Chapter 8

Variable Costing: A Tool for Management

Discussion Case (30 minutes)

Discussion of this issue should include many of the following points:

1. Absorption costing is argued to better adhere to the “matching princi-
ple” than variable costing making it a better candidate for external fi-
nancial reporting. The matching principle argues that revenues gener-
ated in a period should be matched with related costs incurred to gen-
erate those revenues (i.e., the unit cost of products produced should
only be recognized in the income statement when those units of prod-
uct are actually sold). In addition, proponents of absorption costing
would argue that product costs should include ALL costs related to
manufacturing, whether they are variable or fixed.
2.“Phantom” or “illusory” profits are generated when a company produces
more product than they expect to sell in order to boost operating in-
come. These profits are “illusory” in that they are not sustainable, nor
are they generated by productive means. They are purely an artefact of
the accounting system.
3. A firm with sales below breakeven could report profits assuming the
majority of their manufacturing costs were fixed and they overproduced
in order to hold some of those fixed costs back in inventory at the end
of the period.
4. Some firms that have been accused of inventory manipulation since
2000 include Bristol-Myers Squibb Co., Diamond Foods and Coca-Cola.
Students could be asked to research these accusations in more detail
on the web and report on what they find. (Possible sources include
http://www.sec.gov/news/press/2005-118.htm,
http://www.huffingtonpost.com/2012/03/19/diamond-foods-
accounting-scandal_n_1361234.html)

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Solutions Manual, Chapter 8 1
Solutions to Questions

8-1 Absorption and variable costing differ in ing overhead cost of the current period is de-
how they handle fixed manufacturing overhead. ferred in inventory to the next period. In con-
Under absorption costing, fixed manufacturing trast, all of the fixed manufacturing overhead
overhead is treated as a product cost and hence cost of the current period is immediately ex-
is an asset until products are sold. Under varia- pensed under variable costing.
ble costing, fixed manufacturing overhead is
treated as a period cost and is expensed on the 8-5 If fixed manufacturing overhead cost is
current period’s income statement. released from inventory, then inventory levels
must have decreased and therefore production
8-2 Advocates of variable costing argue that must have been less than sales.
variable costing simplifies short-term planning
since the income statement under variable cost- 8-6 Inventory increased. The increase re-
ing is presented in the contribution format. In sulted in fixed manufacturing overhead cost be-
this format, contribution margin, an important ing charged to ending inventory on the balance
short-term measure of profit, is prominently fea- sheet. This reduced fixed manufacturing over-
tured and therefore, provides information in a head cost resulting in a profit even though the
simpler format to support the manager’s prepa- company operated at its breakeven level of
ration of cost-volume-profit and other analyses sales.
focused on the short-term. In addition, since
fixed costs do not change in the short-term, an 8-7 Generally speaking, variable costing
income statement that focuses the manager on cannot be used externally for financial reporting
changes in variable cost is useful for short-term purposes although it can be used for tax pur-
decision making. poses in Canada.

8-3 If production and sales are equal, 8-8 Differences in reported operating in-
operating income should be the same under come between absorption and variable costing
absorption and variable costing. When production arise because of changing levels of inventory. In
equals sales, inventories do not increase or de- lean production, goods are produced strictly to
crease and therefore under absorption costing customers’ orders. With production geared to
fixed manufacturing overhead cost cannot be sales, inventories are largely (or entirely) elimi-
deferred in inventory or released from inventory. nated. If inventories are completely eliminated,
they cannot change from one period to another
8-4 If production exceeds sales, absorption and absorption costing and variable costing will
costing will usually show higher operating in- report the same operating income.
come than variable costing. When production
exceeds sales, inventories increase and under
absorption costing part of the fixed manufactur-

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2 Managerial Accounting, 11th Canadian Edition
Foundational Exercises
1. and 2.
The unit product costs under variable costing and absorption costing are
computed as follows:
Variable Absorption
Costing Costing
Direct materials .............................. $24 $24
Direct labor .................................... 14 14
Variable manufacturing overhead .... 2 2
Fixed manufacturing overhead
($800,000 ÷ 40,000 units) ........... — 20
Unit product cost ............................ $40 $60

3. and 4.
The total contribution margin and net operating income under variable
costing are computed as follows:
Sales ................................................. $2,800,000
Variable expenses:
Variable cost of goods sold
(35,000 units × $40 per unit)......... $1,400,000
Variable selling and administrative
(35,000 units × $4 per unit) .......... 140,000 1,540,000
Contribution margin ............................ 1,260,000
Fixed expenses:
Fixed manufacturing overhead .......... 800,000
Fixed selling and administrative ........ 496,000 1,296,000
Net operating loss .............................. $ (36,000)

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Solutions Manual, Chapter 8 3
Foundational Exercises (continued)

5. and 6.
The total gross margin and net operating income under absorption cost-
ing are computed as follows:
Sales (35,000 units × $80 per unit) ........................... $2,800,000
Cost of goods sold (35,000 units × $60 per unit)........ 2,100,000
Gross margin ........................................................... 700,000
Selling and administrative expenses
[(35,000 units × $4 per unit) + $496,000] .............. 636,000
Net operating income ............................................... $ 64,000

7. The difference between the absorption and variable costing net operat-
ing incomes is explained as follows:

Manufacturing overhead deferred in (released from) inventory = Fixed

manufacturing overhead in ending inventory – Fixed manufacturing
overhead in beginning inventory = ($20 per unit × 5,000 units) − $0
= $100,000
Variable costing net operating loss........................... $(36,000)
Add fixed manufacturing overhead cost deferred in
inventory under absorption costing* ..................... 100,000
Absorption costing net operating income ................. $ 64,000

8. The break-even point in units is computed as follows:

Profit = Unit CM × Q − Fixed expenses
$0 = ($80 − $44) × Q − $1,296,000
$0 = ($36) × Q − $1,296,000
$36Q = $1,296,000
Q = $1,296,000 ÷ $36
Q = 36,000 units
The break-even point is above the actual sales volume; however, in
question 6, the absorption costing net operating income is $64,000. This
counter-intuitive result emerges because $100,000 of fixed manufactur-
ing overhead is deferred in inventory under absorption costing.

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4 Managerial Accounting, 11th Canadian Edition
Foundational Exercises (continued)

9. and 10.
The variable costing net operating income would be the same as the an-
swer to question 4 as shown below:
Sales ................................................. $2,800,000
Variable expenses:
Variable cost of goods sold
(35,000 units × $40 per unit)......... $1,400,000
Variable selling and administrative
(35,000 units × $4 per unit) .......... 140,000 1,540,000
Contribution margin ............................ 1,260,000
Fixed expenses:
Fixed manufacturing overhead .......... 800,000
Fixed selling and administrative ........ 496,000 1,296,000
Net operating loss .............................. $ (36,000)

When the number of units produced equals the number of units sold,
absorption costing net operating income equals the variable costing net
operating income. Therefore, the answer to question 11 is that the ab-
sorption costing net operating loss would be $36,000.

11. Absorption costing income will be lower than variable costing income.
The variable costing income statement will only include the fixed
manufacturing overhead costs incurred during the second year of op-
erations, whereas the absorption costing cost of goods sold will in-
clude all of the fixed manufacturing overhead costs incurred during
the second year of operations plus some of the fixed manufacturing
overhead costs that were deferred in inventory at the end of the prior
year.

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Solutions Manual, Chapter 8 5
Exercise 8-1 (15 minutes)
1. Under absorption costing, all manufacturing costs (variable and fixed)
are included in product costs.
Direct materials ............................................................ $100
Direct labor .................................................................. 320
Variable manufacturing overhead .................................. 40
Fixed manufacturing overhead ($60,000 ÷ 250 units) ..... 240
Absorption costing unit product cost .............................. $700

2. Under variable costing, only the variable manufacturing costs are includ-
ed in product costs.

Direct materials ............................................................ $100

Direct labor .................................................................. 320
Variable manufacturing overhead .................................. 40
Variable costing unit product cost .................................. $460
Note that selling and administrative expenses are not treated as product
costs under either absorption or variable costing. These expenses are
always treated as period costs and are charged against the current peri-
od’s revenue.

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6 Managerial Accounting, 11th Canadian Edition
Exercise 8-2 (20 minutes)
1. 25 units in ending inventory × $240 per unit fixed manufacturing over-
head per unit = $6,000

2. The variable costing income statement appears below:

Sales ............................................................ $191,250
Variable expenses:
Variable cost of goods sold
(225 units sold × $460 per unit) ............... $103,500
Variable selling and administrative expenses
(225 units × $20 per unit) ........................ 4,500 108,000
Contribution margin....................................... 83,250
Fixed expenses:
Fixed manufacturing overhead ..................... 60,000
Fixed selling and administrative expenses ..... 20,000 80,000
Net operating income .................................... $ 3,250
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 $6,000 of fixed manufacturing over-
head cost has been deferred in inventory to the next period. Thus, net
operating income under the absorption costing approach is $6,000 high-
er than it is under variable costing.

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Solutions Manual, Chapter 8 7
Exercise 8-3 (20 minutes)
1. Year 1 Year 2 Year 3
Beginning inventories
(units) .............................. 150 180 160
Ending inventories (units) .... 160 150 200
Change in inventories
(units) .............................. 10 (30) 40

Variable costing operating

income ............................. $292,400 $269,200 $251,800
Add: Fixed manufacturing
overhead cost deferred in
inventory under absorp-
tion costing (10 units ×
$2,500 per unit; 40 units
× $2,500 per unit) ............ 25,000 100,000
Deduct: Fixed manufactur-
ing overhead cost re-
leased from inventory un-
der absorption costing (30
units × $2,500 per unit) .... (75,000)
Absorption costing
operating income .............. $317,400 $194,200 $351,800

2. Because absorption costing operating income was less than variable

costing operating income in Year 4, inventories must have decreased
during the year and hence fixed manufacturing overhead was released
from inventories. The amount released is just the difference between
the two operating incomes or $35,000 = $240,200 - $205,200.

Note: Using the change in inventory to do reconciliation is easy when pro-

duction levels remain the same from year to year but students should be
cautioned that when production levels change, so do fixed overhead costs
per unit and you then must calculate overhead costs released and deferred
in inventories separately.

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8 Managerial Accounting, 11th Canadian Edition
Exercise 8-4 (30 minutes)
1. a. By assumption, the unit selling price, unit variable costs, and total
fixed costs are constant from year to year. Consequently, operating
income will vary with sales using variable costing. If sales increase,
variable costing operating income will increase. If sales decrease,
variable costing operating income will decrease. If sales are
constant, variable costing operating income will be constant. Because
variable costing operating income was $16,847 each year, unit sales
must have been the same in each year.
The same is not true of absorption costing operating income. Sales
and absorption costing operating income do not necessarily move in
the same direction because changes in inventories also affect
absorption costing operating income.

b. When variable costing operating income exceeds absorption costing

operating income, sales exceeds production. Inventories shrink and
fixed manufacturing overhead costs are released from inventories. In
contrast, when variable costing operating income is less than absorption
costing operating income, production exceeds sales. Inventories grow
and fixed manufacturing overhead costs are deferred in inventories.
The year-by-year effects are shown below.

Year 1 Year 2 Year 3

Variable costing Variable costing Variable costing
OI = Absorption OI < Absorption OI > Absorption
costing OI costing OI costing OI
Production = Sales Production > Sales Production < Sales
Inventories remain
the same Inventories grow Inventories shrink

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Solutions Manual, Chapter 8 9
Exercise 8-4 (continued)
2. a. As discussed in part (1 a) above, unit sales and variable costing
operating income move in the same direction when unit selling prices
and the cost structure are constant. Because variable costing operating
income declined, unit sales must have also declined. This is true even
though the absorption costing operating income increased. How can
that be? By manipulating production (and inventories) it may be
possible to maintain or increase the level of absorption costing oper-
ating income even though unit sales decline. However, eventually
inventories will grow to be so large that they cannot be ignored.
b. As stated in part (1 b) above, when variable costing operating income
is less than absorption costing operating income, production exceeds
sales. Inventories grow and fixed manufacturing overhead costs are
deferred in inventories. The year-by-year effects are shown below.

Year 1 Year 2 Year 3

Variable costing Variable costing Variable costing
OI = Absorption OI < Absorption OI < Absorption
costing OI costing OI costing OI
Production = Sales Production > Sales Production > Sales
Inventories remain
the same Inventories grow Inventories grow

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10 Managerial Accounting, 11th Canadian Edition
Exercise 8-4 (continued)
3. 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 operating income fluctuates 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, absorption costing
operating income increases from year to year even though unit sales
decline. Absorption costing operating income is potentially more subject
to manipulation than variable costing. Simply by changing production
levels (and thereby deferring or releasing costs from inventory) absorp-
tion costing operating income can be manipulated upward or downward.

Note: This exercise is based on the following data:

Common data:
Annual fixed manufacturing costs ....... $153,153
Contribution margin per unit .............. $35,000
Annual fixed SGA costs ...................... $180,000

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 operating income ...... $16,847 $16,847 $16,847
Deduct Fixed manufacturing overhead
in beginning inventory* ................. $15,315 $15,315 $27,846
Add Fixed manufacturing overhead in
ending inventory ........................... $15,315 $27,846 $17,017
Absorption costing operating income $16,847 $29,378 $6,018

* Fixed manufacturing overhead in beginning inventory is assumed in both

parts 1 and 2 for Year 1. A FIFO inventory flow assumption is used.

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Solutions Manual, Chapter 8 11
Exercise 8-4 (continued)
Part 2:
Year 1 Year 2 Year 3
Beginning inventory .................... 1 1 4
Production ................................. 10 12 20
Sales ......................................... 10 9 8
Ending ....................................... 1 4 16
Variable costing operating
income (loss) ......................... $16,847 ($18,153) ($53,153)
Deduct Fixed manufacturing
overhead in beginning invento-
ry* ........................................ $15,315 $15,315 $51,051
Add Fixed manufacturing over-
head in ending inventory ........ $15,315 $51,051 $122,522
Absorption costing operating
income .................................. $16,847 $17,583 $18,318

* Fixed manufacturing overhead in beginning inventory is assumed in both

parts 1 and 2 for Year 1. A FIFO inventory flow assumption is used.

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12 Managerial Accounting, 11th Canadian Edition
Exercise 8-5 (30 minutes)
1. Under variable costing, only the variable manufacturing costs are includ-
ed in product costs.
Direct materials .................................... $ 8
Direct labour ........................................ 10
Variable manufacturing overhead .......... 2
Unit product cost .................................. $20
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.

2. The variable costing income statement appears below:

Sales (21,500 × $35) .......................... $752,500
Variable expenses:
Variable cost of goods sold:
Beginning inventory ....................... $ 0
Add variable manufacturing costs
(25,000 units × $20 per unit) ...... 500,000
Goods available for sale ................. 500,000
Less ending inventory (3,500 units
× $20 per unit)........................... 70,000
Variable cost of goods sold* ............. 430,000
Variable selling and administrative
(21,500 units × $4 per unit) .......... 86,000 516,000
Contribution margin ............................ 236,500
Fixed expenses:
Fixed manufacturing overhead .......... 75,000
Fixed selling and administrative ........ 110,000 185,000
Operating profit.................................. $51,500

* The variable cost of goods sold could be computed more simply as:
21,500 units sold × $20 per unit = $430,000.

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Solutions Manual, Chapter 8 13
Exercise 8-5 (continued)
3. The break-even point in units sold can be computed using the contribu-
tion margin per unit as follows:

Selling price per unit ..................... $35

Variable product cost per unit ........ 20
Variable selling and admin cost per
unit……………………………………….. 4
Contribution margin per unit ......... $ 11

Fixed expenses
Break-even unit sales =
Unit contribution margin

$185,000
=
$11 per unit

= 16,819 units

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14 Managerial Accounting, 11th Canadian Edition
Exercise 8-6 (20 minutes)
1. Under absorption costing, all manufacturing costs (variable and fixed)
are included in product costs.
Direct materials .................................... $ 8
Direct labour ........................................ 10
Variable manufacturing overhead .......... 2
Fixed manufacturing overhead
($75,000 ÷ 25,000 units) ................... 3
Unit product cost .................................. $23

2. The absorption costing income statement appears below:

Sales (21,500 units × $35 per unit) ......... $752,500
Cost of goods sold:
Beginning inventory ............................. $ 0
Add cost of goods manufactured
(25,000 units × $23 per unit)............. 575,000
Goods available for sale ........................ 575,000
Less ending inventory
(3,500 units × $23 per unit) .............. 80,500 494,500
Gross margin.......................................... 258,000
Selling and administrative expenses:
Variable selling and administrative
(21,500 units × $4 per unit) .............. 86,000
Fixed selling and administrative ............ 110,000 196,000
Operating income ................................... $ 62,000

Note: Operating income is larger under absorption costing because the

company holds back $10,500 ($3 x 3,500 units) worth of fixed costs in
ending inventory.

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Solutions Manual, Chapter 8 15
Exercise 8-7 (30 minutes)
1. a. The unit product cost under absorption costing would be:
Direct materials ................................................................ $25
Direct labour .................................................................... 12
Variable manufacturing overhead ...................................... 3
Total variable manufacturing costs ..................................... 40
Fixed manufacturing overhead ($200,000 ÷ 25,000 units) .. 8
Unit product cost .............................................................. $48

b. The absorption costing income statement:

Sales (21,000 units × $65 per unit) ............ $1,365,000
Cost of goods sold:
Beginning inventory (first year of opera-
tions)................................................... $ 0
Add cost of goods manufactured
(25,000 units × $48 per unit)................ 1,200,000
Goods available for sale ........................... 1,200,000
Less ending inventory
(4,000 units × $48 per unit) ................. 192,000 1,008,000
Gross margin............................................. 357,000
Selling and administrative expenses ............ 215,000 *
Operating income ...................................... $ 142,000
*(21,000 units × $5 per unit) + $110,000 = $215,000.

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16 Managerial Accounting, 11th Canadian Edition
Exercise 8-7 (continued)
2. a. The unit product cost under variable costing would be:
Direct materials ..............................................................
$25
Direct labour ................................................................
12
Variable manufacturing overhead ................................3
Unit product cost ............................................................
$40

b. The variable costing income statement:

Sales (21,000 units × $65 per unit) ................................ $1,365,000
Less variable expenses:
Variable cost of goods sold:
Beginning inventory ................................ $ 0
Add variable manufacturing costs
(25,000 units × $40 per unit) ................................
1,000,000
Goods available for sale ................................
1,000,000
Less ending inventory
(4,000 units × $40 per unit) ................................
160,000
Variable cost of goods sold ................................840,000 *
Variable selling expense
(21,000 units × $5 per unit) ................................
105,000 945,000
Contribution margin ........................................................ 420,000
Less fixed expenses:
Fixed manufacturing overhead ................................
200,000
Fixed selling and administrative ................................
110,000 310,000
Operating income ........................................................... $ 110,000
* The variable cost of goods sold could be computed more simply
as: 21,000 units × $40 per unit = $840,000.

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Solutions Manual, Chapter 8 17
Exercise 8-8 (20 minutes)
1. The company is using variable costing. The computations are:
Variable Absorption
Costing Costing
Direct materials .............................. $10 $10
Direct labour .................................. 5 5
Variable manufacturing overhead .... 2 2
Fixed manufacturing overhead
($90,000 ÷ 30,000 units) ............. — 3
Unit product cost ............................ $17 $20
Total cost, 5,000 units .................... $85,000 $100,000

2. a. The total cost based on variable costing of $85,000 would be ac-

ceptable for tax purposes, but not for external reporting.

b. The finished goods inventory account should be stated at $100,000,

which represents the absorption cost of the 5,000 unsold units. Thus,
the account should be increased by $15,000 for external reporting
purposes. This $15,000 consists of the amount of fixed manufacturing
overhead cost that is allocated to the 5,000 unsold units under ab-
sorption costing:
5,000 units × $3 per unit fixed manufacturing overhead cost =
$15,000

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18 Managerial Accounting, 11th Canadian Edition
Exercise 8-9 (20 minutes)

1. Sales (40,000 units × $33.75 per unit)………… $1,350,000

Variable expenses:
Variable cost of goods sold
(40,000 units × $16 per unit*)………………….. $640,000
Variable selling and administrative expenses
(40,000 units × $3 per unit) ……………………… 120,000 760,000
Contribution margin………………………………….. 590,000
Fixed expenses:
Fixed manufacturing overhead……………………. 250,000
Fixed selling and administrative expenses…….. 300,000 550,000
Operating income……………………………………… $ 40,000

* Direct materials…………………………. $10

Direct labour……………………………… 4
Variable manufacturing overhead… 2
Total variable manufacturing cost.. $16

2. The difference in operating income can be explained by the $50,000 in

fixed manufacturing overhead deferred in inventory under the absorp-
tion costing method:

Variable costing operating income ………………………… $40,000

Add: Fixed manufacturing overhead cost deferred in in-
ventory under absorption costing: 10,000 units × $5 per
unit in fixed manufacturing overhead cost………………. 50,000
Absorption costing operating income……………………… $90,000

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Solutions Manual, Chapter 8 19
Exercise 8-10 (10 minutes)
Sales were above the company’s break-even sales and yet the company
sustained a loss. The apparent contradiction is explained by the fact that
the CVP analysis is based on variable costing, whereas the income reported
to shareholders is prepared using absorption costing. Because sales were
above the break-even point, the variable costing net operating income
would have been positive. However, the absorption costing net operating
income was negative. Ordinarily, this would only happen if inventories de-
creased and fixed manufacturing overhead deferred in inventories was re-
leased to the income statement on the absorption costing income state-
ment. This added fixed manufacturing overhead cost resulted in a loss on
an absorption costing basis even though the company operated at its
break-even point on a variable costing basis.

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20 Managerial Accounting, 11th Canadian Edition
Problem 8-11 (30 minutes)
1. The unit product cost under the variable costing approach would be
computed as follows:
Direct materials .................................... $ 8
Direct labour ........................................ 10
Variable manufacturing overhead .......... 2
Unit product cost .................................. $20
With this figure, the variable costing income statements can be pre-
pared:
Year 1 Year 2
Sales ......................................................... $1,000,000 $1,500,000
Variable expenses:
Variable cost of goods sold @ $20 per unit 400,000 600,000
Variable selling and administrative @ $3
per unit ................................................ 60,000 90,000
Total variable expenses ............................... 460,000 690,000
Contribution margin .................................... 540,000 810,000
Fixed expenses:
Fixed manufacturing overhead .................. 350,000 350,000
Fixed selling and administrative ................ 250,000 250,000
Total fixed expenses ................................... 600,000 600,000
Operating income (loss) .............................. $ (60,000) $ 210,000

2. Variable costing operating income (loss) ...... $ (60,000) $ 210,000

Add: Fixed manufacturing overhead cost
deferred in inventory under absorption
costing (5,000 units × $14 per unit) ......... 70,000
Deduct: Fixed manufacturing overhead cost
released from inventory under absorption
costing (5,000 units × $14 per unit) ......... (70,000)
Absorption costing operating income ........... $ 10,000 $ 140,000

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Solutions Manual, Chapter 8 21
Problem 8-12 (45 minutes)
1. a. The unit product cost under absorption costing:
Direct materials .................................... $12
Direct labour ........................................ 9
Variable manufacturing overhead .......... 5
Fixed manufacturing overhead
(600,000 ÷ 20,000 units) ................... 30
Unit product cost .................................. $56

b. The absorption costing income statement follows:

Sales (15,000 units × $80 per unit) ......... $1,200,000
Cost of goods sold:
Beginning inventory ............................. $ 0
Add cost of goods manufactured
(20,000 units × $56 per unit) ............ 1,120,000
Goods available for sale ....................... 1,120,000
Less ending inventory
(5,000 units × $56 per unit) .............. 280,000 840,000
Gross margin ......................................... 360,000
Selling and administrative expenses* ....... 565,000
Operating loss ........................................ $ (205,000)
*(15,000 units × $6 per unit) + $475,000 = $565,000.

2. a. The unit product cost under variable costing:

Direct materials .................................... $12
Direct labour ........................................ 9
Variable manufacturing overhead .......... 5
Unit product cost .................................. $26

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22 Managerial Accounting, 11th Canadian Edition
Problem 8-12 (continued)
b. The variable costing income statement follows:
Sales (15,000 units × $80 per unit) .............. $1,200,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory ................................ $ 0
Add variable manufacturing costs
(20,000 units × $26 per unit) ............... 520,000
Goods available for sale .......................... 520,000
Less ending inventory
(5,000 units × $26 per unit) ................. 130,000
Variable cost of goods sold ........................ 390,000
Variable selling expense
(15,000 units × $6 per unit) ................... 90,000 480,000
Contribution margin ..................................... 720,000
Fixed expenses:
Fixed manufacturing overhead ................... 600,000
Fixed selling and administrative expense .... 475,000 1,075,000
Operating loss ............................................. $ (355,000)

3. The difference in the ending inventory relates to a difference in the

handling 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 $30 per unit ($600,000 ÷ 20,000 units produced = $30 per unit).
Thus, under absorption costing a portion of the $600,000 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 × $30 per unit) ....................................... $ 150,000
Expensed as part of cost of goods sold
(15,000 units × $30 per unit) ..................................... 450,000
Total fixed manufacturing overhead cost for the month .. $600,000

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Solutions Manual, Chapter 8 23
Problem 8-12 (continued)
Because $150,000 of fixed manufacturing overhead cost has been de-
ferred in inventory under absorption costing, the operating income
reported under that costing method is $150,000 higher than the operat-
ing income under variable costing, as shown in parts (1) and (2) above.

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24 Managerial Accounting, 11th Canadian Edition
Problem 8-13 (45 minutes)

Absorption Variable
1. a. and b. Costing Costing
Direct materials .................................... $ 152 $152
Variable manufacturing overhead .......... 10 10
Fixed manufacturing overhead
($340,000 ÷ 4,000 units) ................... 85 —
Unit product cost .................................. $247 $162

2. Absorption costing income statement:

Sales (3,200 units × $400 per unit) ................ $1,280,000
Cost of goods sold:
Beginning inventory .................................... $ 0
Add cost of goods manufactured
(4,000 units × $247 per unit) .................... 988,000
Goods available for sale ............................... 988,000
Less ending inventory
(800 units × $247 per unit) ...................... 197,600 790,400
Gross margin................................................. 489,600
Selling and administrative expenses
(15% × $1,280,000 + $160,000).................. 352,000
Operating income .......................................... $ 137,600

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Solutions Manual, Chapter 8 25
Problem 8-13 (continued)
3. Variable costing income statement:
Sales (3,200 units × $400 per unit) ......... $1,280,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory ........................... $ 0
Add variable manufacturing costs
(4,000 units × $162 per unit) .......... 648,000
Goods available for sale ..................... 648,000
Less ending inventory
(800 units × $162 per unit) ............. 129,600
Variable cost of goods sold* ................. 518,400
Variable selling and administrative ex-
pense ($1,280,000 × 15%)................ 192,000 710,400
Contribution margin ................................ 569,600
Fixed expenses:
Fixed manufacturing overhead .............. 340,000
Fixed selling and administrative ............ 160,000 500,000
Operating income ................................... $ 69,600
* This figure could be computed more simply as:
3,200 units × $162 per unit = $518,400.

4. A manager may prefer to take the statement prepared under the ab-
sorption approach in part (2), because it shows a higher profit for the
month. As long as inventory levels are rising, absorption costing will re-
port higher profits than variable costing.

5. Variable costing operating income ...................................... $ 69,600

Add: Fixed manufacturing overhead cost deferred in in-
ventory under absorption costing (800 units × $85 per
unit) ............................................................................... 68,000
Absorption costing operating income ...................................$137,600

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26 Managerial Accounting, 11th Canadian Edition
Problem 8-14 (60 minutes)

1. a. Direct materials ........................................... $1.00

Direct labour ............................................... 0.80
Variable manufacturing overhead ................. 0.20
Fixed manufacturing overhead
($75,000 ÷ 50,000 units) .......................... 1.50
Unit product cost......................................... $3.50

b. Sales (40,000 units) .................................. $200,000

Cost of goods sold:
Beginning inventory ................................ $ 0
Add cost of goods manufactured
(50,000 units × $3.50 per unit) ............ 175,000
Goods available for sale .......................... 175,000
Less ending inventory
(10,000 units × $3.50 per unit) ............ 35,000 140,000
Gross margin ............................................ 60,000
Selling and administrative expenses*.......... 50,000
Operating income ...................................... $ 10,000
*$30,000 variable plus $20,000 fixed = $50,000.

c. Variable costing operating loss .................................. $ (5,000)

Add: Fixed manufacturing overhead cost deferred in
inventory under absorption costing
(10,000 units × $1.50 per unit) .............................. 15,000
Absorption costing operating income ......................... $ 10,000

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Solutions Manual, Chapter 8 27
Problem 8-14 (continued)
2. Under absorption costing, the company did earn a profit for the month.
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 the release of fixed manufacturing overhead costs to expense. Advocates
of variable costing would argue that all such costs should be expensed
immediately, and that no profit is earned unless the revenues of a peri-
od are sufficient to cover the fixed manufacturing overhead costs in full.
From this point of view, then, no profit was earned during the month,
because the fixed costs were not fully covered.
Advocates of absorption costing would argue, however, that fixed manu-
facturing overhead costs attach to units of product as they are pro-
duced, and that such costs do not become expense until the units are
sold. Therefore, if the selling price of a unit is greater than the unit 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 hap-
pens to inventories. In particular, profits can be consciously manipulated
by increasing or decreasing a company’s inventories.

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28 Managerial Accounting, 11th Canadian Edition
Problem 8-14 (continued)

3. a. Sales (60,000 units × $5 per unit).................. $300,000

Variable expenses:
Variable cost of goods sold
(60,000 units × $2 per unit) ..................... $120,000
Variable selling and administrative expenses
(60,000 units × $0.75 per unit)................. 45,000 165,000
Contribution margin ...................................... 135,000
Fixed expenses:
Fixed manufacturing overhead..................... 75,000
Fixed selling and administrative expense ...... 20,000 95,000
Operating income .......................................... $ 40,000

b. The absorption costing unit product cost will remain at $3.50, the
same as in part (1).

Sales (60,000 units × $5 per unit)................ $300,000

Cost of goods sold:
Beginning inventory
(10,000 units × $3.50 per unit) .............. $ 35,000
Add cost of goods manufactured
(50,000 units × $3.50 per unit) .............. 175,000
Goods available for sale ............................ 210,000
Less ending inventory ............................... 0 210,000
Gross margin .............................................. 90,000
Selling and administrative expenses (60,000
units × $0.75 per unit + $20,000) ............. 65,000
Operating income ........................................ $ 25,000

c. Variable costing operating income ................................. $ 40,000

Deduct: Fixed manufacturing overhead cost released
from inventory under absorption costing (10,000 units
× $1.50 per unit)....................................................... 15,000
Absorption costing operating income ............................. $ 25,000

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Solutions Manual, Chapter 8 29
Problem 8-15 (45 minutes)

1. a. and b. Absorption Variable

Costing Costing
Direct materials .................................... $ 12 $ 12
Direct labour ........................................ 24 24
Variable manufacturing overhead .......... 8 8
Fixed manufacturing overhead
($240,000 ÷ 15,000 units) ................. 16 —
Unit product cost .................................. $60 $44

2. May June
Sales (13,000 units, 17,000 units) ................ $1,040,000 $1,360,000
Less Variable expenses:
Variable cost of goods sold:
Beginning inventory .................................. 0 88,000
Add variable production costs @ $44 per unit 660,000 660,000
Good available for sale ............................. 660,000 748,000
Less ending inventory ............................... 88,000 0
Variable cost of goods sold 572,000 748,000
Variable selling and administrative @ $6 per
unit ......................................................... 78,000 102,000
Total variable expenses ............................... 650,000 850,000
Contribution margin .................................... 390,000 510,000
Fixed expenses:
Fixed manufacturing overhead .................. 240,000 240,000
Fixed selling and administrative ................. 180,000 180,000
Total fixed expenses.................................... 420,000 420,000
Operating income (loss) .............................. $ (30,000) $ 90,000

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30 Managerial Accounting, 11th Canadian Edition
Problem 8-15 (continued)

3. May June
Variable costing operating income (loss) ..........................$ (30,000) $ 90,000
Add: Cost deferred in inventory under ab-
sorption costing (2,000 units × $16 per
unit) ................................................................32,000
Deduct: Cost released from inventory under
absorption costing (2,000 units × $16 per
unit) ................................................................ (32,000)
Absorption costing operating income ...............................$ 2,000 $ 58,000

4. As shown in the reconciliation in part (3) above, $32,000 of product cost

was deferred in inventory under absorption costing at the end of May,
because $16 of fixed manufacturing overhead cost “attached” to each of
the 2,000 unsold units that went into inventory at the end of that
month. This $32,000 was part of the $420,000 total fixed cost that has
to be covered each month in order for the company to break even. Be-
cause the $32,000 was added to the inventory account, and thus did not
appear on the income statement for May as an expense, the company
was able to report a small profit for the month even though it sold less
than the break-even volume of sales. In short, only $388,000 of fixed
cost ($420,000 – $32,000) was expensed for May, rather than the full
$420,000 as contemplated in the break-even analysis. As stated in the
text, this is a major problem with the use of absorption costing internal-
ly for management purposes. The method does not harmonize well with
the principles of cost-volume-profit analysis, and can result in data that
are unclear or confusing to management.

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Solutions Manual, Chapter 8 31
Problem 8-16 (30 minutes)
1. Because of soft demand for the New Zealand Division’s product, the in-
ventory should be drawn down to the minimum level of 1,500 units.
Drawing inventory down to the minimum level would require production
as follows during the last quarter:
Desired inventory, December 31 ............ 1,500 units
Expected sales, last quarter .................. 18,000 units
Total needs .......................................... 19,500 units
Less inventory, September 30................ 12,000 units
Required production ............................. 7,500 units
Drawing inventory down to the minimum level would save inventory car-
rying costs such as storage (rent, insurance), interest, and obsoles-
cence.
The number of units scheduled for production will not affect the report-
ed 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 man-
ufacturing overhead cost will be shifted between periods through the in-
ventory account and income will be a function of the number of units
sold, rather than a function of the number of units produced.

2. To maximize the New Zealand Division’s operating income, Ms. Hartley

could produce as many units as storage facilities will allow. By building
inventory to the maximum level, Ms. Hartley will be able to defer a por-
tion of the year’s fixed manufacturing overhead costs to future years
through the inventory account, rather than having all of these costs ap-
pear as charges on the current year’s income statement. Building inven-
tory to the maximum level of 30,000 units would require production as
follows during the last quarter:
Desired inventory, December 31 ............ 30,000 units
Expected sales, last quarter .................. 18,000 units
Total needs .......................................... 48,000 units
Less inventory, September 30................ 12,000 units
Required production ............................. 36,000 units

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32 Managerial Accounting, 11th Canadian Edition
Problem 8-16 (continued)
Thus, by producing enough units to build inventory to the maximum
level that storage facilities will allow, Ms. Hartley could relieve the cur-
rent year of fixed manufacturing overhead cost and thereby maximize
the current year’s operating income.

3. By setting a production schedule that will maximize her division’s operating

income—and maximize her own bonus— Ms. Hartley 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 Ms.
Hartley sets a production schedule as shown in part (2) above, she will
obtain her bonus as a result of producing rather than as a result of sell-
ing. Moreover, she will obtain it by creating greater expenses—rather
than fewer expenses—for the company as a whole.
In summary, producing as much as possible so as to maximize the division’s
operating income and the manager’s bonus would be unethical because
it subverts the goals of the overall organization.

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Solutions Manual, Chapter 8 33
Problem 8-17 (45 minutes)
1. The break-even point in units sold can be computed using the contribu-
tion margin per unit as follows:
Selling price per unit ..................... $58
Variable cost per unit .................... 38
Contribution margin per unit ......... $20
Break-even unit sales = Fixed expenses ÷ Unit contribution margin
= $1,200,000 ÷ $20 per unit
= 60,000 units

2 a. Under variable costing, only the variable manufacturing costs are in-
cluded in product costs.
Year 1 Year 2 Year 3
Direct materials .................................... $20 $20 $20
Direct labor .......................................... 12 12 12
Variable manufacturing overhead .......... 4 4 4
Variable costing unit product cost .......... $36 $36 $36
Note that selling and administrative expenses are not treated as
product costs; that is, they are not included in the costs that are in-
ventoried. These expenses are always treated as period costs.

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34 Managerial Accounting, 11th Canadian Edition
Problem 8-17 (continued)
2 b. The variable costing income statements appear below:
Year 1 Year 2 Year 3
Sales........................................................................ $3,480,000 $2,900,000 $3,770,000
Variable expenses:
Variable cost of goods sold @ $36 per unit .............. 2,160,000 1,800,000 2,340,000
Variable selling and administrative @ $2 per unit ..... 120,000 100,000 130,000
Total variable expenses ............................................. 2,280,000 1,900,000 2,470,000
Contribution margin .................................................. 1,200,000 1,000,000 1,300,000
Fixed expenses:
Fixed manufacturing overhead ................................ 960,000 960,000 960,000
Fixed selling and administrative............................... 240,000 240,000 240,000
Total fixed expenses ................................................. 1,200,000 1,200,000 1,200,000
Net operating income (loss) ...................................... $ 0 $ (200,000) $ 100,000

3 a. The unit product costs under absorption costing:

Year 1 Year 2 Year 3
Direct materials .................................... $20 $20.00 $20
Direct labor .......................................... 12 12.00 12
Variable manufacturing overhead .......... 4 4.00 4
Fixed manufacturing overhead .............. *16 **12.80 ***24
Absorption costing unit product cost ...... $52 $48.80 $60
* $960,000 ÷ 60,000 units = $16 per unit.
** $960,000 ÷ 75,000 units = $12.80 per unit.
*** $960,000 ÷ 40,000 units = $24 per unit.

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Solutions Manual, Chapter 8 35
Problem 8-17 (continued)
3 b. The absorption costing income statements appears below:
Year 1 Year 2 Year 3
Sales ..................................................... $3,480,000 $2,900,000 $3,770,000
Cost of goods sold.................................. 3,120,000 2,440,000 3,620,000
Gross margin ......................................... 360,000 460,000 150,000
Selling and administrative expenses ........ 360,000 340,000 370,000
Net operating income (loss) .................... $ 0 $ 120,000 $ (220,000)
Cost of goods sold computations:
Year 1: 60,000 units × $52 per unit = $3,120,000
Year 2: 50,000 units × $48.80 per unit = $2,440,000
Year 3: (25,000 × $48.80 per unit) + (40,000 × $60 per unit) = $3,620,000

4.
Year 1 Year 2 Year 3
Units sold ........................................................... 60,000 50,000 65,000
Break-even point in units ..................................... 60,000 60,000 60,000
Units above (below) break-even point .................. 0 (10,000) 5,000
Variable costing net operating income (loss) ......... $0 $(200,000) $ 100,000
Absorption costing net operating income (loss) ..... $0 $ 120,000 $(220,000)

The absorption costing net operating incomes in years 2 and 3 are counter-intuitive. In year 2, the
number of units sold is below the break-even point; however, absorption costing reports a net op-
erating income greater than zero. In year 3, the number of units sold is above the break-even
point; however, absorption costing reports a net operating income less than zero.

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36 Managerial Accounting, 11th Canadian Edition
Problem 8-18 (75 minutes)
1. Year 1 Year 2 Year 3
Sales .......................................... $1,000,000 $ 800,000 $1,000,000
Variable expenses:
Variable cost of goods sold @
$4 per unit............................. 200,000 160,000 200,000
Variable selling and administra-
tive @ $2 per unit .................. 100,000 80,000 100,000
Total variable expenses ................ 300,000 240,000 300,000
Contribution margin..................... 700,000 560,000 700,000
Fixed expenses:
Fixed manufacturing overhead ... 600,000 600,000 600,000
Fixed selling and administrative . 70,000 70,000 70,000
Total fixed expenses .................... 670,000 670,000 670,000
Operating income (loss) ............... $ 30,000 $(110,000) $ 30,000

2. a. Year 1 Year 2 Year 3

Variable manufacturing cost ............ $ 4 $ 4 $ 4
Fixed manufacturing cost:
$600,000 ÷ 50,000 units.............. 12
$600,000 ÷ 60,000 units.............. 10
$600,000 ÷ 40,000 units.............. 15
Unit product cost............................ $16 $14 $19

b. Variable costing operating

income (loss) ................................ $30,000 $(110,000) $ 30,000
Add (Deduct): Fixed manufacturing
overhead cost deferred in invento-
ry from Year 2 to Year 3 under ab-
sorption costing (20,000 units ×
$10 per unit) ................................. 200,000 (200,000)
Add: Fixed manufacturing overhead
cost deferred in inventory from
Year 3 to the future under absorp-
tion costing (10,000 units × $15
per unit) ....................................... 150,000
Absorption costing operating
income (loss) ................................ $30,000 $ 90,000 $(20,000)

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Solutions Manual, Chapter 8 37