SOLUTION
(60 min.) Variable and absorption costing and breakeven points
1.
2017 Variable-Costing Based Operating Income Statement
Revenues (1,300 boards
´
$800 per board)
Variable costs:
Beginning inventory (240 boards
´
$375 per board)
Variable manufacturing costs (1,200 boards
´
$375 per board)
Deduct: Ending inventory (140 boards
´
$375 per board)
Variable shipping costs (1,300 boards
´
$20 per board)
26 ,000
Fixed costs
2.
2017 Absorption-Costing Based Operating Income Statement
Revenues (1,300 boards
´
$800 per board)
Cost of goods sold:
Beginning inventory (240 boards
´
$665a per board)
Variable manufacturing costs (1,200 boards
´
$375 per board)
Allocated fixed manufacturing costs (1,200 boards
´
$290 per board)
´
´
26,000
3. Breakeven point in units:
a. Variable Costing:
Q=
Total Fixed Costs Target Operating Income
Contribution Margin Per Unit
+
Q=
($319,000 $150,000) $0
$800 ($375 $20)
+ +
– +
Q=
$469,000
$405
Q= 1,159 hoverboards (rounding up)
b. Absorption costing:
Fixed manufacturing cost rate = $319,000 ÷ 1,100 = $290 per hoverboard
Total Target Fixed Breakeven Units
fixed operating manufacturing sales produced
costs income cost rate in units
Contribution margin per unit
Q
é ù
æ ö
ê ú
ç ÷
+ + ´ –
ê ú
ç ÷
ç ÷
ê ú
è ø
ë û
=
Q=
[ ]
($319,000 $150,000) $0 $290 (Q 1, 200)
$405
+ + + –
$405Q= $469,000 + $290Q – $348,000
$392,000+$280 Q−$252,000
4. Proof of breakeven point:
a. Variable Costing:
b. Absorption costing:
Revenues, $800
´
1,053 units $842,400
*This is not zero due to rounding up to 1,159 and 1,053 whole units sold.
5. If $44,000 of fixed administrative costs were reclassified as production costs, there would
be no change in breakeven sales using variable costing. This is because all fixed costs,
regardless of whether they are for production or administrative activities, are treated the same
6. The additional $20 per unit variable production cost will cause unit contribution margin
to decrease from $405 to $385. This decrease will cause the breakeven point to increase.
In the case of variable costing:
9-41 Downward demand spiral. Market.com is about to enter the highly
competitive personal electronics market with a new type of tablet. In anticipation of future
growth, the company has leased a large manufacturing facility and has purchased several
expensive pieces of equipment. In 2017, the company’s first year, Market.com budgets for
production and sales of 50,000 units, compared with its practical capacity of 78,000. The
company’s cost data are as follows:
Required:
1. Assume that Market.com uses absorption costing and uses budgeted units produced as the
denominator for calculating its fixed manufacturing overhead rate. Selling price is set at
140% of manufacturing cost. Compute Market.com’s selling price.
2. Market.com enters the market with the selling price computed previously. However, despite
growth in the overall market, sales are not as robust as the company had expected, and a
competitor has priced its product at $102.00. Mr. Samuel Buttons, the company’s president,
insists that the competitor must be pricing its product at a loss and that the competitor will be
unable to sustain that. In response, Market.com makes no price adjustments but budgets
production and sales for 2018 at 43,800 tablets. Variable and fixed costs are not expected to
change. Compute Market.com’s new selling price. Comment on how Market.com’s choice of
budgeted production affected its selling price and competitive position.
3. Recompute the selling price using practical capacity as the denominator level of activity.
How would this choice have affected Market.com’s position in the marketplace? Generally,
how would this choice affect the production-volume variance?
SOLUTION
(20 min.) Downward demand spiral.
1. Fixed manufacturing overhead rate =
¿
$650,000/50,000 units = $13 per unit
Manufacturing cost per unit:
$22 direct materials + $30 direct mfg. labor + $12 var. mfg. OH + $13 fixed mfg. OH = $77
2. Fixed manufacturing overhead rate =
¿
$650,000/43,800 units = $14.84 per unit
By using budgeted units produced, and not practical capacity, as the denominator level,
Market.com is burdening its products with the cost of unused capacity. Apparently, the
3. Fixed manufacturing overhead rate =
¿
$650,000/78,000 units = $8.33 per unit
Manufacturing cost per unit:
If Market.com had used practical capacity as its denominator level of activity, its initial selling
price of $101.26 would have been virtually in line with the $102 selling price of its competitor,
9-42 Absorption costing and production-volume variance—
alternative capacity bases. Planet Light First (PLF), a producer of energy-efficient
light bulbs, expects that demand will increase markedly over the next decade. Due to the high
fixed costs involved in the business, PLF has decided to evaluate its financial performance using
absorption costing income. The production-volume variance is written off to cost of goods sold.
The variable cost of production is $2.40 per bulb. Fixed manufacturing costs are $1,170,000 per
year. Variable and fixed selling and administrative expenses are $0.20 per bulb sold and
$220,000, respectively. Because its light bulbs are currently popular with environmentally
conscious customers, PLF can sell the bulbs for $9.80 each.
PLF is deciding among various concepts of capacity for calculating the cost of each unit
produced. Its choices are as follows:
Theoretical capacity 900,000 bulbs
Practical capacity 520,000 bulbs
Normal capacity 260,000 bulbs (average expected output for the next three years)
Master-budget capacity 225,000 bulbs expected production this year
Required:
1. Calculate the inventoriable cost per unit using each level of capacity to compute fixed
manufacturing cost per unit.
2. Suppose PLF actually produces 300,000 bulbs. Calculate the production-volume variance
using each level of capacity to compute the fixed manufacturing overhead allocation rate.
3. Assume PLF has no beginning inventory. If this year’s actual sales are 225,000 bulbs,
calculate operating income for PLF using each type of capacity to compute fixed
manufacturing cost per unit.
SOLUTION
(35 min.) Absorption costing and production volume variance — alternative capacity
bases
1. Inventoriable cost per unit = Variable production cost + Fixed manufacturing
overhead/Capacity
Capacity Type
Capacity
Level
Fixed Mfg.
Overhead
Fixed Mfg.
Overhead
Rate
Variable
Production
Cost
Inventoriable
Cost Per Unit
Theoretical 900,000 $1,170,000 $1.30 $2.40 $3.70
2. PLF’s actual production level is 300,000 bulbs. We can compute the production-volume
variance as:
Production Volume Variance = Budgeted Fixed Mfg. Overhead
Capacity Type
Capacity
Level
Fixed Mfg.
Overhead
Fixed Mfg.
Overhead
Rate
Fixed Mfg.
Overhead
Rate × Actual
Production
Production
Volume
Variance
3. Operating Income for PLF given production of 300,000 bulbs and sales of 225,000 bulbs @
$9.80 apiece:
Theoretical Practical Normal Master Budget
Revenue a$2,205,000 $2,205,000 $2,205,000 $2,205,000
Less: Cost of
a225,000 × 9.80
b225,000 × 3.70, × 4.65, × 6.90, × 7.60
c225,000 × 0.20
9-43 Operating income effects of denominator-level choice and
disposal of production-volume variance (continuation of 9-42).
Required:
1. If PLF sells all 300,000 bulbs produced, what would be the effect on operating income of
using each type of capacity as a basis for calculating manufacturing cost per unit?
2. Compare the results of operating income at different capacity levels when 225,000 bulbs are
sold and when 300,000 bulbs are sold. What conclusion can you draw from the comparison?
3. Using the original data (that is, 300,000 units produced and 225,000 units sold) if PLF had
used the proration approach to allocate the production-volume variance, what would
operating income have been under each level of capacity? (Assume that there is no ending
work in process.)
SOLUTION
(35 min.) Operating income effects of denominator-level choice and disposal of
production-volume variance (continuation of 9-42)
1. Since no beginning inventories exist, if PLF sells all 300,000 bulbs manufactured, its
operating income will be the same under all four capacity options. Calculations are provided
below:
Theoretical Practical Normal Master Budget
Revenue a$2,940,000 $2,940,000 $2,940,000 $2,940,000
Less: Cost of 1,110,000 1,395,000 2,070,000 2,280,000
goods sold b
Less: Production
2. If the manager of PLF produces and sells 300,000 bulbs, then all capacity levels will result in
the same operating income of $770,000 (see requirement 1 above). If the manager of PLF is able
to sell only 225,000 of the bulbs produced and if the production-volume variance is closed to
cost of goods sold, then the operating income is given as in requirement 3 of 9-42. Both sets of
numbers are reproduced below.
Theoretical Practical Normal Master Budget
3. In this scenario, the manager of PLF produces 300,000 bulbs and sells 225,000 of them, and
the production volume variance is prorated. Given the absence of ending work in process
inventory or beginning inventory of any kind, the fraction of the production volume variance that
is absorbed into the cost of goods sold is given by 225,000/300,000 or 75%. The operating
income under various denominator levels is then given by the following modification of the
solution to requirement 3 of 9-42:
Theoretical Practical Normal Master Budget
Revenue $2,205,000 $2,205,000 $2,205,000 $2,205,000
Less: Cost of goods
9-44 Variable and absorption costing, actual costing. The Iron City
Company started business on January 1, 2017. Iron City manufactures a specialty honey beer,
which it sells directly to state-owned distributors in Pennsylvania. Honey beer is produced and
sold in six-packs, and in 2017, Iron City produced more six-packs than it was able to sell. In
addition to variable and fixed manufacturing overhead, Iron City incurred direct materials costs
of $880,000, direct manufacturing labor costs of $400,000, and fixed marketing and
administrative costs of $295,000. For the year, Iron City sold a total of 180,000 six-packs for a
sales revenue of $2,250,000.
Iron City’s CFO is convinced that the firm should use an actual costing system but is debating –
whether to follow variable or absorption costing. The controller notes that Iron City’s operating
income for the year would be $438,000 under variable costing and $461,000 under absorption
costing. Moreover, the ending finished-goods inventory would be valued at $7.15 under variable
costing and $8.30 under absorption costing.
Iron City incurs no variable nonmanufacturing expenses.
Required:
1. What is Iron City’s total contribution margin for 2017?
2. Iron City incurs fixed manufacturing costs in addition to its fixed marketing and
administrative costs. How much did Iron City incur in fixed manufacturing costs in 2017?
3. How many six-packs did Iron City produce in 2017?
4. How much in variable manufacturing overhead did Iron City incur in 2017?
5. For 2017, how much in total manufacturing overhead is expensed under variable costing,
either through cost of goods sold or as a period expense?
SOLUTION
(30 min.) Variable and absorption costing, actual costing.
1. Since no beginning inventories exist, the cost of the ending inventory must be the same as the
cost of goods sold for the period. So, the unit cost of goods sold under variable costing is $7.15.
2. The profit under variable costing is given as $438,000. We just calculated the contribution
margin of Iron City as $963,000. The difference, $525,000 ($963,000 – $438,000) must
represent the total fixed costs incurred by Iron City in 2017.
In requirement 2, we calculated that the total fixed manufacturing costs are $230,000.
So, Units produced = Total manufacturing costs/Unit fixed manufacturing cost of production
4. In 2017, Iron City incurred a total of 200,000 × $7.15 = $1,430,000 in variable manufacturing
costs. This includes $880,000 in direct materials costs (given), $400,000 in direct manufacturing
labor costs (given), and the rest in variable manufacturing overhead.
5. Under variable costing, the proportion of variable manufacturing overhead corresponding to
the units sold, relative to units produced, is expensed as variable cost of goods sold. This equals:
9-45 Cost allocation, downward demand spiral. Meals To Go operates a
chain of 10 hospitals in the Los Angeles area. Its central food-catering facility, Mealman,
prepares and delivers meals to the hospitals. It has the capacity to deliver up to 1,460,000 meals a
year. In 2017, based on estimates from each hospital controller, Mealman budgeted for 1,050,000
meals a year. Budgeted fixed costs in 2017 were $1,533,000. Each hospital was charged $6.16
per meal—$4.70 variable costs plus $1.46 allocated budgeted fixed cost.
Recently, the hospitals have been complaining about the quality of Mealman’s meals and their
rising costs. In mid-2017, Meals To Go’s president announces that all Meals To Go hospitals and
support facilities will be run as profit centers. Hospitals will be free to purchase quality-certified
services from outside the system. Dean Wright, Mealman’s controller, is preparing the 2018
budget. He hears that three hospitals have decided to use outside suppliers for their meals, which
will reduce the 2018 estimated demand to 912,500 meals. No change in variable cost per meal or
total fixed costs is expected in 2018.
Required:
1. How did Wright calculate the budgeted fixed cost per meal of $1.46 in 2017?
2. Using the same approach to calculating budgeted fixed cost per meal and pricing as in 2017,
how much would hospitals be charged for each Mealman meal in 2018? What would the
reaction of the hospital controllers be to the price?
3. Suggest an alternative cost-based price per meal that Wright might propose and that might
be more acceptable to the hospitals. What can Mealman and Wright do to make this price
profitable in the long run?