CHAPTER 20

DISCUSSION QUESTIONS

Q20-1. Direct costs are direct materials, direct labor,

and other costs directly assignable to a product.
Direct costing is a procedure by which only
prime costs plus variable factory overhead
are assigned to a product or inventory; all
fixed costs are considered period costs.
Q20-2. Product costs are associated with the manufacture of a product and include direct materials, direct labor, and factory overhead. These
costs are charged against revenue as cost of
goods sold, or shown on the balance sheet as
inventories of work in process and finished
goods. Period costs are associated with the
passage of time and are included as expenses
in the income statement. Under direct costing,
fixed factory overhead is treated as a period
cost rather than as a product cost.
Q20-3. Under direct costing, only variable manufacturing costs are included in inventory. Under
absorption costing (the current, generally
accepted method of costing inventory for external reporting), all manufacturing costs, both
variable and fixed, are included in inventory.
Q20-4. It is argued that fixed manufacturing costs are
the expenses of maintaining productive
capacity. Such expenses are more closely
associated with the passage of time than with
production activity and should, therefore, be
charged to period expense rather than to the
product.
Q20-5. The direct costing method is useful for internal reporting because it focuses attention on
the fixed-variable cost relationship and the
contribution margin concept. It facilitates managerial decision making, product pricing, and
cost control. It allows certain calculations to
be readily made, such as break-even points
and contribution margins of products, sales
territories, operating divisions, etc. The focus
on the contribution margin (sales revenue
less variable costs) enables management to
emphasize profitability in making short-run
business decisions. Fixed costs are not easily
controllable in the short run and hence may
not be particularly relevant for short-run business decisions.

Q20-6. Arguments for the use of direct costing

include the following:
(a) For profit-planning and decision-making
purposes, management requires costvolume-profit relationship data that are
more readily available from direct cost
statements than from absorption cost
statements.
(b) Since fixed factory overhead is absorbed
as a period cost, fluctuations in production and differences between the number
of units produced and the number sold do
not affect the per unit product cost.
(c) Direct costing reports are more easily
understood by management because the
statements follow managements decision-making processes more closely than
do absorption cost statements.
(d) Reporting the total fixed cost for the
period in the income statement directs
managements attention to the relationship of such cost to profits.
(e) The elimination of allocated joint fixed cost
permits a more objective appraisal of
income contributions according to products, sales areas, kinds of customers, etc.
Cost-volume relationships are highlighted.
(f) The similarity of the underlying concepts
of direct costing and flexible budgets facilitates the adoption and use of these
methods for reporting and cost control.
(g) Direct costing provides a means of costing
inventory that is similar to managements
concept of inventory cost as the current
out-of-pocket expenditures necessary to
produce or replace the inventory.
(h) Clerical costs are lower under direct costing because the method is simpler and
does not require involved allocations of
fixed costs or special analyses of absorption data.
(i) The computation of product costs is simpler and more reliable under direct costing
because a basis for allocating the fixed
costs, which involves estimates and personal judgment, is eliminated.

20-1

20-2

Q20-7. Arguments against the use of direct costing

include the following:
(a) Separation of costs into fixed and variable
might be difficult, especially when such
costs are semivariable in nature.
Moreover, all costsincluding fixed
costsare variable at some level of production and in the long run.
(b) Long-range pricing of products and other
long-range policy decisions require a
knowledge of complete manufacturing
cost, which would require additional separate computations to allocate fixed overhead.
(c) The pricing of inventories by the direct
costing method is not acceptable for
income tax computation purposes.
(d) Direct costing has not been recognized
as conforming with generally accepted
accounting principles applied in the
preparation of financial statements for
stockholders and the general public.
(e) Profits determined by direct costing are not
true and proper because of the exclusion
of fixed production costs that are part of
total production costs and inventory.
Production would not be possible without
plant facilities, equipment, etc. To disregard
these fixed costs violates the general principle of matching costs with revenue.
(f) The elimination of fixed costs from inventory results in a lower figure and consequent reduction of reported working
capital for financial analysis purposes.
Q20-8. Assuming that the quantity of ending inventory is larger than the quantity of beginning
inventory and the lifo method is used, operating income using direct costing would be
smaller than operating income using absorption costing. Direct costing excludes fixed factory overhead from inventories because such
costs are considered to be period costs which
are expensed when incurred. In contrast,
absorption costing includes fixed factory overhead in inventories because such costs are
considered to be product costs, which are
expensed only when the products are sold.
When the quantity of inventory increases during a period, direct costing produces a lower
dollar increase in inventory than absorption
costing, because fixed costs are expensed
rather than charged to inventory. Since a
smaller amount of current period cost is

Chapter 20

charged against income under the absorption

costing method when inventories increase,
absorption costing income would be larger
than direct costing income.
Q20-9. The break-even point is the point at which
costs and revenue are in equilibrium, showing
neither profit nor loss for the business.
Q20-10. The contribution margin is the result of subtracting variable cost from the sales figure. The
contribution margin indicates the amount available for the recovery of fixed cost and for profit.
Q20-11.(a) R(BE) = F
1V
or (in words):
Revenue at the =
Total fixed cost
break-even point
Contribution margin
per dollar of sales
(b) Q(BE) =
F
PC
or (in words):
Units of sales at =
Total fixed cost
break-even point
Contribution margin
per unit of sales
Q20-12. (1) Dollars of revenue and costs.
(2) Volume of output, expressed in units, percent of capacity, sales, or some other
measure.
(3) Total cost line.
(4) Variable cost area.
(5) Fixed cost area.
(6) Break-even point.
(7) Loss area.
(8) Profit area.
(9) Sales line.
Q20-13. An analysis of the expected behavior of a
firms expenses and revenue for the purpose
of constructing a break-even chart is usually
restricted to the output levels at which the firm
is likely to operate. Assumptions about the
level of fixed cost, the rate of variable cost,
and sales prices are based on the operating
conditions and managerial policies that will be
in effect over the expected output levels.
These expected output levels represent the
firms relevant range, and the cost-volumeprofit relationships shown in a break-even
chart are applicable only to output levels
within this range. The behavior of fixed cost,
variable cost, and sales prices at levels of output below or above the relevant range are
likely to result in an entirely different set of
cost-volume-profit relationships because of

Chapter 20

changed operating conditions or managerial

policies. The fact that the cost and revenue
lines on a break-even chart are typically
extended past the upper and lower limits of
the relevant range should not, therefore, be
interpreted to mean that they are valid for
these levels of output.
A break-oven chart showing cost-volumeprofit relationships for all levels of output could
be developed. The shapes of the cost and revenue lines in such a chart could not, however,
be expected to approximate straight-line (linear) patterns. By restricting the underlying cost
and revenue behavior assumptions in breakeven analyses to a relatively narrow output
range (the range over which the firm is likely to
operate), it is usually possible to assume linear
behavior patterns without any significant distortions in cost-volume-profit relationships,
thereby simplifying the analysis.
If the range over which a firm is likely to
operate is quite wide, curvilinear functions
may be employed; or it may be desirable to
develop a number of break-even charts, each
having its own relevant range, for which the
underlying cost and revenue behavior
assumptions are valid.
Q20-14. Weaknesses inherent in the preparation and
use of break-even analysis are:
(a) When more than one product is produced, the contribution margin of each
product will probably differ. Accordingly, a
break-even analysis for the whole operation will not indicate the contribution of
each product to fixed cost and the volume
required for each product.
(b) Some costs are almost impossible to
classify conclusively as being either fixed
or variable.
(c) General economic conditions and other
external factors may affect the data used
in the analysis.
(d) In the final analysis, fixed cost is related to
production and sales and, therefore, may
decrease somewhat due to decreased
production and salesand vice versa.
(e) Quite often costs increase sharply at certain points in production and sales levels
and then level out until a certain greater
stage of production and/or sales is
reached, at which time the phenomenon
is repeated as production and/or sales
are again increased.

20-3

(f) Performance must be constantly compared to the break-even analysis in order

to determine whether the conditions that
existed at the time of the calculations
have held true, and whether any changes
have been considered.
Q20-15. (a) With sales price per unit and total fixed
cost remaining constant, the break-even
point moves up rapidly as unit variable
cost is increased; at the same time, the
break-even point moves down as unit
variable cost is decreased.
(b) A decrease in fixed cost lowers the breakeven point. An increase in fixed cost
moves the break-even point higher.
Q20-16. The margin of safety is a selected sales figure
less break-even sales. The margin of safety is
a cushion against sales decreases. The
greater the margin, the greater the cushion
against suffering a loss.
Q20-17. Cost-volume-profit relationship is the relationship of profit to sales volume. This relationship
is important to management because management tries at all times to keep volume,
cost, price, and product mix in a ratio that will
achieve a desired level of profit.
Q20-18. The Theory of Constraints is a specialized
version of direct costing for use in short-run
optimization decisions. A distinction between
TOC and direct costing is that TOC focuses
on only the purely variable costs and does not
consider direct labor to be purely variable.
Q20-19. Most companies that classify costs into fixed
and variable categories treat direct labor as
variable, so in direct costing, direct labor is
assigned to products as a variable or incremental cost of production. In the Theory of
Constraints, direct labor is stipulated to be not
purely variable and therefore is not treated as
an incremental cost of output.
The difference between the contribution
margin measure in direct costing and the
throughput measure in TOC is that direct
labor is one of the costs deducted from sales
to calculate contribution margin, but direct
labor is not a cost to be deducted from sales
in calculating throughput.
There are many differences in emphasis
between direct costing and the Theory of
Constraints. For example, while direct costing is widely used as an accounting
approach for internal reporting of income
and product cost, TOC deals heavily with the

20-4

improvement of constraints or bottlenecks in a

production system.
Q20-20. Throughput is the rate at which a system generates money through sales. It is calculated
as sales minus the purely variable costs, and
often the only purely variable cost is the cost
of materials.
Q20-21. Elevating a constraint means improving the
constraintimproving the conditions at a bottleneck in the system. Its significance is greatest if the constraint is the tightest one in the

Chapter 20

system; there, any improvement will increase

the total throughput of the entire system.
An improvement in product quality can help
elevate a constraint because it can reduce the
workload on a bottleneck resource. For example, removing defective units before rather
than after they reach the bottleneck means
there will be fewer units passing through the
bottleneck. This has approximately the same
effect on the bottleneck as increasing its
capacity.

Chapter 20

20-5

EXERCISES
E20-1
Operating income for 20A using direct costing:
Sales (90,000 $12) ..................................................................
Variable cost of goods sold (90,000 $4) ..............................
Gross contribution margin .......................................................
Variable marketing and administrative expenses
(90,000 $20) ................................................................
Contribution margin..................................................................
Less fixed expenses:
Factory overhead........................................ $200,000
Marketing and administrative expenses ..
90,000
Operating income......................................................................

$1,080,000
360,000
$ 720,000
18,000
$ 702,000

290,000
$ 412,000

E20-2
(1)

Variable cost
$7,000,000
60%
$4,200,000

per unit:
total variable cost
manufacturing cost portion
total variable manufacturing cost

$4,200,000 total variable manufacturing cost

140,000 units actually produced

$30 per unit

Fixed cost per unit:

$11,200,000 total fixed cost
50% manufacturing cost portion
$5,600,000 total fixed factory overhead
$5,600,000 total fixed factory overhead
160,000 units normal production volume
Full cost per unit at standard
Number of units sold during the year
Cost of goods sold at standard under
absorption costing
(2)

35 per unit
$65
100,000
$6,500,000

Units actually produced during the year....................

140,000
Units sold during the year ...........................................
100,000
Unit increase in inventory ...........................................
40,000
Standard variable manufacturing cost per unit.........
30
Ending inventory at standard direct cost .................. $1,200,000

20-6

Chapter 20

E20-2 (Concluded)
(3)

(4)

Normal production volume.....................................................

Units actually produced during the year ..............................
Excess of budget over actual production.............................
Fixed factory overhead per unit.............................................
Factory overhead volume variance .......................................
Sales (100,000 units $180)...................................................
Standard variable cost of goods sold (100,000 units $30
unit variable cost)...........................................................
Gross contribution margin .....................................................
Variable selling expense ($7,000,000 variable cost 40%).
Contribution margin ................................................................
Less fixed costs ......................................................................
Operating income under direct costing ................................

160,000
140,000
20,000
$35
700,000

$18,000,000
3,000,000
$15,000,000
2,800,000
$12,200,000
11,200,000
$1,000,000

E20-3
(1)

(2)

(3)

Income statement using absorption costing:

Sales (9,000 $30) ..................................................................
Cost of goods sold (9,000 ($10 + $5)) ................................
Gross profit ..............................................................................
Less commercial expenses....................................................
Operating income....................................................................
Income statement using direct costing:
Sales (9,000 $30) ..................................................................
Variable cost of goods sold (9,000 $10).............................
Contribution margin ................................................................
Less fixed expenses:
Factory overhead ..................................
$40,000
Commercial expenses ..........................
44,000
Operating income....................................................................
Computations explaining the difference in operating income:
Absorption costing operating income ..................................
Direct costing operating income ...........................................
Difference .................................................................................
Units produced during the period .........................................
Units sold during the period ..................................................
Unit decrease in finished goods inventory .........................
Fixed factory overhead charged to each unit of product
under absorption costing ..............................................
Difference .................................................................................

$270,000
135,000
$135,000
44,000
$ 91,000
$270,000
90,000
$180,000

84,000
$ 96,000
$ 91,000
96,000
$ (5,000)
8,000
9,000
(1,000)

$5
$ (5,000)

Chapter 20

20-7

E20-4
$6, 000 $6, 000
$6, 000
=
=
= $10, 000 break-even po
oint in dollars
1 $ .80 1 .40
.60
$2.00
$10,000 $2 = 5,000 break-even point in units
(or)
$6, 000
$6, 000
=
= 5, 000 break-even point in units
$2, 00 $.80
$1.20
5,0
000 units $2 = $10,000 break-even point in dollars
E20-5
Materials ...................................................................................
Direct labor ..............................................................................
Variable factory overhead.......................................................
Variable marketing expense ...................................................
Total variable cost per unit.....................................................

Sales price per unit .................................................................

Variable cost per unit..............................................................
Contribution margin per unit..................................................

Fixed factory overhead ...........................................................

Fixed marketing expense .......................................................
Fixed administrative expense ................................................
Total fixed expense .................................................................

$15,000
5,000
6,000
$26,000

(1)

$26,000 total fixed cost

$2 contribution margin

(2)

13,000 units $5 per unit = $65,000 sales to break even

(3)

$26,000 fixed cost + $10,000 profit = 18,000 units

$2 contribution margin

(4)

18,000 units $5 per unit = $90,000 sales

1.00
1.20
.50
.30
3.00
5.00
3.00
2.00

= 13,000 units of sales to break even

E20-6
Planned sales ..........................................................................
Break-even sales .....................................................................
Margin of safety.......................................................................

$2,000,000
1,500,000
$ 500,000

20-8

Chapter 20

E20-6 (Continued)
$500,000 Margin of safety = 25% Margin of safety ratio
$2,000,000 Planned sales
E20-7
(1)

$9, 300
= $15, 000 break-even point sales
.62

(2)

$15, 000 $15, 000

=
= $20, 000 actual sales
1 .25
.75

(3)

PR = C/M M/S; PR = .62 .25 = .155

$20,000 .155 = $3,100 profit for the month

E20-8
(1)

$30, 000
= $50, 000 break-even sales
.60

(2)

$50, 000 $50, 000

=
= $62, 500 sales for the year
1 .20
.80
PR = C/M M/S; PR = .20 .60 = .12
$62,500 .12 = $7,500 profit for the year

(3)

Sales .........................................................................................
Variable cost ($62,500 (1 .60))..........................................
Contribution margin ($62,500 .60) ......................................

$62,500
25,000
$37,500

E20-9
Chip A

Chip B

Total

Sales:
(100,000 $8).......................................
(200,000 $6).......................................
Variable cost:
($800,000 30%)..................................

$800,000
$1,200,000

$2,000,000

($1,200,000 25%)...............................
Contribution margin.........................................

300,000
$560,000 $ 900,000

540,000
$1,460,000

Planned operating profit .................................

Fixed cost .........................................................

240,000

270,000
$1,190,000

Chapter 20

20-9

E20-10
Sales price per unit ......................................................
Variable cost per unit ...................................................
Contribution margin per unit.......................................

Tables
$110
50
$ 60

Chairs
$35
20
$15

$720, 000 fixed cost

= $1, 500, 000 sales to break even
1 ((($50 + (4 $20)) ($110 + (4 $35)))
or alternatively:
$720, 000 fixed cost
= $1, 500, 000 sales to break even
($60 + (4 $15)) ($110 + (4 $35))
$1, 500, 000 sales
= 6, 000 hypothetical packages
$110 + (4 $35)
or alternatively:
$720, 000 fixed cost
= 6, 000 hypothetical packages
$60 + (4 $15) CM
6,000 packages 1 table per package
6,000 packages 4 chairs per package
6,000 tables $110 per table..............
24,000 chairs $ 35 per chair ............
Total sales to break even....................

= 6,000 tables to break even

= 24,000 chairs to break even
= $ 660,000
=
840,000
$1,500,000

E20-11
Product L Product M
Sales price per unit .............................
$20
$15
Variable cost per unit..........................
12
10
Unit contribution margin ....................
$ 8
$ 5
Expected sales mix .............................
2
3
Contribution margin per
hypothetical package .................
$16
+
$15
=

$31

20-10

Chapter 20

E20-11 (Concluded)
(1)

$372,000 fixed cost

$31 contribution margin

= 12,000 packages to break even

12,000 packages

2 units of L
=
12,000 packages

3 units of M =
24,000 units of L

$20
=
36,000 units of M

$15
=
Break-even sales.......................................................
(2)

24,000 units of L
36,000 units of M
$ 480,000 sales of L
540,000 sales of M
$1,020,000

$372,000 fixed cost + $93,000 profit = 15,000 packages to achieve profit

$31 contribution margin
15,000 packages

2 units of L
= 30,000 units of L
15,000 packages

3 units of M = 45,000 units of M

30,000 units of L

$20
=
$600,000 sales of L
45,000 units of M

$15
=
675,000 sales of M
Sales to achieve profit.............................................. $1,275,000

E20-12
(1)

Variable manufacturing cost...............................................................

Fixed manufacturing cost ...................................................................
Variable marketing expense................................................................
Fixed marketing and administrative expenses .................................
Total costs to produce and sell 70,000 units ....................................
$455,000 total cost
70,000 units

$210,000
80,000
105,000
60,000
$455,000

= $6.50 sales price per unit to break even

(2)

($80,000 + $60,000) fixed cost = 51,852 units

$8 $4.50 (10% $8)

(3)

($147,000 + $60,000) fixed cost

$8 $4.50 (15% $8)

= 90,000 units

CGA-Canada (adapted). Reprint with permission.

7,000
8,000

Profit
Area

Variable
Cost

Total Cost Line

9,000
10,000

Fixed
Cost

1,000

2,000

4,000

6,000

$200,000

$180,000

$160,000

$140,000

$120,000

$100,000

$80,000

$60,000

$40,000

$20,000

Sales Revenue

Units of Sales

$10,000

$10,000

5,000

$20,000

$30,000

$40,000

$20,000

$30,000

$40,000

3,000

$60,000
$50,000

$60,000

$70,000

$50,000

$70,000

$80,000

Fixed Cost Line

$80,000

$90,000

$100,000

$100,000

Loss Area

$110,000

$110,000

$90,000

$120,000

$120,000

$130,000

$140,000

$130,000

$140,000

$160,000
$150,000

Break-Even Point

$170,000

$180,000

$150,000

$160,000

$170,000

$180,000

$190,000

$190,000

Sales Revenue Line

Costs
$200,000

Costs

2,000

3,000
4,000

5,000
6,000

8,000

9,000
10,000

Profit
Area

$200,000

$180,000
$160,000

$140,000

7,000

$120,000

$100,000
$80,000

$60,000
$40,000

$20,000

1,000

Variable Cost Line

Loss Area

Total Cost Line

Break-Even Point

Sales Revenue Line

Alternative break-even chart:

$200,000

E20-13 Break-even chart:

Sales Revenue

Units of Sales

Variable
Cost

Fixed
Cost

Chapter 20
20-11

20-12

Chapter 20

E20-14
(1)

throughput/unit = sales materials cost = $45 ($14 + $1) = $30

(2)

Maximum throughput per month is $144,000. Total throughput for a period is the
$30/unit (from requirement 1) multiplied by the number of units shipped; units
are limited by the lowest-capacity operation, which is Surface Preps 4,800 units
per month: 4,800 units/month $30/unit = $144,000/month.

(3)

Surface Prep is the tightest constraint, with a 4,800-unit capacity.

E20-15
(1)

No, they should not acquire the equipment. Gloss Coat is not the tightest constraint, so increasing its capacity will not help.

(2)

Zero. Maximum monthly throughput will not increase.

(3)

Yes, an additional Surface Prep (SP) crew should be hired. The increase in overall throughput more than justifies the cost.

(4)

Maximum throughput will increase by about $15,000 per month (500 units/month
$30/unit). SP is the tightest constraint, so increasing its capacity will increase
throughput of the entire system until SPs improvement causes another constraint to become the tightest. Gloss Coat, the second-tightest constraint,
presently has capacity 500 units higher than SPs.

E20-16
(1)

Yes, an inspection should be created just prior to Surface Prep (SP). For each
1,000 shipped, 50 defectives enter SP26, 14, and 10 arising in the three preceding operations, respectively. SP is the tightest constraint, so removing defectives prior to SP will increase total system throughput. At $30 throughput per
unit, the 50 added units (per thousand shipped) do justify the added inspection.

(2)

Removing all defectives just prior to SP will increase the number of good units
entering SP by 50/1,000 or about 5%. With SP presently handling 4,800 units per
month, a 5% increase in units shipped is .05 4,800 = 240. Additional throughput will be 240 units/month $30/unit = $7,200 per month. Because the inspection will cost $1,800 per month, the monthly advantage of the added inspection
operation will be $7,200 minus $1,800, or $5,400 per month.

Chapter 20

20-13

PROBLEMS
P20-1
TAYLOR TOOL CORPORATION
Product-Line Income Statement
(Contribution Margin Approach)

Total

Electronic
Tools

Pneumatic
Tools

Hand
Tools

Sales .......................................................
Less variable cost of goods sold ........

$3,000,000
1,400,000

$1,500,000
700,000

$1,000,000
500,000

$500,000
200,000

Gross contribution margin ...................

Less variable marketing expenses
(packing and shipping) ....................

$1,600,000

$ 800,000

$ 500,000

$300,000

250,000

100,000

100,000

50,000

Contribution margin..............................

$1,350,000

$ 700,000

$ 400,000

$250,000

Less traceable fixed expenses:

Manufacturing...................................
Marketing (advertising)....................

$ 250,000
450,000

$ 100,000
200,000

$ 100,000
200,000

$ 50,000
50,000

Total traceable fixed expense......

$ 700,000

$ 300,000

$ 300,000

$100,000

Product contribution.............................

$ 650,000

$ 400,000

$ 100,000

$150,000

Less common fixed expenses:

Manufacturing1 .................................
Marketing2 .........................................
Administration ..................................

$ 300,000
100,000
150,000

Total common fixed expenses ....

$ 550,000

Operating income..................................

$ 100,000

1
2

$1,950,000 absorption cost of goods sold $1,400,000 variable costs $250,000 traceable fixed cost
$800,000 total marketing costs $250,000 variable expense $450,000 advertising expense

20-14

P20-2
(1)

Chapter 20

ROBERTS CORPORATION
Income Statement
For Year Ended 12-31-20
Sales (52,000 $25)......................................................................
Cost of goods sold:
Standard full cost (52,000 $15) ......................... $780,000
Net unfavorable variable cost variances .............
2,000
Unfavorable volume variance* .............................
5,000
Gross profit ...................................................................................
Less commercial expenses:
Variable expenses (52,000 $1)........................... $ 52,000
Fixed expenses ......................................................
180,000
Operating income under absorption costing ............

$1,300,000

787,000
$ 513,000

232,000
$ 281,000

*Units budgeted for production during the year.........................

Units actually produced during the year....................................
Fixed factory overhead charged to each unit............................
Unfavorable volume variance ......................................................
(2)

(3)

$
$

50,000
49,000
1,000
5
5,000

ROBERTS CORPORATION
Income Statement
For Year Ended 12-31-20
Sales (52,000 $25)......................................................................
Cost of goods sold:
Standard variable cost (52,000 $10) ................. $520,000
Net unfavorable variable cost variances .............
2,000
Gross contribution margin ..........................................
Variable commercial expenses (52,000 $1).............................
Contribution margin .....................................................................
Less fixed costs:
Factory overhead
(50,000 units budgeted $5) .......................... $250,000
Commercial expenses...........................................
180,000
Operating income under direct costing .....................................

$1,300,000

430,000
$ 296,000

Operating income under absorption costing.............................

Operating income under direct costing .....................................
Difference ......................................................................................

$ 281,000
296,000
$ (15,000)

Units produced during the year ..................................................

Units sold during the year ...........................................................
Unit decrease in finished goods inventory ................................
Fixed factory overhead charged to each unit under
absorption costing ....................................................................
Difference ......................................................................................

49,000
52,000
(3,000)

522,000
$ 778,000
52,000
$ 726,000

$
5
$ (15,000)

Chapter 20

P20-3
(1)

PLACID CORPORATION
Income Statement
For Year Ended 12-31-20
Sales (48,000 $16)......................................................................
Cost of goods sold:
Standard full cost (48,000 $9) ........................... $432,000
Net unfavorable variable cost variances .............
1,000
Favorable volume variance* .................................
(3,000)
Gross profit ...................................................................................
Less commercial expenses:
Variable expenses (48,000 $1)...........................
$48,000
Fixed expenses ......................................................
99,000
Operating income under absorption costing.............................
*Units budgeted for production during the year.........................
Units actually produced during the year....................................
Fixed factory overhead charged to each unit............................
Favorable volume variance ..........................................................

(2)

(3)

PLACID CORPORATION
Income Statement
For Year Ended 12-31-20
Sales (48,000 $16)......................................................................
Cost of goods sold:
Standard variable cost (48,000 $6) ................... $288,000
Net unfavorable variable cost variances .............
1,000
Gross contribution margin ..........................................................
Variable commercial expenses (48,000 $1).............................
Contribution margin .....................................................................
Less fixed costs:
Factory overhead
(50,000 units budgeted $3) ............................ $150,000
Commercial expenses...........................................
99,000
Operating income under direct costing .....................................

20-15

$768,000

430,000
$338,000

147,000
$191,000
50,000
51,000
(1,000)

$3
$ (3,000)

$768,000

289,000
$479,000
48,000
$431,000

249,000
$182,000

Operating income under absorption costing ............

Operating income under direct costing .....................
Difference ......................................................................

$191,000
182,000
$ 9,000

Units produced during the year ..................................

Units sold during the year ...........................................
Unit increase in finished goods inventory.................
Fixed factory overhead charged to each unit under
absorption costing....................................................
Difference ......................................................................

51,000
48,000
3,000

$3
9,000

20-16

Chapter 20

P20-4
(1)

Absorption costing:
Sales ................................................................
Direct materials ..............................................
Direct labor .....................................................
Variable factory overhead .............................
Fixed factory overhead..................................
Cost of goods manufactured ........................
Beginning inventory.......................................
Cost of goods available for sale...................
Ending inventory ............................................
Cost of goods sold ........................................
Gross profit.....................................................
Marketing and administrative expenses......
Operating income...........................................
1
2

(2)

Quarter
First
Second
$200,000
$260,000
$ 30,000
$ 20,000
60,000
40,000
45,000
30,000
62,400
62,400
$197,400
$152,400
65,800
$197,400
$218,200
30,480 2
65,800 1
$131,600
$187,720
$68,400
$72,280
25,000
28,000
$ 43,400
$ 44,280

$1 + $2 + $1.50 + ($62,400 30,000) = $6.58

$6.58 10,000 units = $65,800
$1 + $2 + $1.50 + ($62,400 20,000) = $7.62
$7.62 4,000 units = $30,480

Direct Costing:
Sales ................................................................
Direct materials ..............................................
Direct labor .....................................................
Variable factory overhead .............................
Variable cost of goods manufactured..........
Beginning inventory.......................................
Variable cost of goods available for sale.....
Ending inventory ............................................
Variable cost of goods sold ..........................
Gross contribution margin ............................
Variable marketing and administrative
expenses ................................................
Contribution margin.......................................
Less fixed expenses:
Factory overhead ..................................
Marketing and administrative ..............
Total fixed expense ........................................
Operating income...........................................

Quarter
First
Second
$200,000
$260,000
$ 30,000
$ 20,000
60,000
40,000
45,000
30,000
$135,000
$ 90,000
45,000
$135,000
$135,000
45,000
18,000
$90,000
$117,000
$110,000
$143,000
10,000
$100,000

13,000
$130,000

$ 62,400
15,000
$ 77,400
$ 22,600

$ 62,400
15,000
$ 77,400
$ 52,600

Chapter 20

20-17

P20-4 (Concluded)
Quarter
First
Second
$43,400
$ 44,280
22,600
52,600
$20,800
$ (8,320)

(3)
Operating income under absorption costing
Operating income under direct costing.......
Difference........................................................
Change in inventory under absorption costing:
Ending inventory ...................................
Beginning inventory..............................
Increase (decrease) in inventory .........
Change in inventory under direct costing:
Ending inventory ...................................
Beginning inventory..............................
Increase (decrease) in inventory .........
Difference between absorption and
direct costing.........................................

$65,800
0
$65,800

$ 30,480
65,800
$(35,320)

$45,000
0
$45,000

$18,000
45,000
$(27,000)

$20,800

$ (8,320)

Capital
Intensive
$30.00

Labor
Intensive
$30.00

Capital-intensive manufacturing method:

Fixed factory overhead ..................................................
Fixed marketing expenses ............................................
Total fixed cost ...............................................................

$2,440,000
500,000
$2,940,000

P20-5

Sales price ......................................................

Variable costs:
Materials................................................. $5.00
$5.60
Direct labor ............................................ 6.00
7.20
Variable factory overhead .................... 3.00
4.80
Variable marketing expenses............... 2.00 16.00 2.00 19.60
Contribution margin per unit ........................
$14.00
$10.40
(a)

$2,940,000 fixed cost

= 210,000 units of sales to break even
$14 contribution margin per unit
(b) Labor-intensive manufacturing method:
Fixed factory overhead .................................................. $1,320,000
Fixed marketing expenses ............................................
500,000
Total fixed cost ............................................................... $1,820,000
$1,820,000 fixed cost
= 175,000 units of sales to break even
$10.40 contribution margin per unit

20-18

Chapter 20

P20-5 (Concluded)
(2)

Kimbrell Company would be indifferent between the two alternative manufacturing methods at the volume of sales for which total cost was equal under both
alternatives. Let Q equal the quantity of units of product manufactured and sold.
($16 Q)
$2,940,000

$2,940,000
$1,820,000
$1,120,000
311,111

= ($19.80 Q) + $1,820,000
= ($19.60 Q) ($16 Q)
= $ 3.60 Q
= Q

Total cost will be the same for both manufacturing methods at 311,111 units of
sales.
P20-6
(1)

The number of units to break even at a per unit sales price of $38.50:
Variable costs:
Direct materials...................................................................... $ 60,000
Direct labor.............................................................................
40,000
Variable factory overhead.....................................................
20,000
Variable marketing and administrative expenses ..............
10,000
$130,000
$30, 000 + $15, 000 $45, 000
=
= 3, 600 break-even
n units
$38.50 $26.00 *
$12.50
*$130,000 5,000 units = $26 variable cost per unit

(2)

(3)

Units that must be sold to produce an $18,000 profit, at a $40 per unit sales price:
$45, 000 + $18, 000 $63, 000
=
= 4, 500 units
$40 $26
$14
The price Castleton must charge at a 5,000-unit sales level, in order to produce
a profit equal to 20% of sales:
Let x = sales price per unit
5,000x = 5,000($26) + $45,000 + 5,000 (.2x)
4,000x = $175,000
x = $43.75 sales price per unit
CGA-Canada (adapted). Reprint with permission.

Chapter 20

20-19

P20-7
Sales price per unit........................................
Less:
Variable manufacturing cost per unit .
Variable selling expense per unit
(5% of sales price) ..........................
Total variable cost per unit ..................
Contribution margin per unit ........................

B2
$180.00

B4
$176.00*

$121.00

$ 96.00

9.00
$130.00
$ 50.00

8.80
$104.80
$ 71.20

*$160 sales price per unit in 20A + ($160 10% increase in 20B)
Total fixed factory overhead
((20,000 B2s + 40,000 B4s) $25 per unit).................
Total fixed selling and administrative expenses..................
Total fixed costs ......................................................................
$1,707,330 fixed cost + ($135,000 profit (1 .4))
(2 B2s $50 CM each) + (3 B4s $71.20 CM each)

$1,707,330 fixed cost + $225,000 pretax profit

$313.60 CM per package

$1,932,330
$313.60
6,162 packages 2 units of B2 = 12,324 units of B2
6,162 packages 3 units of B4 = 18,486 units of B4

$1,500,000
207,330
$1,707,330

6,162 packages

20-20

Chapter 20

P20-8
(1)

The 20A sales mix in units is 1:2 (70,000 tape recorders; 140,000 electronic calculators).
Let x = Number of tape recorders to break even
2x = Number of electronic calculators to break even
At break even:
Sales = Variable cost + Fixed cost
$15x + 2 ($22.50x) = $8x + 2 ($9.50x) + $1,320,0001
$15x + $45x = $8x + $19x + $1,320,000
$60x = $27x + $1,320,000
$33x = $1,320,000
x = 40,000 tape recorders
2x = 80,000 electronic calculators
1Fixed costs:
Factory overhead ..................................... $ 280,000
Marketing and administrative .................
1,040,000
Total........................................................ $1,320,000

Chapter 20

20-21

P20-8 (Continued)
(2)

The following formula can be used to calculate the sales dollars required to earn
an aftertax profit of 9% on sales, using 20B estimates:
S = VC(S) + FC + P(S)
1 T
Where:

S
VC
FC
P
T

=
=
=
=
=

Necessary sales dollars

Variable cost stated as a percentage of sales dollars (S)
Fixed costs
Desired profit stated as a percentage of sales dollars (S)
Income tax rate
.09(S)
S = .46S1 + $1,377,0002 +
(1 .55)

S = .46S + $1,377,000 + .2S

.34S = $1,377,000
S = $4,050,000
1Variable

cost rate for tape recorders and electronic calculators:

Tape
Electronic
Recorders
Calculators
Per
Per
%
Unit
%
Unit
Sales price ......................................................$15.00 100% $20.00 100.0%
Variable costs:
Materials................................................. $3.80
$ 3.60
Direct labor ............................................ 2.20
3.30
Factory overhead .................................. 2.00
2.00
Total variable cost ............................. $7.80
52% $ 8.90 44.5%
Contribution margin....................................... $7.20

48%

$11.10

55.5%

Composite variable cost rate per dollar of sales:

(.20 Tape recorder variable cost rate) + (.80 Calculator variable cost rate) =
.20 (.52) + .80 (.445) = .104 + .356 = .46
2Fixed costs:
Factory overhead ...........................................................
$ 280,000
Marketing and administrative .......................................
1,040,000
Additional advertising....................................................
57,000
Total .............................................................................
$1,377,000

20-22

Chapter 20

P20-8 (Concluded)
(3)

Let: x = Number of
3x = Number of
At break even:
Sales =
$15x + 3($20x) =
$15x + $60x =
$75x =
$40.50x =
x=
3x =

tape recorders to break even

electronic calculators to break even
Variable cost + Fixed cost
$7.80x + 3($8.90x) + $1,377,000
7.80x + $26.70x + $1,377,000
$34.50x + $1,377,000
$1,377,000
34,000 tape recorders
102,000 electronic calculators

P20-9
(1)

(a)

In order to break even, Almo must sell 500 units determined as follows:
Q(BE) =

F
$100, 000
=
= 500 units
P C $400 $200

where F = fixed cost, P = sales price per unit, and C = variable cost per
unit.
(b)

To achieve an after-tax profit of $240,000, Almo must sell 2,500 units

determined as follows:

Q=

F+
$100, 000 + ($240, 000 (1 .40)) $100, 000 + $400
0, 000
=
=
PC
$400 $200
$200
$500, 000
$200
= 2, 500 units
=

where P, F, and C are defined the same as in (1)(a), and is the after-tax
profit objective.

Chapter 20

20-23

P20-9 (Concluded)
(2)

Almo Company should choose alternative (a) because it will result in the largest
after tax profit.

Alternative (a):
Revenue = ($400 unit sales price 350 units) + (($400 $40 price reduction) 2,700 units)
= $140,000 + $972,000
= $1,112,000
Variable Cost = $200 per unit (350 units sold + 2,700 units to be sold)
= $610,000
After-tax Profit =
=
=
=
Alternative (b):

(Revenue Variable Cost Fixed Cost) (1 Tax Rate)

($1,112,000 $610,000 $100,000) (1 .4)
$402,000 .6
$241,200

Revenue = ($400 unit sales price 350 units) + (($400 $30 price reduction) 2,200 units
= $140,000 + $814,000
= $954,000
Variable Cost = ($200 per unit 350 units) + (($200 $25 cost reduction) 2,200 units)
= $70,000 + $385,000
= $455,000
After-tax Profit =
=
=
=
Alternative (c):

(Revenue Variable Cost Fixed Cost) (1 Tax Rate)

($954,000 $455,000 $100,000) (1 .4)
$399,000 .6
$239,400

Revenue = ($400 unit sales price 350 units) + ($400 (1 5% price reduction) 2,000 units)
= $140,000 + $760,000
= $900,000
Variable Cost = $200 per unit (350 units sold + 2,000 units to be sold)
= $470,000
After-tax Profit =
=
=
=

(Revenue Variable Cost Fixed Cost) (1 Tax Rate)

($900,000 $470,000 ($100,000 $10,000 cost reduction)) (1 .4)
$340,000 .6
$204,000

20-24

Chapter 20

P20-10
(1)

Estimated break-even point based on pro forma income statement:

Sales ......................................................................................... $10,000,000
Variable costs:
Cost of goods sold ...............................
$6,000,000
Commissions paid to agents...............
2,000,000
8,000,000
Contribution margin ................................................................ $2,000,000
Contribution margin ratio = $2,000,000 = 20% C/M
$10,000,000
$100,000 fixed cost = $500,000 break-even point
20% C/M

(2)

Estimated break-even point with the company employing its own salespersons:
Variable cost ratios:
Cost of goods sold to sales ($6,000,000 $10,000,000)
Commissions on sales ..................................................
Total variable cost ratio .............................................

60%
5%
65%

Contribution margin ratio = 1 65% variable cost ratio = 35%

Fixed costs:
Administrative ................................................................
Sales manager................................................................
Salaries of salespersons (3 $30,000) ........................
Total fixed costs .........................................................
$350,000 fixed cost = $1,000,000 break-even point
35% C/M

$100,000
160,000
90,000
$350,000

Chapter 20

20-25

P20-10 (Concluded)
(3)

Estimated sales volume to yield net income projected in pro forma income statement with independent sales agents receiving 25% commission:
Total income before income tax ............................................
Fixed cost.................................................................................
Total fixed cost and profit ......................................................

$1,900,000
100,000
$2,000,000

Variable cost ratios:

Cost of goods sold to sales.....................................................
Commissions on sales.............................................................
Total variable cost ratio....................................................

60%
25%
85%

Contribution margin ratio = 1 85% variable cost ratio = 15%

$2,000,000 fixed cost and profit
15% C/M
(4)

= $13,333,333 sales

Estimated sales volume to yield an identical income regardless of whether the

company employs its own salespersons or continues with independent sales
agents and pays them a 25% commission:
Total cost with agents =
receiving 25% commission

Total cost with companys

own sales force

(85% variable cost sales) =

+ $100,000 fixed cost

(65% variable cost sales)

+ $350,000 fixed cost

20% sales =
sales =

$250,000
$1,250,000

20-26

Chapter 20

CASES
C20-1
(1)

Because Star Company uses absorption costing, income from operations is

influenced by both sales volume and production volume. Sales volume was
increased in the November 30 forecast, and at standard gross profit rates this
would increase income from operations by $5,600. However, during this same
period, production volume was below the January 1 forecast, causing an
unplanned volume variance of $6,000. The volume variance and the increased
marketing expenses (due to the 10% increase in sales) overshadowed the added
profits from sales, as follows:
Increased sales ................................................
Increased cost of goods sold at standard ....
Increased gross profit at standard ................
Less:
Volume variance......................................... $6,000
Increased marketing expense .................. 1,340
Decrease in income from operations ............

$ 26,800
21,200
$ 5,600

7,340
$(1,740)

Chapter 20

20-27

C20-1 (Concluded)
(2)

Star Company could adopt direct costing. Under direct costing, fixed manufacturing costs would be treated as period costs and would not be assigned to production. Consequently, earnings would not be affected by production volume,
but only by sales volume. Statements prepared on a direct-costing basis are as
follows:
STAR COMPANY
Forecasts of Operating Results for 20
Forecasts as of
January 1 November 30
Sales ................................................................
$268,000
$294,800
Variable costs:
Manufacturing...........................................
$182,000
$200,200*
Marketing ..................................................
13,400
14,740
Total variable cost ..............................
$195,400
$214,940
Contribution margin.......................................
$ 72,600
$ 79,860
Fixed costs:
Manufacturing...........................................
$ 30,000
$ 30,000
Administrative ..........................................
26,800
26,800
Total fixed cost ...................................
$ 56,800
$ 56,800
Income from operations ................................
$ 15,800
$ 23,060
*$182,000 110% = $200,200
Reconciliation of differences in income from operations:
January 1: No difference in absorption vs. direct costing because $30,000 fixed
factory overhead was expensed in both cases.
November 30:
Direct costing .................................................
Absorption costing ........................................
Difference........................................................

Income from
Operations
$23,060
14,060
$ 9,000

Fixed factory overhead included in cost of goods sold at standard:

November 30 forecast ($30,000 in January 1 forecast
+ 10% sales volume increase) ....................
$33,000
January 1 forecast .........................................
30,000
$ 3,000
Underapplied fixed factory overhead...........
6,000
Difference........................................................
$ 9,000

20-28

Chapter 20

C20-2
(1)

In absorption costing, as currently employed by RGS Corporation, fixed factory

overhead is considered a product cost rather than a period cost. Fixed factory
overhead is applied to production based on a normal capacity of 1,000,000 units.
Thus, the fixed factory overhead is applied to products in the same manner as
variable costs, even though it does not vary with production. In addition, if production and sales are not equal during the year, fixed factory overhead is
deferred as part of inventory costs (when production exceeds sales) or released
upon sales of the inventory (when sales exceed production).
During 20A, production exceeded sales, resulting in a portion of the fixed factory overhead being inventoried in finished goods rather than being expensed in
20A. This resulted in 20A operating income being larger than it would have been
if all fixed factory overhead had been charged against 20A sales revenue. Then
in 20B, sales exceeded production, resulting In more fixed factory overhead
being charged against 20B sales revenue than was incurred in 20B. First, finished goods were sold out of inventory, which meant that the part of fixed factory overhead that was incurred in 20A and inventoried in 20A was charged
against 20B sales revenue. Second, fixed factory overhead was underapplied in
20B because only 850,000 units were produced (150,000 units less than normal
capacity used in determining the factory overhead rate). This resulted in an unfavorable volume variance that was charged to the cost of goods sold in 20B. Both
of these occurrences increased the cost of goods sold and resulted in a reduction of gross profit and operating income in 20B.

Chapter 20

20-29

C20-2 (Continued)
(2)
(a)

RGB CORPORATION
Operating Income Statement
For the Years Ended November 30, 20A and 20B
(in thousands)
20A
Sales .......................................................
Variable cost of goods sold:
900,000 units at $5.00 ....................
300,000 units at $5.00 ....................
700,000 units at $5.50 ....................
Contribution margin..............................
Fixed expenses:
Fixed factory overhead..................
Selling and administrative ............
Operating income..................................

20B
$9,000

$11,200

4,500
$1,500
3,850
$4,500
$3,000
1,500

4,500
0

$3,300
1,500

5,350
$ 5,850

4,800
$ 1,050

(b) Reconciliation:
20A
Operating income
absorption costing.........................
Operating income
direct costing .................................
Difference...............................................
Difference accounted for as follows:
Inventory change under
absorption costing:
Ending inventory:
300,000 units at $8.00 ............
$2,400
150,000 units at $8.80 ............
Beginning inventory: .................
0
300,000 units at $8.00 ............
Inventory change under direct costing:
Ending inventory:
300,000 units at $5.00 ............
$1,500
150,000 units at $5.50 ............
Beginning inventory ..................
0
300,000 units at $5.00 ............
Difference ..............................................

20B
$ 900

645

0
$ 900

1,050
$ (405)

$1,320
$2,400
2,400

$(1,080)

$ 825
1,500
1,500
$ 900

(675)
$ (405)

20-30

Chapter 20

C20-2 (Concluded)
(3)

The advantages of direct costing for internal reporting include the following:
(a) Direct costing aids in forecasting and in evaluating reported income for
internal management decision-making purposes, because fixed costs are
not arbitrarily allocated between accounting periods (or among different
products, sales territories, operating divisions, etc.).
(b) Fixed costs are reported at incurred values (and not absorbed values),
increasing opportunity for more effective control of these costs.
(c) Profits vary directly with sales volume and are unaffected by changes in
inventory levels.
(d) Analysis of the cost-volume-profit relationship is facilitated, and management is able to determine the break-even point and total profit for a given
volume of production and sales.
The disadvantages of direct costing for internal reporting include the following:
(a) Management may fail to consider properly the fixed cost element in longrange pricing decisions.
(b) Direct costing lacks acceptability for external financial reporting or as a
basis for computing taxable income. As a consequence, additional recordkeeping costs must be incurred to use direct costing.
(c) The separation of costs into fixed and variable elements is a costly process.
In addition, the distinction between fixed and variable cost is not precise and
not reliable at all levels of activity.

C20-3
(1)
Daly would determine the number of units of Product Y that it would have to sell
to attain a 20% profit on sales, by dividing total fixed costs plus desired profit
(i.e., 20% of sales price per unit multiplied by the units to attain a 20% profit) by
unit contribution margin (i.e., sales price per unit less variable cost per unit).
(2)
If variable cost per unit increases as a percentage of the sales price, Daly would
have to sell more units of Product Y to break even. Because the unit contribution
margin (i.e., sales price per unit less variable cost per unit) would be lower, Daly
would have to sell more units to cover the fixed cost in order to break even.

Chapter 20

20-31

C20-3 (Concluded)
(3)

The limitations of break-even and cost-volume-profit analysis in managerial

decision making follow:
(a) The analysis is fundamentally a static analysis, and, in most cases, changes
can be determined only by recomputing results. If a break-even chart is
used, changes can be shown only by drawing a new chart or series of
charts.
(b) The amount of fixed and variable cost, as well as the slope of the sales line,
is meaningful in a defined range of activity and must be redefined for activity outside the relevant range.
(c) The analysis is highly dependent upon a meaningful separation of fixed and
variable costs, which may be difficult to obtain in actual practice.
(d) The analysis is based on a single mix of products. If the mix is expected to
change, the results must be recomputed.
(e) The analysis assumes that production technology (i.e., labor productivity,
level of automation, and product specifications) will be unchanged. If
changes in production technology are expected to occur, the analyst must
consider the expected effects on costs.
(f) The analysis assumes that selling prices, input prices, and other market
conditions will not change. Expected changes must be incorporated into the
analysis. If a range of possible changes can occur, a different result must be
determined for each possible combination.