AF2110 Management Accounting 1

Assignment 05 Suggested Solutions

Exercise 6-13 (20 minutes)

1. The company is using variable costing. The computations are:
Variable Absorption
Costing Costing
Direct materials............................ $  9 $  9
Direct labor.................................. 10 10
Variable manufacturing overhead. . 5 5
Fixed manufacturing overhead
($150,000 ÷ 25,000 units).........  —      6
Unit product cost.......................... $24 $30
Total cost, 3,000 units.................. $72,000 $90,000

2. a. No, $72,000 is not the correct figure to use because variable costing
is not generally accepted for external reporting purposes or for tax
purposes.

b. The Finished Goods inventory account should be stated at $90,000,

which represents the absorption cost of the 3,000 unsold units. Thus,
the account should be increased by $18,000 for external reporting
purposes. This $18,000 consists of the amount of fixed manufacturing
overhead cost that is allocated to the 3,000 unsold units under
absorption costing (3,000 units × $6 per unit fixed manufacturing
overhead cost = $18,000).
Problem 6-23 (60 minutes)
1. a. Absorption costing unit product cost is:
Direct materials.................................. $ 3.50
Direct labor........................................ 12.00
Variable manufacturing overhead........ 1.00
Fixed manufacturing overhead
($300,000 ÷ 30,000 units)................  10.00
Absorption costing unit product cost.... $26.50

b. The absorption costing income statement is:

Sales (28,000 units)............................................... $1,120,000
Cost of goods sold (28,000 units × $26.50 per unit).     742,000
Gross margin......................................................... 378,000
Selling and administrative expenses
($200,000 + 28,000 units × $6.00 per unit)..........     368,000
Net operating income............................................. $    10,000

c. The reconciliation is as follows:

Units in ending inventory = Units in beginning inventory + Units
produced – Units sold = 0 units +30,000 units – 28,000 units
= 2,000 units
Manufacturing overhead deferred in (released from) inventory = Fixed
manufacturing overhead in ending inventory – Fixed manufacturing
overhead in beginning inventory = (2,000 units × $10 per unit) – $0
= $20,000
Variable costing net loss......................................... $(10,000)
Add fixed manufacturing overhead cost deferred in
inventory under absorption costing.......................   20,000
Absorption costing net operating income................. $ 10,000
Problem 6-23 (continued)
2. Under absorption costing, the company did earn a profit for the quarter.
However, before the question can really be answered, one must first
define what is meant by a “profit.” The central issue here relates to
timing of release of fixed manufacturing overhead costs to expense.
Advocates of variable costing argue that all such costs should be
expensed immediately, and that no profit is earned unless the revenues
of a period are sufficient to cover the fixed manufacturing overhead
costs in full. From this point of view, no profit was earned during the
quarter because the fixed costs were not fully covered.

Advocates of absorption costing would argue, however, that fixed

manufacturing overhead costs attach to units of product as they are
produced, and that such costs do not become an expense until the units
are sold. Therefore, if the selling price of a unit is greater than the unit
product cost (including a proportionate amount of fixed manufacturing
overhead), then a profit is earned even if some units produced are
unsold and carry some fixed manufacturing overhead with them to the
following period. A difficulty with this argument is that “profits” will vary
under absorption costing depending on how many units are added to or
taken out of inventory. That is, profits will depend not only on sales, but
on what happens to inventories. In particular, profits can be consciously
manipulated by increasing or decreasing a company’s inventories.

3. a. The variable costing income statement is:

Sales (32,000 units × $40 per unit)............ $1,280,000
Variable expenses:
Variable cost of goods sold
(32,000 units × $16.50 per unit)........... $528,000
Variable selling and administrative
expenses (32,000 units × $6 per unit). .  192,000    720,000
Contribution margin.................................. 560,000
Fixed expenses:
Fixed manufacturing overhead................ 300,000
Fixed selling and administrative expense..  200,000     500,000
Net operating income................................ $   60,000
Problem 6-23 (continued)
b. The absorption costing income statement would be constructed as
follows:
The absorption costing unit product cost will remain at $26.50, the
same as in part (1).
Sales (32,000 units × $40 per unit)........................... $1,280,000
Cost of goods sold (32,000 units × $26.50 per unit)...     848,000
Gross margin........................................................... 432,000
Selling and administrative expenses
($200,000 + 32,000 units × $6.00 per unit)............     392,000
Net operating income............................................... $    40,000

c. The reconciliation of variable costing and absorption costing income

is:
Units in ending inventory = Units in beginning inventory + Units
produced – Units sold = 2,000 units +30,000 units – 32,000 units
= 0 units
Manufacturing overhead deferred in (released from) inventory = Fixed
manufacturing overhead in ending inventory – Fixed manufacturing
overhead in beginning inventory = (0 units × $10 per unit) – (2,000
units × $10 per unit) = -$20,000
Variable costing net operating income..................... $ 60,000
Deduct fixed manufacturing overhead cost released
from inventory under absorption costing...............  (20,000)
Absorption costing net operating income................. $ 40,000
Problem 6-25 (75 minutes)

1. Year 1 Year 2 Year 3

Unit sales.................................... 50,000 40,000 50,000
Sales........................................... $800,000 $ 640,000 $800,000
Variable expenses:
Variable cost of goods sold
@ $2 per unit......................... 100,000 80,000 100,000
Variable selling and
administrative expenses
@ $1 per unit.........................     50,000     40,000     50,000
Total variable expenses................   150,000   120,000   150,000
Contribution margin.....................   650,000   520,000   650,000
Fixed expenses:
Fixed manufacturing overhead. . . 480,000 480,000 480,000
Fixed selling and administrative
expenses................................   140,000   140,000   140,000
Total fixed expenses.....................   620,000   620,000   620,000
Net operating income (loss).......... $  30,000 $(100,000)$  30,000
 Problem 6-25 (continued)

a.2. Year 1 Year 2 Year 3

Variable manufacturing cost................. $ 2.00 $ 2.00 $ 2.00
Fixed manufacturing cost:
$480,000 ÷ 50,000 units................... 9.60
$480,000 ÷ 60,000 units................... 8.00
$480,000 ÷ 40,000 units...................                      12.00
Absorption costing unit product cost..... $11.60 $10.00 $14.00

b. Units in beginning inventory................ 0 0 20,000

+ Units produced................................ 50,000 60,000 40,000
− Units sold........................................ 50,000 40,000 50,000
= Units in ending inventory.................         0 20,000 10,000
Fixed manufacturing overhead in
ending inventory.............................. $       0 $160,000 $120,000
− Fixed manufacturing overhead in
beginning inventory..........................          0            0 160,000
= Manufacturing overhead deferred in
(released from) inventory.................. $       0 $160,000 $(40,000)
Variable costing net operating income
(loss)............................................... $30,000 $(100,000) $ 30,000 
Add fixed manufacturing overhead
deferred in inventory........................ 160,000
Deduct fixed manufacturing overhead
cost released from inventory.............                           (40,000)
Absorption costing net operating
income (loss)................................... $30,000 $  60,000 $(10,000)

3. Production went up sharply in Year 2, thereby reducing the unit product

cost, as shown in (2a) above. This reduction in cost per unit, combined
with the large amount of fixed manufacturing overhead deferred in
inventory for the year, more than offset the loss of revenue. The net
result is that the company’s net operating income increased.

4. The fixed manufacturing overhead deferred in inventory from Year 2

was charged against Year 3 operations. This added charge against Year
3 operations was offset somewhat by the fact that part of Year 3’s fixed
Problem 6-25 (continued)
 manufacturing overhead costs were deferred in inventory to future
years. Overall, the added costs charged against Year 3 were greater
than the costs deferred to future years, so the company reported less
income for the year even though the same number of units was sold as
in Year 1.

5. a. With lean production, production would have been tied 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, the net operating income under
absorption costing would have been the same as under variable
costing in all three years. With production tied to sales, there would
have been no ending inventory, and therefore there would have been
no fixed manufacturing overhead costs deferred in inventory to other
years. If the predetermined overhead rate is based on 50,000 units in
each year, the income statements under absorption costing would
have appeared as follows:
Year 1 Year 2 Year 3
Unit sales.............................. 50,000 40,000 50,000
Sales..................................... $ 800,000 $ 640,000 $ 800,000
Cost of goods sold:
Cost of goods
manufactured @ $11.60
per unit............................ 580,000 464,000 * 580,000
Add underapplied overhead.                    96,000 **             
Cost of goods sold.................   580,000    560,000  580,000
Gross margin......................... 220,000 80,000 220,000
Selling and administrative
expenses............................   190,000     180,000   190,000
Net operating income (loss). . . $  30,000 $(100,000) $  30,000
* 40,000 units × $11.60 per unit = $464,000.
** 10,000 units not produced × $9.60 per unit fixed manufacturing
overhead cost per unit = $96,000 fixed manufacturing overhead cost
not applied to products.
Problem 6-27 (30 minutes)
1. Because of soft demand for the Brazilian Division’s product, the
inventory should be drawn down to the minimum level of 50 units.
Drawing inventory down to the minimum level would require production
as follows during the last quarter:
Desired inventory, December 31.......... 50 units
Expected sales, last quarter................. 600 units
Total needs........................................ 650 units
Less inventory, September 30.............. 400 units
Required production............................ 250 units
This plan would save inventory carrying costs such as storage (rent,
insurance), interest, and obsolescence.
The number of units scheduled for production will not affect the
reported net operating income or loss for the year if variable costing is
in use. All fixed manufacturing overhead cost will be treated as an
expense of the period regardless of the number of units produced.
Thus, no fixed manufacturing overhead cost would be shifted between
periods through the inventory account and income would be a function
of the number of units sold, rather than a function of the number of
units produced.

2. To maximize the Brazilian Division’s operating income, Mr. Cavalas could

produce as many units as storage facilities will allow. By building
inventory to the maximum level, Mr. Cavalas would be able to defer a
portion of the year’s fixed manufacturing overhead costs to future years
through the inventory account, rather than having all of these costs
appear as charges on the current year’s income statement. Building
inventory to the maximum level of 1,000 units would require production
as follows during the last quarter:
Desired inventory, December 31.... 1,000 units
Expected sales, last quarter........... 600 units
Total needs.................................. 1,600 units
Less inventory, September 30....... 400 units
Required production..................... 1,200 units
Problem 6-27 (continued)
Thus, by producing enough units to build inventory to the maximum
level that storage facilities would allow, Mr. Cavalas could relieve the
current year of fixed manufacturing overhead cost and thereby
maximize the current year’s operating income.

3. By setting a production schedule that will maximize his division’s net

operating income—and maximize his own bonus—Mr. Cavalas would be
acting against the best interests of the company as a whole. The extra
units aren’t needed and would be expensive to carry in inventory.
Moreover, there is no indication that demand would 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.
Cavalas sets a production schedule as shown in part (2) above, he
would obtain his bonus as a result of producing rather than as a result
of selling. Moreover, he would obtain it by creating greater expenses—
rather than fewer expenses—for the company as a whole.
In sum, 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.
Case 6-29 (45 minutes)
1 a. Under variable costing, only the variable manufacturing costs are included in product costs.
Year 1 Year 2 Year 3
Direct materials..................................... $32 $32 $32
Direct labor........................................... 20 20 20
Variable manufacturing overhead...........    4    4    4
Variable costing unit product cost........... $56 $56 $56

1 b. The variable costing income statements appear below:

Year 1 Year 2 Year 3
Sales........................................................................... $6,000,000 $6,750,000 $5,625,000
Variable expenses:
Variable cost of goods sold @ $56 per unit.................. 4,480,000 5,040,000 4,200,000
Variable selling and administrative @ $3 per unit.........    240,000    270,000    225,000
Total variable expenses................................................ 4,720,000 5,310,000 4,425,000
Contribution margin...................................................... 1,280,000 1,440,000 1,200,000
Fixed expenses:
Fixed manufacturing overhead.................................... 660,000 660,000 660,000
Fixed selling and administrative..................................     120,000      120,000     120,000
Total fixed expenses.....................................................     780,000      780,000     780,000
Net operating income................................................... $  500,000 $   660,000 $  420,000

2a. and 2b.

The answers to 2a and 2b are the same as 1a and 1b because the unit product costs are the same
for all three years. The inventory flow assumption is irrelevant when the unit product cost stays
constant.
Case 6-29 (continued)
3 a. The unit product costs under absorption costing:
Year 1 Year 2 Year 3
Direct materials..................................... $32.00 $32.00 $32.00
Direct labor........................................... 20.00 20.00 20.00
Variable manufacturing overhead........... 4.00 4.00 4.00
Fixed manufacturing overhead...............  *6.60  **8.80 ***8.25
Absorption costing unit product cost....... $62.60 $64.80 $64.25

* $660,000 ÷ 100,000 units = $6.60 per unit.

** $660,000 ÷ 75,000 units = $8.80 per unit.
*** $660,000 ÷ 80,000 units = $8.25 per unit.

3 b. The absorption costing income statements appear below (FIFO):

Year 1 Year 2 Year 3
Sales...................................................... $6,000,000 $6,750,000 $5,625,000
Cost of goods sold..................................  5,008,000  5,788,000  4,821,500
Gross margin.......................................... 992,000 962,000 803,500
Selling and administrative expenses.........     360,000    390,000     345,000
Net operating income.............................. $  632,000 $  572,000 $  458,500

Cost of goods sold computations:

Year 1: 80,000 units × $62.60 per unit = $5,008,000
Year 2: (20,000 units × $62.60 per unit) + (70,000 units × $64.80 per unit) = $5,788,000
Year 3: (5,000 × $64.80 per unit) + (70,000 × $64.25 per unit) = $4,821,500
Case 6-29 (continued)
4 a. The unit product costs under absorption costing:
Year 1 Year 2 Year 3
Direct materials..................................... $32.00 $32.00 $32.00
Direct labor........................................... 20.00 20.00 20.00
Variable manufacturing overhead........... 4.00 4.00 4.00
Fixed manufacturing overhead...............  *6.60 **8.80 ***8.25
Absorption costing unit product cost....... $62.60 $64.80 $64.25

* $660,000 ÷ 100,000 units = $6.60 per unit.

** $660,000 ÷ 75,000 units = $8.80 per unit.
*** $660,000 ÷ 80,000 units = $8.25 per unit.

4 b. The absorption costing income statements appears below (LIFO):

Year 1 Year 2 Year 3
Sales...................................................... $6,000,000 $6,750,000 $5,625,000
Cost of goods sold..................................  5,008,000  5,799,000  4,818,750
Gross margin.......................................... 992,000 951,000 806,250
Selling and administrative expenses.........     360,000     390,000     345,000
Net operating income.............................. $  632,000 $  561,000 $  461,250

Cost of goods sold computations:

Year 1: 80,000 units × $62.60 per unit = $5,008,000
Year 2: (75,000 units × $64.80 per unit) + (15,000 units × $62.60 per unit) = $5,799,000
Year 3: 75,000 × $64.25 per unit = $4,818,750