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Solutions Manual, Chapter 7 335
Chapter 7
Variable Costing: A Tool for Management
Solutions to Questions
7-1 Absorption and variable costing differ in how they handle fixed manufacturing overhead. Under absorption costing, fixed manufacturing overhead is treated as a product cost and hence is an asset until products are sold. Under varia- ble costing, fixed manufacturing overhead is treated as a period cost and is expensed on the current period’s income statement.
7-2 Selling and administrative expenses are treated as period costs under both variable cost- ing and absorption costing.
7-3 Under absorption costing, fixed manu- facturing overhead costs are included in product costs, along with direct materials, direct labor, and variable manufacturing overhead. If some of the units are not sold by the end of the period, then they are carried into the next period as inventory. The fixed manufacturing overhead cost attached to the units in ending inventory follow the units into the next period. When the units are finally sold, the fixed manufacturing overhead cost that has been carried over with the units is included as part of that period’s cost of goods sold.
7-4 Absorption costing advocates believe that absorption costing does a better job of matching costs with revenues than variable cost- ing. They argue that all manufacturing costs must be assigned to products to properly match the costs of producing units of product with the revenues from the units when they are sold. They believe that no distinction should be made between variable and fixed manufacturing costs for the purposes of matching costs and reve- nues.
7-5 Advocates of variable costing argue that fixed manufacturing costs are not really the cost of any particular unit of product. If a unit is
made or not, the total fixed manufacturing costs will be exactly the same. Therefore, how can one say that these costs are part of the costs of the products? These costs are incurred to have the capacity to make products during a particu- lar period and should be charged against that period as period costs according to the matching principle. 7-6 If production and sales are equal, net operating income should be the same under ab- sorption and variable costing. When production equals sales, inventories do not increase or de- crease and therefore under absorption costing fixed manufacturing overhead cost cannot be deferred in inventory or released from inventory. 7-7 If production exceeds sales, absorption costing will usually show higher net operating income than variable costing. When production exceeds sales, inventories increase and under absorption costing part of the fixed manufactur- ing overhead cost of the current period is de- ferred in inventory to the next period. In con- trast, all of the fixed manufacturing overhead cost of the current period is immediately ex- pensed under variable costing. 7-8 If fixed manufacturing overhead cost is released from inventory, then inventory levels must have decreased and therefore production must have been less than sales. 7-9 Inventory decreased. The decrease re- sulted in fixed manufacturing overhead cost be- ing released from inventory and expensed as part of cost of goods sold. This added fixed manufacturing overhead cost resulted in a loss even though the company operated at its break- even.
336 Managerial Accounting, 12th Edition
7-10 Under absorption costing net operating income can be increased by simply increasing the level of production without any increase in sales. If production exceeds sales, units of prod- uct are added to inventory. These units carry a portion of the current period’s fixed manufactur- ing overhead costs into the inventory account, thereby reducing the current period’s reported expenses and causing net operating income to increase.
7-11 Generally speaking, variable costing cannot be used externally for financial reporting
purposes nor can it be used for tax purposes. It can, however, be used in internal reports. 7-12 Differences in reported net operating income between absorption and variable costing arise because of changing levels of inventory. In lean production, goods are produced strictly to customers’ orders. With production geared to sales, inventories are largely (or entirely) elimi- nated. If inventories are completely eliminated, they cannot change from one period to another and absorption costing and variable costing will report the same net operating income.
338 Managerial Accounting, 12th Edition
Exercise 7-2 (30 minutes)
- 2,000 units × R60 per unit fixed manufacturing overhead = R120,
- The variable costing income statement appears below:
Sales ................................................. R4,000, Variable expenses: Variable cost of goods sold: Beginning inventory ....................... R 0 Add variable manufacturing costs (10,000 units× R310 per unit) .. 3,100, Goods available for sale ................. 3,100, Less ending inventory (2,000 units × R310 per unit) ...... 620, Variable cost of goods sold* ............. 2,480, Variable selling and administrative (8,000 units × R20 per unit) .......... 160,000 2,640, Contribution margin ............................ 1,360, Fixed expenses: Fixed manufacturing overhead .......... 600, Fixed selling and administrative ........ 400,000 1,000, Net operating income ......................... R 360,
- The variable cost of goods sold could be computed more simply as: 8,000 units sold × R310 per unit = R2,480,000. The difference in net operating income between variable and absorption costing can be explained by the deferral of fixed manufacturing over- head cost in inventory that has taken place under the absorption costing approach. Note from part (1) that R120,000 of fixed manufacturing overhead cost has been deferred in inventory to the next period. Thus, net operating income under the absorption costing approach is R120,000 higher than it is under variable costing.
Solutions Manual, Chapter 7 339
Exercise 7-3 (20 minutes)
- Year 1 Year 2 Year 3 Beginning inventories (units) .............................. 180 150 160 Ending inventories (units) .... 150 160 200 Change in inventories (units) .............................. (30) 10 40
Variable costing net operat- ing income ....................... $292,400 $269,200 $251, Add: Fixed manufacturing overhead cost deferred in inventory under absorp- tion costing (10 units × $450 per unit; 40 units × $450 per unit) .................. 4,500 18, Deduct: Fixed manufactur- ing overhead cost re- leased from inventory un- der absorption costing ( units × $450 per unit) ....... 13, Absorption costing net op- erating income.................. $278,900 $273,700 $269,
- Because absorption costing net operating income was greater than vari- able costing net operating income in Year 4, inventories must have in- creased during the year and hence fixed manufacturing overhead was deferred in inventories. The amount of the deferral is just the difference between the two net operating incomes or $27,000 = $267,200 – $240,200.
Solutions Manual, Chapter 7 341
Exercise 7-4 (continued)
- a. As discussed in part (1 a) above, unit sales and variable costing net operating income move in the same direction when unit selling prices and the cost structure are constant. Because variable costing net op- erating income declined, unit sales must have also declined. This is true even though the absorption costing net operating income in- creased. How can that be? By manipulating production (and invento- ries) it may be possible to maintain or increase the level of absorption costing net operating income even though unit sales decline. Howev- er, eventually inventories will grow to be so large that they cannot be ignored. b. As stated in part (1 b) above, when variable costing net operating in- come is less than absorption costing net operating income, produc- tion exceeds sales. Inventories grow and fixed manufacturing over- head costs are deferred in inventories. The year-by-year effects are shown below.
Year 1 Year 2 Year 3 Variable costing NOI = Absorption cost- ing NOI
Variable costing NOI < Absorption cost- ing NOI
Variable costing NOI < Absorption costing NOI Production = Sales Production > Sales Production > Sales Inventories remain the same Inventories grow Inventories grow
342 Managerial Accounting, 12th Edition
Exercise 7-4 (continued)
- Variable costing appears to provide a much better picture of economic reality than absorption costing in the examples above. In the first case, absorption costing net operating income fluctuates wildly even though unit sales are the same each year and unit selling prices, unit variable costs, and total fixed costs remain the same. In the second case, ab- sorption costing net operating income increases from year to year even though unit sales decline. Absorption costing is much more subject to manipulation than variable costing. Simply by changing production levels (and thereby deferring or releasing costs from inventory) absorption costing net operating income can be manipulated upward or downward.
Note: This exercise is based on the following data:
Common data: Annual fixed manufacturing costs ....... $153, Contribution margin per unit .............. $35, Annual fixed SGA costs ...................... $180,
Part 1: Year 1 Year 2 Year 3 Beginning inventory ........................... 1 1 2 Production ........................................ 10 11 9 Sales ................................................ 10 10 10 Ending .............................................. 1 2 1 Variable costing net operating income. $16,847 $16,847 $16, Fixed manufacturing overhead in be- ginning inventory*......................... $15,315 $15,315 $27, Fixed manufacturing overhead in end- ing inventory ................................. $15,315 $27,846 $17, Absorption costing net operating in- come ............................................ $16,847 $29,378 $6,
- Fixed manufacturing overhead in beginning inventory is assumed in both parts 1 and 2 for Year 1. A FIFO inventory flow assumption is used.
344 Managerial Accounting, 12th Edition
Exercise 7-5 (30 minutes)
- Under variable costing, only the variable manufacturing costs are includ- ed in product costs. Direct materials .................................... $ 60 Direct labor .......................................... 30 Variable manufacturing overhead .......... 10 Unit product cost .................................. $ Note that selling and administrative expenses are not treated as product costs; that is, they are not included in the costs that are inventoried. These expenses are always treated as period costs and are charged against the current period’s revenue.
- The variable costing income statement appears below:
Sales ................................................. $1,800, Variable expenses: Variable cost of goods sold: Beginning inventory ....................... $ 0 Add variable manufacturing costs (10,000 units × $100 per unit) .... 1,000, Goods available for sale ................. 1,000, Less ending inventory (1,000 units × $100 per unit) ......................... 100, Variable cost of goods sold* ............. 900, Variable selling and administrative (9,000 units × $20 per unit) .......... 180,000 1,080, Contribution margin ............................ 720, Fixed expenses: Fixed manufacturing overhead .......... 300, Fixed selling and administrative ........ 450,000 750, Net operating loss .............................. $ (30,000)
- The variable cost of goods sold could be computed more simply as: 9,000 units sold × $100 per unit = $900,000.
Solutions Manual, Chapter 7 345
Exercise 7-5 (continued)
- The break-even point in units sold can be computed using the contribu- tion margin per unit as follows:
Selling price per unit ..................... $ Variable cost per unit .................... 120 Contribution margin per unit ......... $ 80
Fixed expenses Break-even unit sales = Unit contribution margin
$750,
$80 per unit
= 9,375 units
Solutions Manual, Chapter 7 347
Exercise 7-7 (30 minutes)
- a. The unit product cost under absorption costing would be:
Direct materials ................................................................ $ Direct labor ...................................................................... 7 Variable manufacturing overhead ...................................... 2 Total variable manufacturing costs ..................................... 27 Fixed manufacturing overhead ($160,000 ÷ 20,000 units) .. 8 Unit product cost .............................................................. $
b. The absorption costing income statement: Sales (16,000 units × $50 per unit) ............ $800, Cost of goods sold: Beginning inventory ................................ $ 0 Add cost of goods manufactured (20,000 units × $35 per unit)................ 700, Goods available for sale........................... 700, Less ending inventory (4,000 units × $35 per unit) ................. 140,000 560, Gross margin............................................. 240, Selling and administrative expenses ............ 190,000 * Net operating income ................................ $ 50, *(16,000 units × $5 per unit) + $110,000 = $190,000.
348 Managerial Accounting, 12th Edition
Exercise 7-7 (continued)
- a. The unit product cost under variable costing would be:
Direct materials ................................................... $ Direct labor ......................................................... 7 Variable manufacturing overhead ......................... 2 Unit product cost ................................................. $
b. The variable costing income statement: Sales (16,000 units × $50 per unit) ................ $800, Less variable expenses: Variable cost of goods sold: Beginning inventory .................................. $ 0 Add variable manufacturing costs (20,000 units × $27 per unit) ................. 540, Goods available for sale ............................ 540, Less ending inventory (4,000 units × $27 per unit) ................... 108, Variable cost of goods sold .......................... 432,000 * Variable selling expense (16,000 units × $5 per unit) ..................... 80,000 512, Contribution margin ....................................... 288, Less fixed expenses: Fixed manufacturing overhead ..................... 160, Fixed selling and administrative ................... 110,000 270, Net operating income .................................... $ 18,
- The variable cost of goods sold could be computed more simply as: 16,000 units × $27 per unit = $432,000.
350 Managerial Accounting, 12th Edition
Exercise 7-9 (20 minutes)
- Sales (40,000 units × $33.75 per unit) ........... $1,350, Variable expenses: Variable cost of goods sold (40,000 units × $16 per unit*).................. $640, Variable selling and administrative expenses (40,000 units × $3 per unit) ..................... 120,000 760, Contribution margin....................................... 590, Fixed expenses: Fixed manufacturing overhead ..................... 250, Fixed selling and administrative expenses..... 300,000 550, Net operating income .................................... $ 40, * Direct materials .............................. $ Direct labor .................................... 4 Variable manufacturing overhead..... 2 Total variable manufacturing cost .... $
- The difference in net operating income can be explained by the $50, in fixed manufacturing overhead deferred in inventory under the absorp- tion costing method: Variable costing net operating income............................ $40, Add: Fixed manufacturing overhead cost deferred in in- ventory under absorption costing: 10,000 units × $ per unit in fixed manufacturing overhead cost ............. 50, Absorption costing net operating income........................ $90,
Solutions Manual, Chapter 7 351
Problem 7-10 (30 minutes)
- The unit product cost under the variable costing approach would be computed as follows: Direct materials .................................... $ 8 Direct labor .......................................... 10 Variable manufacturing overhead .......... 2 Unit product cost .................................. $ With this figure, the variable costing income statements can be pre- pared: Year 1 Year 2 Sales ......................................................... $1,000,000 $1,500, Variable expenses: Variable cost of goods sold @ $20 per unit 400,000 600, Variable selling and administrative @ $ per unit ................................................ 60,000 90, Total variable expenses ............................... 460,000 690, Contribution margin .................................... 540,000 810, Fixed expenses: Fixed manufacturing overhead .................. 350,000 350, Fixed selling and administrative ................ 250,000 250, Total fixed expenses ................................... 600,000 600, Net operating income (loss) ........................ $ (60,000) $ 210,
- Variable costing net operating income (loss) $ (60,000) $ 210, Add: Fixed manufacturing overhead cost deferred in inventory under absorption costing (5,000 units × $14 per unit) ......... 70, Deduct: Fixed manufacturing overhead cost released from inventory under absorption costing (5,000 units × $14 per unit) ......... (70,000) Absorption costing net operating income ..... $ 10,000 $ 140,
Solutions Manual, Chapter 7 353
Problem 7-11 (continued)
b. The variable costing income statement follows: Sales (35,000 units × $60 per unit) .............. $2,100, Variable expenses: Variable cost of goods sold: Beginning inventory ................................ $ 0 Add variable manufacturing costs (40,000 units × $24 per unit) ............... 960, Goods available for sale .......................... 960, Less ending inventory (5,000 units × $24 per unit) ................. 120, Variable cost of goods sold ........................ 840, Variable selling expense (35,000 units × $2 per unit) ................... 70,000 910, Contribution margin ..................................... 1,190, Fixed expenses: Fixed manufacturing overhead ................... 640, Fixed selling and administrative expense .... 560,000 1,200, Net operating loss ....................................... $ (10,000)
- The difference in the ending inventory relates to a difference in the han- dling of fixed manufacturing overhead costs. Under variable costing, these costs have been expensed in full as period costs. Under absorp- tion costing, these costs have been added to units of product at the rate of $16 per unit ($640,000 ÷ 40,000 units produced = $16 per unit). Thus, under absorption costing a portion of the $640,000 fixed manu- facturing overhead cost of the month has been added to the inventory account rather than expensed on the income statement: Added to the ending inventory (5,000 units × $16 per unit) ....................................... $ 80, Expensed as part of cost of goods sold (35,000 units × $16 per unit) ..................................... 560, Total fixed manufacturing overhead cost for the month .. $640,
354 Managerial Accounting, 12th Edition
Problem 7-11 (continued)
Because $80,000 of fixed manufacturing overhead cost has been de- ferred in inventory under absorption costing, the net operating income reported under that costing method is $80,000 higher than the net op- erating income under variable costing, as shown in parts (1) and (2) above.
