CHAPTER 8ABSORPTION AND VARIABLE COSTING, ANDINVENTORY MANAGEMENTDISCUSSION QUESTIONS

8-248-11.The only difference between absorption costing and variable costing is the way in which fixed overhead costs are assigned. Under variable costing, fixed overhead is a period cost; under absorption costing, it is a product cost.2.Absorption-costing income is greater because some of the periods fixed overhead is placed in inventory and not recognized as part of Cost of Goods Sold on the absorption-costing income statement.3.A segment is any subunit of sufficient importance to warrant production of performance reports.4.Contribution margin is the amount available to cover fixed expenses and provide for profit. Segment margin is the amount available to cover common fixed expenses and provide for profit. Contribution margin is the difference between revenues and variable expenses. Segment margin is contribution margin less direct fixed expenses.5.No, the purchase price is not part of the fundamental EOQ formula. However, the potential for quantity discounts may be considered by management in deciding whether or not to order the EOQ amount. For example, the company may order more than the EOQ amount if the quantity discount is larger than the additional carrying cost.6.Ordering costs are the costs of placing and receiving an order. Examples include clerical costs, documents, insurance, and unloading. Carrying costs are the costs of carrying inventory. Examples include insurance, taxes, handling costs, and the opportunity cost of capital tied up in inventory.7.Stockout costs are the costs of insufficient inventory (e.g., lost sales and interrupted production).8.Reasons for carrying inventory include the following: (a) to balance setup and carrying costs, (b) to satisfy customer demand, (c) to avoid shutting down manufacturing facilities, (d) to take advantage of discounts, and (e) to hedge against future price increases.9.If carrying costs increase, that implies that fewer orders are placed. However, the company still needs the annual demand for the part. So fewer orders imply a larger number of parts ordered. This increases carrying costs.10.The economic order quantity is the amount that should be ordered so as to minimize the sum of ordering and carrying costs.11.Safety stock is the difference between maximum demand and average demand, multiplied by the lead time. By reordering whenever the inventory level hits the safety stock point, a company is ensured of always having sufficient inventory on hand to meet demand12.JIT minimizes carrying costs by driving inventories to insignificant levels. Ordering costs are minimized by entering into long-term contracts with suppliers (or driving setup times to zero).

MULTIPLE-CHOICE EXERCISES81a82d83a84e85c86b87d88a89c810d811b812d

CORNERSTONE EXERCISESCornerstone Exercise 8131.Units ending inventory= Units beginning inventory + Units produced Units sold= 400 + 12,000 11,200= 1,200

2.Direct materials$25Direct labor80Variable overhead20Fixed overhead30Unit product cost$155

3.Value of ending inventory = 1,200 $155 = $186,000Cornerstone Exercise 8141.Units ending inventory= Units beginning inventory + Units produced Units sold= 400 + 12,000 11,200= 1,200

2.Direct materials$25Direct labor80Variable overhead20Unit product cost$125

3.Value of ending inventory = 1,200 $125 = $150,000

Cornerstone Exercise 8151.Direct materials$20Direct labor14Variable overhead3Fixed overhead5Unit COGS$42

Total COGS = $42 7,500 units = $315,000

2.Engers CompanyIncome Statement Under Absorption CostingFor the Most Recent Year

Sales ($70 7,500)$525,000Less: Cost of goods sold315,000Gross margin$210,000Less: Selling and administrative expenses142,000Operating income$68,000Cornerstone Exercise 8161.Direct materials$20Direct labor14Variable overhead3Unit variable COGS$37

Total variable COGS = $37 7,500 units = $277,500

2.Engers CompanyIncome Statement Under Variable CostingFor the Most Recent Year

Sales ($70 7,500)$525,000Less: Variable cost of goods sold277,500Contribution margin$247,500Less fixed expense:Overhead$40,000Selling and administrative expenses142,000182,000Operating income$65,500

Cornerstone Exercise 817Fering Nurseries, Inc.Segmented Income StatementFor the Coming Year

PoinsettiasFruit TreesTotal

Sales$1,200,000$3,000,000$4,200,000Variable cost of goods sold(400,000)(1,000,000)(1,400,000)Variable selling expense(36,000)(90,000)(126,000)Contribution margin$764,000$1,910,000$2,674,000

Less direct fixed expenses:Direct fixed overhead(260,000)(200,000)(460,000)Direct selling and administrative(127,000)(78,000)(205,000)Segment margin$377,000$1,632,000$2,009,000

Less common fixed expenses:Common fixed overhead(1,475,000)Common selling and administrative(380,000)Operating income$154,000Cornerstone Exercise 818

1.Number of orders=

= = 5 orders per year

2.Total ordering cost= Number of orders Cost per order= 5 orders $4= $20

3.Total carrying cost=Average number of pounds in inventory Cost of carrying one pound in inventory

= $2=$500

4.Total inventory-related cost= Total ordering cost + Total carrying cost= $20 + $500= $520

Cornerstone Exercise 819

1.EOQ =

EOQ=

= 100 pounds

2.Number of orders=

= = 25 orders per year

3.Total ordering cost= Number of orders Cost per order= 25 orders $4= $100

4.Total annual carrying cost under the EOQ policy= (100/2)/2= $100

5.Total inventory-related cost= Total ordering cost + Total carrying cost= $100 + $100= $200Cornerstone Exercise 820Reorder point = Daily usage Lead timeReorder point = 10 4 days = 40Cornerstone Exercise 8211.Safety stock= (Maximum daily usage Average daily usage) Lead time= (15 10) 4 days= 20

2.Reorder point = Maximum daily usage Lead timeReorder point = 15 4 days = 60

Or

Reorder point = (Average daily usage Lead time) + Safety stockReorder point = (10 4 days) + 20 = 60EXERCISESExercise 822

1.Unit direct materials cost = = $5.30

Unit direct labor cost = = $7.00

Unit variable overhead cost = = $1.06

Unit fixed overhead cost = = $3.40

2.Unit direct materials cost$5.30Unit direct labor cost7.00Unit variable overhead cost1.06Unit fixed overhead cost3.40Absorption cost per unit$16.76

3.Ending inventory in units = 15,000 13,800 = 1,200

4.Absorption-costing ending inventory = $16.76 1,200 = $20,112Exercise 8231.Unit direct materials cost$3.80Unit direct labor cost 3.15Unit variable overhead cost 0.68Variable-costing cost per unit $7.632.Variable-costing ending inventory = $7.63 (30,000 28,900) = $8,393

Exercise 824

1.Unit direct materials cost ()$8.20

Unit direct labor cost ()1.40

Unit variable overhead cost ()1.05

Unit fixed overhead cost ()3.60Absorption cost per unit$14.25

2.Unit direct materials cost ()$8.20

Unit direct labor cost ()1.40

Unit variable overhead cost ()1.05Variable cost per unit$10.65

3.Absorption-costing ending inventory = $14.25 400 = $5,700

4.Variable-costing ending inventory = $10.65 400 = $4,260Exercise 8251.Unit direct materials cost$7.50Unit direct labor cost2.75Unit variable overhead cost3.90Unit fixed overhead cost4.50Absorption cost per unit$18.65

2.Unit direct materials cost$7.50Unit direct labor cost2.75Unit variable overhead cost3.90Variable cost per unit$14.15

Exercise 825(Concluded)3.Absorption-costing income:Sales ($30 74,600)$2,238,000Less: Cost of goods sold ($18.65 74,600)1,391,290Gross margin$846,710Less:Variable selling expense ($2 74,600)$149,200Fixed selling expense56,500Fixed administrative expense213,000418,700Operating income$428,010

4.Variable-costing income:Sales ($30 74,600)$2,238,000Less variable costs:Cost of goods sold ($14.15 74,600)$1,055,590Selling expense ($2 74,600)149,2001,204,790Contribution margin$1,033,210Less fixed costs:Fixed overhead ($4.50 80,000)$360,000Selling and administrative expenses269,500629,500Operating income$403,710Exercise 8261.Direct materials $8.00Direct labor4.00Variable overhead1.50Fixed overhead4.15Absorption-costing unit cost$17.65

2.Direct materials$8.00Direct labor4.00Variable overhead1.50Variable-costing unit cost$13.50

3.Ending inventory= Beginning inventory + Units produced Units sold= 0 + 20,000 17,200= 2,800

4.Absorption-costing ending inventory = $17.65 2,800 = $49,420

5.Variable-costing ending inventory = $13.50 2,800 = $37,800

Exercise 8271.Absorption-costing income:Sales ($32 17,200)$550,400Less: Cost of goods sold ($17.65 17,200)303,580Gross margin$246,820Less:Variable selling expense ($3 17,200)$51,600Selling and administrative expenses24,30075,900Operating income$170,920

2.Variable-costing income:Sales ($32 17,200)$550,400Less variable costs:Cost of goods sold ($13.50 17,200)$232,200Selling expense ($3 17,200)51,600283,800Contribution margin$266,600Less fixed costs:Fixed overhead ($4.15 20,000)$83,000Selling and administrative expenses24,300107,300Operating income$159,300Exercise 8281.Units ending inventory= Units beginning inventory + Units produced Units sold= 0 + 17,000 14,000 = 3,000 units

2.Absorption costing:Direct materials$35Direct labor65Variable overhead30Fixed overhead20Unit product cost$150

Value of ending inventory = 3,000 $150 = $450,000

3.Variable costing:Direct materials$35Direct labor65Variable overhead30Unit product cost$130

Value of ending inventory = 3,000 $130 = $390,000

Exercise 828(Concluded)4.Sales ($200 14,000)$2,800,000Less: Cost of goods sold ($150 14,000)2,100,000Gross margin$700,000Less: Selling and administrative expenses200,000Absorption-costing operating income$500,000

5.B&O Cafe Variable-Costing Income Statement

Sales ($200 14,000)$2,800,000Less: Cost of goods sold ($130 14,000)1,820,000Contribution margin$980,000Less fixed expenses:Fixed overhead ($20 17,000)$340,000Fixed selling and administrative200,000540,000Variable-costing operating income$440,000Exercise 829Trendy Inc.Segmented Income StatementFor the Coming Year

SweatersJacketsTotal

Sales$300,000$420,000$720,000Variable cost of goods sold(180,000)(200,000)(380,000)Variable selling expense(15,000)(21,000)(36,000)Contribution margin$105,000$199,000$304,000Less direct fixed expenses:Direct fixed overhead(25,000)(40,000)(65,000)Direct selling and administrative(20,000)(50,000)(70,000)Segment margin$60,000$109,000$169,000Less common fixed expenses:Common fixed overhead(45,000)Common selling and administrative(15,000)Operating income$109,000

Exercise 8301.ConsumerSmall BusinessComputersComputers

Direct materials$500$1,800Direct labor160290Variable overhead4075Variable selling expense7570Total unit variable cost$775$2,235

No, the unit variable cost does not equal the unit variable product cost. The unit variable product cost includes direct materials, direct labor, and variable overhead. The unit variable cost also includes variable selling and administrative expense.

2.Hill Computers Inc.Segmented Income StatementFor the Coming Year

ConsumerSmall BusinessComputersComputersTotal

Sales$62,400,000$276,000,000$338,400,000Variable cost of goods sold(56,000,000)(259,800,000)(315,800,000)Variable selling expense(6,000,000)(8,400,000)(14,400,000)Contribution margin$400,000$7,800,000$8,200,000Less direct fixed expenses:Direct fixed overhead(120,000)(200,000)(320,000)Segment margin$280,000$7,600,000$7,880,000Less common fixed expenses:Common fixed overhead(700,000)Common selling and administrative(3,460,000)Operating income$3,720,000Exercise 831

1.Orders per year = = 10 orders

2.Total ordering cost = $20 10 = $200

3.Average amount in inventory = = 200 unitsTotal carrying cost = $4 200 units = $800

Exercise 831(Concluded)4.Total inventory-related cost= Total ordering cost + Total carrying cost= $200 + $800 = $1,000Exercise 832

1.EOQ=

=

= 200 units

2.Number of orders=

=

= 20 orders per year

3.Total ordering cost=Number of orders Cost per order=20 orders $20=$400

4.Total carrying cost=Average number of units in inventory Cost of carrying one unit in inventory

= $4

=$400

5.Total inventory-related cost= Total ordering cost + Total carrying cost= $400 + $400= $800

Exercise 8331.Reorder point without safety stock= Average daily rate Lead time= 80 3= 240

2.Safety stock = (Maximum daily rate Average daily rate) Lead time= (90 80) 3= 30

3.Reorder point with safety stock= Reorder point without safety stock + Safety stock= 240 + 30= 270

OR

Reorder point with safety stock= Maximum daily usage Lead time= 90 3= 270Exercise 8341.Reorder point without safety stock= Average daily rate Lead time= 30 6= 180

2.Safety stock= (Maximum daily rate Average daily rate) Lead time= (35 30) 6= 30

3.Reorder point with safety stock= Reorder point without safety stock + Safety stock= 180 + 30= 210

OR

Reorder point with safety stock= Maximum daily usage Lead time= 35 6= 210

PROBLEMSProblem 8351.Direct materials$2.45Direct labor2.10Variable overhead0.25Fixed overhead ($180,000/200,000)0.90Total$5.70

Per-unit inventory cost on the balance sheet is $5.70.

Units in ending inventory= 11,300 + 200,000 208,000= 3,300

Total ending inventory = $5.70 3,300 = $18,810

2.Absorption-costing income:Sales (208,000 $9)$1,872,000Less: Cost of goods sold (208,000 $5.70)1,185,600Gross margin$686,400Less: Selling and administrative expenses118,400Operating income$568,000

3.Direct materials$2.45Direct labor2.10Variable overhead0.25Total$4.80

Per-unit inventory cost under variable costing equals $4.80.This differs from the per-unit inventory cost in Requirement 1 because the balance sheet is for external use and reflects absorption costing. Variable costing does not include per-unit fixed overhead.

4.Variable-costing income:Sales$1,872,000Less variable expenses:Variable cost of goods sold (208,000 $4.80)(998,400)Variable selling and administrative(62,400)Contribution margin$811,200Less fixed expenses:Fixed overhead(180,000)Fixed selling and administrative(56,000)Operating income$575,200

Problem 835(Concluded)5.Absorption-costing income:Sales (196,700 $9)$1,770,300Less: Cost of goods sold (196,700 $5.70)1,121,190Gross margin$649,110Less: Selling and administrative expenses115,010Operating income$ 534,100

Variable-costing income:Sales$1,770,300Less variable expenses:Variable cost of goods sold(944,160)Variable selling and administrative(59,010)Contribution margin$767,130Less fixed expenses:Fixed overhead(180,000)Fixed selling and administrative(56,000)Operating income$531,130Problem 836

1.Unit cost = = $3Absorption-costing ending inventory = 1,500 $3 = $4,500

2.Variable-costing ending inventory:$3 per unit $0.50 per unit = $2.50 per unitEnding inventory = 1,500 $2.50 = $3,750

Sales$454,750Less: Variable cost of goods sold ($2.50 53,500)133,750Contribution margin$321,000Less fixed expenses:Fixed overhead(27,500)Fixed selling and administrative(120,000)Net income$173,500

Problem 836(Concluded)3.Sugarsmooth, Inc.Variable-Costing Income StatementFor the Coming Year

Drugstores &DiscountBeautySupermarketsStoresShopsTotal

Sales$454,750$135,000$90,000$679,750Less variable costs:Cost of goods sold(133,750)(50,000)(25,000)(208,750)Commissions(9,000)(9,000)Return penalties(1,350)(1,350)Packing expense(5,000)(5,000)Contribution margin$321,000$83,650$51,000$455,650Less fixed expenses:Shipping(45,000)(45,000)Additional clerk(30,000)(30,000)Segment margin$321,000$8,650$51,000$380,650Less common costs:Overhead(27,500)Selling and administrative(120,000)Net income$233,150

4.Yes, all three customer groups are profitable. However, the discount stores are the least profitable, and Sugarsmooth might consider how carefully it has estimated the expenses associated with this customer group. Since Sugar-smooth does not currently sell to discount stores, it may not want to expand its customer base by selling to this segment.Problem 8371.Walker CompanySegmented Income Statement

BlendersCoffee MakersTotalSales$2,200,000$1,125,000$3,325,000Less: Variable cost of goods sold2,000,0001,075,0003,075,000Contribution margin$200,000$50,000$250,000Less: Direct fixed expenses90,00045,000135,000Segment margin$110,000$5,000$115,000Less: Common fixed expenses115,000Operating income$0

2.If the coffee maker line is dropped, profits will decrease by $5,000, the segment margin. If the blender line is dropped, profits will decrease by $110,000.

Problem 837(Concluded)3.BlendersCoffee MakersTotal

Sales$2,405,000$1,125,000$3,530,000Less: Variable cost of goods sold2,200,0001,075,0003,275,000Contribution margin$205,000$50,000$255,000Less: Direct fixed expenses90,00045,000135,000Product margin$115,000$5,000$120,000Less: Common fixed expenses115,000Operating income$5,000

Profits increase by $5,000.Problem 8381.Absorption costing:Direct materials$1.20Direct labor0.75Variable overhead0.65Fixed overhead3.10Unit cost$5.70

Cost of ending inventory = $5.70 200 = $1,140

2.Variable costing:Direct materials$1.20Direct labor0.75Variable overhead0.65Unit cost$2.60

Cost of ending inventory = $2.60 200 = $520

3.Selling price$7.50Less:Variable cost of goods sold(2.60)Commission(0.75)Contribution margin per unit$4.15

Problem 838(Concluded)4.Sales ($7.50 17,600)$132,000Less:Variable cost of goods sold$45,760Commissions13,20058,960Contribution margin$73,040Less fixed expenses:Fixed overhead$27,900Fixed administrative23,00050,900Operating income$22,140

Variable costing should be used, since the fixed costs will not increase as production and sales increase.Problem 8391.ScentedMusicalRegularTotalSales$13,000$19,500$25,000$57,500Less: Variable expenses9,10015,60012,50037,200Contribution margin$3,900$3,900$12,500$20,300Less: Direct fixed expenses4,2505,7503,00013,000Product margin$(350)$(1,850)$9,500$7,300Less: Common fixed expenses7,500Operating income (loss)$(200)

Kathy should accept this proposal. The 30 percent sales increase, coupled with the increased advertising, reduces the loss from $1,000 to $200. Both scented and musical product-line profits increase. However, more must be done. If the scented and musical product margins remain negative, the two products may need to be dropped.

2.RegularSales$20,000Less: Variable expenses10,000Contribution margin$10,000Less: Fixed expenses10,500Operating income (loss)$(500)

While dropping the two lines results in a $500 loss versus the original $1,000 loss, it is worse than the alternative offered in requirement 1. Other options need to be developed.

Problem 839(Concluded)3.Combinations would be beneficial. Dropping the musical line (which shows the greatest segment loss) and keeping the scented line while increasing advertising yields a profit (the optimal combination).ScentedRegularTotal

Sales$13,000$22,500$35,500Less: Variable expenses9,10011,25020,350Contribution margin$ 3,900$11,250$15,150Less: Direct fixed expenses4,2503,0007,250Product margin$(350)$8,250$7,900Less: Common fixed expenses7,500Operating income$400Problem 8401.Ordering cost = 12 orders $125 = $1,500

2.Carrying cost = $6 (2,000/2) = $6,000

3.Total cost of current inventory policy = $1,500 + $6,000 = $7,500

4.EOQ= = 1,000

5.Ordering cost at EOQ = $125 = $3,000

Carrying cost at EOQ = $6 = $3,000

6.Total cost EOQ policy = $3,000 + $3,000 = $6,000

Savings = $7,500 $6,000 = $1,500

7.Cost of ordering 2,000 units= Ordering cost + Carrying cost = $1,500 + $6,000 = $7,500

Cost of ordering 1,000 units= Increased price + Ordering cost + Carrying cost= ($0.05 24,000) + $3,000 + $3,000= $1,200 + $3,000 + $3,000= $7,200

Even with the price increase, it is better to order the economic order quantity.Problem 841

1.Ordering cost= $40 = $1,400

Carrying cost= $1.75* = $350

*10% of purchase price or 0.10 $17.50.

Total cost = $1,400 + $350 = $1,750

2.EOQ=

=

= 800

Ordering cost= $40 = $700

Carrying cost= $1.75 = $700

Total cost = $700 + $700 = $1,400

Savings = $1,750 $1,400 = $350

3.Rate of usage= 7 50 = 350 days

= = 40 blocks per day

Reorder point= Average rate of usage Lead time= 40 5= 200

This coincides with the current reorder policy.

Problem 841(Concluded)4.The order quantity would have to be 600 instead of 800 (the EOQ). If so, the following inventory costs would be incurred:

Ordering cost= $40 = $933

Carrying cost= $1.75 = $525

Total cost= $933 + $525= $1,458

This restriction would mean an additional cost of only $58 ($1,458 $1,400) over the cost of using the EOQ.

5.The most cheese that should be kept on hand given the 10-day constraint is 400 blocks (40 10). Reorder would occur when inventory dropped to 200 units.

CASESCase 8421.Many legitimate reasons support the creation of inventory (e.g., the need to avoid stockouts and the need to ensure on-time delivery). Paul Chessers reasons, however, are based on self-interest and ignore whats best for the company. Knowingly producing for inventory to obtain personal financial gain at the expense of the company certainly could be labeled as unethical behavior.

2.Since the decision to produce for inventory was not motivated by any sound economic reasoning, and Ruth knows the real motive behind the decision, she should feel discomfort in the role she has been asked to assume. If she decides to appeal to higher-level management, the divisional manager can counter with arguments that inventory was created because he expected the economy to turn around and did not want to be in a position of not having enough goods to meet demand. Even though Ruth may have a difficult time proving any allegation of improper conduct, if she is convinced that the behavior is truly unethical, then appeals to higher-level management with the prospect of ultimate resignation should be the route she takes.

Alternatively, Ruth might decide that the use of absorption costing for internal reporting and bonus calculation has led to this situation. She could lobby higher management to begin using variable costing as a way of avoiding these dysfunctional decisions. Ruth will have a very hard time proving unethical behaviorat worst, Paul may be accused of having poor judgment regarding future economic upturns.

3.The following standards may apply:Integrity. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. (III2)Credibility. Communicate information fairly and objectively. (IV1) Disclose fully all relevant information that could reasonably be expected to influence an intended users understanding of the reports, analyses, or recommendations. (IV2)

Case 8431.By discussing the amount by which his company and Piura have reduced costs, Mac may have violated the confidentiality standard. Specifically, Mac should: keep information confidential except when disclosure is authorized or legally required. He may also be involved in a conflict of interest, although he may not have realized this until the conversation of the evening unfolded. Finally, he may be guilty of using confidential information for unethical or illegal advantage.

2.Mac would violate a host of standards: disclosing confidential information, accepting a gift or favor that would influence his actions, actively subverting his companys legitimate objectives, and engaging in an activity that would discredit the profession. He would be well advised to refuse the offer and avoid any disclosure of information.

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