manager's annual bonus

7,500
36,000

By setting a production schedule that will maximize his division's net operating income -- and maximize
his 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 indication
that demand will be any better next year than it has been in the current year, so the company may be
required 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 sales
and controlling expenses. If Mr. Constantinos sets a production schedule as shown in part (2) above, he
will 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's
bonus would be unethical because it subverts the goals of the overall organization.

Exercise 6-14:
Working with a Segmented Income Statement
Given:
Marple Associates is a consulting firm that specializes in information systems for
construction and landscaping companies. The firm has two offices -- one in Houston
and 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 most
recent year is given below:
Office
Sales
Variable expenses
Contribution margin
Traceable fixed expenses
Market segment margin
Common fixed expenses
(not traceable to offices)
Net operating income

Total Company
Houston
Dallas
$750,000 100.00% $150,000 100.00% $600,000 100.00%
405,000
54.00%
45,000
30.00% 360,000
60.00%
$345,000
46.00% $105,000
70.00% $240,000
40.00%
168,000
22.40%
78,000
52.00%
90,000
15.00%
$177,000
23.60% $27,000
18.00% $150,000
25.00%
120,000
$57,000

16.00%
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 behavior
patterns.
Increase in Dallas sale
Contribution margin ratio
Increase in Company's NOI

$75,000
40.00%
$30,000

2. Refer to the original data. Assume that sales in Houston increased by $50,000
next year and that sales in Dallas remain unchanged. Assume no change in
fixed costs.
a. Prepare a new segmented income statement for the company using the above
format. Show both amounts and percentages.
Office
Total Company
Sales
Variable expenses

$800,000

100.00%

Houston

Dallas

$200,000

100.00%

$600,000

100.00%

420,000

52.50%

60,000

30.00%

360,000

60.00%

$380,000

47.50%

$140,000

70.00%

$240,000

40.00%

168,000

21.00%

78,000

39.00%

90,000

15.00%

$212,000

26.50%

$62,000

31.00%

$150,000

25.00%

(not traceable to offices)

120,000

15.00%

Net operating income

$92,000

11.50%

Contribution margin
Traceable fixed expenses
Market segment margin
Common fixed expenses

b. Observe from the income statement you have prepared that the CM ratio for
Houston has remained unchanged at 70% (the same as in the above data) but
that 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 no
information to suggest that the selling price per unit or the variable cost per
unit have changed.
Exercise 6-15:
Working with a Segmented Income Statement
Given:
Refer to the data in Exercise 6-14. Assume that Dallas' sales by major market
are as follows:
Dallas: Market Clients
Dallas 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
two markets during the next month. The campaign would cost $8,000. Marketing
studies indicate that such a campaign would increase sales in the construction
market by $70,000 or increase sales in the landscaping market by $60,000.
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.

Increased sales from campaign

Construction

Landscaping

Clients

Clients

$70,000

CM ratio for market client

$60,000

35.00%

Increase in contribution margin

Less cost of the campaign
Increased segment margin & NOI

50.00%

$24,500

$30,000

8,000

8,000

$16,500

$22,000

2. In Exercise 6-14, Dallas shows $90,000 in traceable fixed expenses. What

happened to the $90,000 in this exercise?
The $90,000 of traceable fixed cost to Dallas has been accounted for as follows:

Dallas

Construction

Landscaping

Clients

Clients

Traceable fixed costs

$72,000

Common fixed expenses

(not traceable to markets)
Total

18,000
$90,000

$20,000

$52,000