Demo 6-1: Prepare & Reconcile Variable & Absorption Costing Income Statements -- Production Constant,

Sales Varies
Given:
Linden Company manufactures and sells a single product. Cost data for the product follow:

Variable costs per unit:

Direct materials $6.00
Direct labor 12.00
Variable factory overhead 4.00 $22.00
Variable selling & administrative 3.00
Total variable costs per unit $25.00

Fixed costs per month:

Fixed manufacturing overhead $240,000 8.00
Fixed selling & administrative 180,000
Total fixed cost per month $420,000 $30.00
$40.00
The product sells for $40 per unit. Note: Contribution margin per unit is $15.00
Production and sales data for May and June, the first two months of
operations, are as follows:

Units Units Change in

Produced Sold Inventory
May 30,000 26,000 4,000
June 30,000 34,000 (4,000)
Total 60,000 60,000 0

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 FG $0 $120,000
Add cost of goods manufactured 900,000 900,000
Goods available for sale $900,000 $1,020,000
Less ending inventory FG 120,000 0
Cost of goods sold $780,000 $780,000 $1,020,000 $1,020,000
Gross margin $260,000 $340,000
Selling & administrative expenses 258,000 282,000
Operating income $2,000 $58,000

Required:
1. Determine the unit product cost under:
a. Absorption costing
b. Variable costing
Absorption Variable
Costing Costing
Direct materials $6.00 $6.00
Direct labor 12.00 12.00
 Variable manufacturing overhead 4.00 4.00
Fixed manufacturing overhead ($240,000/30,000) 8.00
$30.00 $22.00

2. Prepare variable costing income statements for May and June using the
contribution margin format approach.

Linden Company
Variable Costing Income Statements
For the Months of May and June
May June
Sales (26,000 X $40; 34,000 X $40) $1,040,000 $1,360,000
Variable expenses:
Variable cost of goods sold 572,000 $572,000 $748,000 748,000
Variable selling & administrative 78,000 78,000 102,000 102,000
Total variable expenses $650,000 $850,000
Contribution margin $15.00 $390,000 $510,000
Fixed expenses: 390,000 510,000
Fixed manufacturing overhead $240,000 $240,000
Fixed selling & administrative 180,000 180,000
Total fixed expenses $420,000 $420,000
Operating income (loss) ($30,000) $90,000

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 26,000.00

B/E = ($420,000 - $32,000)/$15 = 25,866.67
Sales greater than B/E 133.33
CM per unit sold $15.00
Operating income -- 26,000 sales $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.
ction Constant,
Demo 6-2: Prepare & Reconcile Variable & Absorption 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
Sales 40,000 40,000
Production 40,000 50,000
Var. mfg. $/unit $6 $6
Var. S&A $/unit $2 $2
FMOH $ $600,000 $600,000
FMOH $/unit1 $15 $12

Milex Corporation applies FMOH costs to its only product on the basis of each year's production.
1

Year 1 Year 2
Sales (40,000 units each year) $31.25 $1,250,000 $1,250,000 $31.25
Cost of goods sold $840,000 840,000 720,000 $720,000
Gross margin $410,000 $530,000
Selling & administrative expense $80,000 350,000 350,000 $80,000 $270,000
Net operating income $60,000 $180,000

Required:
1. Compute the unit product cost for each year under:
a. Absorption costing
b. Variable costing

Year 1 Year 2 Year 1 Year 2

Absorption Absorption Variable Variable
Costing Costing Costing Costing
Variable mfg. $6.00 $6.00 $6.00 $6.00
Fixed MOH 15.00 12.00 N/A N/A
$21.00 $18.00 $6.00 $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 $1,250,000 $1,250,000

Variable expenses:
Cost of goods sold $240,000 $240,000
Selling & Administrative 80,000 80,000
 Total variable expenses $320,000 $320,000
Contribution margin $930,000 $930,000
Fixed expenses:
Fixed manufacturing overhead $600,000 $600,000
Fixed selling & administrative 270,000 270,000
Total fixed expenses $870,000 $870,000
Net operating income $60,000 $60,000

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

Year 1 Year 2
Operating variable costing income $60,000 $60,000
Adjustment for Change in inventory during Year
Production 40,000 50,000
Sales 40,000 40,000
Increase in inventory 0 10,000
Fixed MOH rate $15.00 $12.00
Fixed $ deferred in inventory $0 0 $120,000 120,000
Operating absorption costing income $60,000 $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).
Demo 6-3: Prepare & Reconcile Variable & Absorption Costing Income 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): (See a - d below).
SP $20 $20 $20
50,000 40,000 50,000
Absorption Costing Year 1 Year 2 Year 3
Sales $1,000,000 $800,000 $1,000,000
Cost of goods sold
Beginning inventory $0 $0 $280,000
Add: Cost of goods manufactured 800,000 840,000 760,000
Cost of goods available for sale $800,000 $840,000 $1,040,000
Less: Ending Inventories 280000 0 280,000 190,000 190000
Cost of goods sold $800,000 $560,000 $850,000
Gross margin $200,000 $240,000 $150,000
Selling and administrative expenses 170,000 150,000 170,000
Net operating income (Loss) $30,000 $90,000 ($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 50,000 40,000 50,000
Variable Costing Year 1 Year 2 Year 3
Sales $20 $1,000,000 $800,000 $1,000,000
Variable expenses:
Cost of goods sold ($4 per unit sold) $4 $200,000 $160,000 $200,000
Selling & administrative ($2/unit sold) $2 100,000 80,000 100,000
Total variable expenses $300,000 $240,000 $300,000
Contribution margin $14 $700,000 $560,000 $700,000
Fixed expenses:
Manufacturing overhead $600,000 $600,000 $600,000
Selling and administrative expenses 70,000 70,000 70,000
Total fixed expenses $670,000 $670,000 $670,000
Net operating income (Loss) $140,000 $30,000 ($110,000) $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 Year 1 Year 2 Year 3

Variable cost of goods manufacturing $4 $4 $4
Fixed manufacturing costs 12 10 15
Unit product costs $16 $14 $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 $30,000 ($110,000) $30,000
Change in inventory Year 2
Production 60,000
Sales 40,000
Inventory increase 20,000
FMOH rate Year 2 $10
Deferred FMOH Costs $200,000 200,000

Change in inventory Year 3

Fifo Cost Flow
Released from EI Y2 20,000
FMOH rate Year 2 $10 (200,000)

BI Y3 Units 20,000
Production 40,000
Sales (50,000)
EI Y3 Units 10,000
FMOH Rate Year 3 $15
Deferred FMOH Year 3 $150,000 150,000
NOI -- Absorption Costing $30,000 $90,000 ($20,000)
NOI -- Absorption Costing $30,000 $90,000 ($20,000)
OK OK 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) ($140,000) ($140,000)

FMOH costs deferred in inventory (accounting change) 200,000
Increase in NOI $60,000

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 COGS (20,000 X $10) ($200,000)
FMOH costs from Year 3 deferred in EI of Year 3 (10,000 X $15) 150,000
Differences in NOI (Year 3 compared with Year 1) Decrease ($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

Year 1 Year 2 Year 3

Sales in units 50,000 40,000 50,000
Production (matched to sales) 50,000 40,000 50,000
Absorption Costing Year 1 Year 2 Year 3
Sales 12 $1,000,000 $800,000 $1,000,000
Cost of goods sold
Beginning inventory $0 $0 $0
New mfg. costs added:
Variable manufacturing costs ($4) 200,000 160,000 200,000
Fixed mfg. costs applied ($12) 600,000 480,000 600,000
Underapplied overhead 120,000
 Cost of goods available for sale $800,000 $760,000 $800,000
Ending Inventories 0 0 0
Cost of goods sold $800,000 $760,000 $800,000
Gross margin $200,000 $40,000 $200,000
Selling and administrative expenses 170,000 150,000 170,000
Net operating income (Loss) $30,000 ($110,000) $30,000
Note: Same as Variable Costing
Variable Costing NOI $30,000 ($110,000) $30,000
Demo 6-4 & 6-5: 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
Total Company Houston Dallas
Sales $750,000 100.00% $150,000 100.00% $600,000 100.00%
Variable expenses 405,000 54.00% 45,000 30.00% 360,000 60.00%
Contribution margin $345,000 46.00% $105,000 70.00% $240,000 40.00%
Traceable fixed expenses1 168,000 22.40% 78,000 52.00% 90,000 15.00%
Office segment margin $177,000 23.60% $27,000 18.00% $150,000 25.00%
Common fixed expenses2
(not traceable to offices) 120,000 16.00%
Net operating income $57,000 7.60%

1
Traceable fixed costs = A fixed cost that is incurred because of the existence of a
particular business segment and that would be eliminated if
the segment were eliminated.
2
Common fixed costs = A fixed cost that supports more than one business segment,
but is not traceable in whole or in part to any one of the
business segments.

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 $75,000

Contribution margin ratio 40.00%
Increase in Company's NOI $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 Houston Dallas
Sales $800,000 100.00% $200,000 100.00% $600,000 100.00%
Variable expenses 420,000 52.50% 60,000 30.00% 360,000 60.00%
Contribution margin $380,000 47.50% $140,000 70.00% $240,000 40.00%
Traceable fixed expenses 168,000 21.00% 78,000 39.00% 90,000 15.00%
Office segment margin $212,000 26.50% $62,000 31.00% $150,000 25.00%
Common fixed expenses $35,000
 (not traceable to offices) 120,000 15.00% $35,000
Net operating income $92,000 11.50% $35,000

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.

Demo 6-5:
Given:
Refer to the data in Demo 6-4. Assume that Dallas' sales by major market are as follows:

Dallas: Client-type
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%
Client-type 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%
Office segment margin $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 client-type market would you recommend that the company focus its
advertising campaign?

The company should focus its campaign on Landscaping Clients.

Construction Landscaping
Clients Clients
Increased sales from campaign $70,000 $60,000
CM ratio by client type 35.00% 50.00%
Increase in contribution margin $24,500 $30,000
Less cost of the campaign 8,000 8,000
Increased segment margin & NOI $16,500 $22,000
2. In Demo 6-4, 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:

Construction Landscaping
Dallas Clients Clients
Traceable fixed costs $72,000 $20,000 $52,000
Common fixed expenses
(not traceable to markets) 18,000
Total $90,000
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 18,000

Desired minimum inventory 1,500 **
Total units needed for sales and desired EI 19,500
Less: Current inventory on hand -- September 30 12,000
Desired production for the 4th quarter 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 18,000

Maximum inventory storage facilities available 30,000 **
Total units needed for sales and desired EI 48,000
Less: Current inventory on hand -- September 30 12,000
Desired production for the 4th quarter 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 7,500
2. Production schedule designed to maximize divisional manager's annual bonus 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.