Chapter 15 Measuring and Assigning Costs for...

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Chapter 15: Measuring and Assigning Costs for Income Statements 117 Chapter 15 Measuring and Assigning Costs for Income Statements LEARNING OBJECTIVES Chapter 15 addresses the following objectives: © 2012 John Wiley and Sons Canada, Ltd.

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Chapter 15Measuring and Assigning Costs for Income Statements

LEARNING OBJECTIVES

Chapter 15 addresses the following objectives:

LO1 Prepare absorption and variable costing income statements and reconcile the resulting net incomes.LO2 Discuss the factors that affect the choice of production volume measures for allocating fixed overhead.LO3 Prepare absorption and variable costing income statements considering beginning inventory balances, and evaluate the impact of inventory on income.LO4 Prepare throughput costing income statement and evaluate absorption, variable, and throughput costing income.

These learning objectives (LO1 through LO4) are cross-referenced in the textbook to individual exercises and problems.

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QUESTIONS

15.1 The three methods are similar because they assign some costs to inventory as product costs, and expense other costs as period costs. The three methods differ in the categories that are used for product and period costs. Details of these categorizations follow.

Absorption costing allocates all production costs, both fixed and variable, to units as product costs so cost of goods sold and inventory on the balance sheet include fixed manufacturing costs. Cost of goods sold is subtracted from revenue to arrive at gross margin, and then other nonmanufacturing expenses are subtracted to arrive at operating income.

Variable costing assigns direct costs (direct labour and direct materials) and variable overhead costs to inventory and variable cost of goods sold. Variable cost of goods sold and all other non-manufacturing variable costs are subtracted from revenue to arrive at contribution margin. All fixed costs, both manufacturing and non-manufacturing, are then subtracted from contribution margin to arrive at operating income.

Throughput costing assigns only direct materials costs to inventory and throughput cost of goods sold. Throughput cost of goods sold is subtracted from revenue to arrive at throughput margin. All other costs are considered period costs and deducted from throughput margin to arrive at operating income.

Uses of the three methods are different, also. Absorption costing income statements meet GAAP and are used by shareholders and other external stakeholders. Variable costing income statements generally do not meet GAAP and are only available for internal reporting. Information from these reports is used in decision-making. Throughput accounting income statements provide information for very short-term decisions and are especially helpful when capacity constraints exist.

15.2 The allocated fixed manufacturing overhead that is added (if production is greater than sales) or subtracted (if production is less than sales) from finished goods is the reconciliation amount between variable versus absorption costing.

15.3 The volume variance arises because of differences between actual volumes and budgeted volumes used to allocate fixed manufacturing overhead. Under variable costing all fixed manufacturing overhead is treated as a period expense; there are no allocations of fixed manufacturing overhead to inventory or variable cost of goods sold. Hence, there will be no volume variances.

15.4 Under variable costing, all fixed manufacturing overhead is treated as an expense of the period, regardless of how many units were produced or sold; income will vary only with the number of units sold, the level of production has no effect. Under absorption costing, fixed manufacturing overhead is first assigned to product; the amount of fixed overhead that appears on the income statement depends on unit sales. Income depends upon both the level of production and the level of sales.

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15.5 Eventually all of the units are sold under either method, so eventually all of the fixed manufacturing cost will be expensed under either method. Under variable costing, it is expensed during the period it is incurred, whereas under absorption costing, a portion of fixed manufacturing cost is inventoried and expensed when the inventory is sold rather than during the period it was incurred.

15.6 A variable cost increases proportionately with volume. Variable costing is a method of calculating income.

15.7 Unless the organization is not-for-profit, none. For most on-going, profit-seeking firms, denominator volume should exceed breakeven volume because the firm plans to be operating at volumes greater than breakeven.

15.8 The fixed manufacturing overhead of the current period will be shown in its entirety as an expense if variable costing is used. If absorption costing is used, some of it will be assigned to the units added to inventory, so that the fixed manufacturing overhead included in cost of goods sold will be less than the total fixed manufacturing overhead that is expensed on the variable costing income statement.

15.9 Both IFRS and GAAP require absorption costing to match production-related expenses to revenues.

15.10 This can be accomplished through the use of an adjusting journal entry at the end of the period. The objective is to distribute or allocate the fixed manufacturing overhead of the period between inventories on hand (WIP and FG) and cost of goods sold.

15.11 A joint cost may be either fixed or variable and a separable cost may be either fixed or variable. Both variable and absorption costing can be applied to joint product situations. Under variable costing, the joint costs are first categorized as fixed or variable and then listed on the income statement under the headings of variable or fixed production costs. Under absorption costing, the common and separable costs are considered product costs and assigned to inventory.

15.12 Under absorption costing, managers could manipulate earnings during a period by producing more inventory than is sold. As inventory on the balance sheet increases, the amount of fixed overhead expense allocated to the units in inventory also increases, while expense for cost of goods sold decreases because the fixed overhead is spread across and increasingly large number of units, some of which are not sold.

15.13 Supply-based capacity levels measure the amount of capacity that is available for production. Theoretical capacity and practical capacity are supply based. Demand-based capacity levels measure the amount of capacity needed to meet sales volumes. Normal capacity and budgeted capacity are demand based.

15.14 Theoretical capacity is the maximum number of units that would be produced under continuous, uninterrupted production over 365 days per year. Practical capacity is the upper capacity limit taking into account regularly scheduled times for production and

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planned downtimes for holidays, maintenance, and any other scheduled interruptions in production. Normal capacity is an average use of capacity across time under normal circumstances. Budgeted or expected capacity is the planned use of capacity in the next period. Theoretical capacity and practical capacity are supply-based capacity levels that depend on the amount of capacity available for production. Normal capacity and budgeted or expected capacity are demand-based capacity levels that measure the amount of capacity needed to meet sales volumes.

15.15 In the financial statements, volume variances that are immaterial are allocated to cost of goods sold. When the volume variance is large and favorable, the variance is prorated among cost of goods sold and ending inventory. If production is below normal capacity, the volume variance is closed to cost of goods sold to avoid increasing the amount of fixed cost in inventory on the balance sheet.

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MULTIPLE-CHOICE QUESTIONS

The following information pertains to Questions 15.16 and 15.17:

Vintage Co. made 4,000 units of a product during its first year of operations and sold 3,000 units for $600,000. There was no ending work-in-process inventory. Total costs were $600,000:Direct materials and direct labour $250,000Manufacturing overhead (50% fixed) $200,000Marketing and administrative costs (100% variable) $150,000

15.16 The cost of the 1,000 units of finished goods ending inventory under variable costing is:a) $150,000b) $125,000c) $112,500d) $87,500e) $62,500

Ans: D ( $250,000 + ($200,000 *50%) )/4000 * 1000 = $87,500

15.17 The cost of the 1,000 units of finished goods ending inventory under absorption costing is:a) $150,000b) $125,000c) $112,500d) $62,500e) $25,000

Ans: C ( $250,000 + $200,000 )/4000 * 1000 = $112,500

15.18 In Company LL, the fixed factory overhead per unit is $5, and the fixed selling administration charges are $11. This year, the company produced and sold 100,000 units of product. The company uses the LIFO method of accounting for its inventory. What would be the difference in income reported by the company if it used variable costing instead of absorption costing?a) $ 0b) $ 500,000c) $1,100,000d) $1,600,000

Ans: A Since there is no ending inventory all fixed costs are reported on the income statement under both methods.

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15.19 How does the accounting treatment of selling and administration costs differ between absorption and variable costing if more units are produced than are sold?a) The variable portion is added to the cost of ending inventory based on a pro rata

portion of units produced to those sold.b) The fixed portion is added to the costs of ending inventory based on a pro rata

portion of units produced to those sold.c) There is no difference in the treatment.d) Both fixed and variable portions are added to the cost of ending inventory based on a

prorata portion of units produced to those sold.

Ans: C

15.20 Which of the following statements is true about the variable cost method?a) It is always inappropriate for performing a profitability analysis.b) It is useful for determining the price of a product for a special order.c) It is always useful when fixing the price for a long period.

d) It is helpful for performing target costing.

Ans: B

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EXERCISES

15.21 Absorption and Variable Income - Famous Desk Company

A and B. First list all pertinent information:

Revenue = 220 desks * $300 = $66,000Variable production costs = 220 desks * $80 = $17,600Variable selling and administrative costs = 220 desks * $30 = $6,600Fixed selling and administrative = $6,000Fixed overhead absorbed into inventory under normal production

Beginning Inventory 100 units with variable cost of $80 per desk and absorption cost of $146.67 per desk$146.67 - $80 = $66.67 fixed costs per desk

Fixed overhead volume variance = $10,000 – (200 desks x $66.67) = $3,334 overapplied, which is closed to COGS

Variable Costing Absorption CostingRevenue $66,000Variable costs:

Production (17,600)Selling (6,600)

Contribution Margin 41,800

Fixed costs:Production (10,000)Admin and Sales (6,000)

Operating income $25,800

Revenue $66,000Cost of goods sold

220 desks x ($80 + $66.67) (32,267)Volume variance 3,334

Gross Margin 37,067

Selling and administrative($6,600 + $6,000) (12,600)

Operating income $24,467

Double-check calculations: Difference in operating income = 20 units x $66.67 = $1,333 (fixed overhead brought into income statement under absorption costing from units produced in prior periods)Difference in operating income = $25,800 - $24,467 = $1,333.

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15.22 Absorption and Variable Income, Reconcile Incomes - Rock Crusher Corp.

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A. Variable costing income statement

Computation details for variable production cost per unit:A100: $20,000/4,000 tons = $5 per tonA300: $15,000/6,000 tons = $2.50 per ton

B. Absorption costing income statement:

© 2012 John Wiley and Sons Canada, Ltd.

VARIABLE COSTING

Variable cost per unit producedA100 $5.00A300 $2.50

Revenue $240,000Variable costs: Production: A100 $15,000 A300 10,000 (25,000) Selling (35,000) Contribution margin 180,000Fixed costs: Production: (100,000) Selling and administrative (60,000) Operating income $20,000

ABSORPTION COSTINGFixed production cost per ton $10.00Total production cost per ton: A100 $15.00 A300 $12.50

Revenue $240,000Cost of goods sold: A100 $45,000 A300 50,000 (95,000) Gross margin 145,000Selling and administrative: Variable $35,000 Fixed 60,000 (95,000) Operating income $50,000

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Calculation details for cost of goods sold:Fixed production cost per ton = $100,000/10,000 tons = $10 per tonVariable production cost per ton was calculated in Part ACost of goods sold:

A100 [($10+$5) x 3,000] $45,000A300 [($10+$2.50) x 4,000] 50,000

Total $95,000

C. The difference in income resides in inventory. There was no beginning inventory, but there were 3,000 tons (10,000 tons produced – 7,000 tons sold) with $10 of fixed production cost per ton absorbed into inventory on the balance sheet under absorption costing. The difference in income = $50,000 - $20,000 = $30,000, and the fixed production cost in inventory is 3,000 x $10 = $30,000.

15.23 Absorption and Variable Inventory and Income, Reconciliation - Start-Up Firm

A and B. Units in ending inventory:

Units beginning inventory 0Units produced 1,000Units sold (850)

Units ending inventory 150

Variable Costing Absorption CostingRevenue (850 units × $89) $75,650Variable costs:

Production (850 units × $40) (34,000)Selling (850 units × $9) (7,650)

Contribution Margin 34,000

Fixed costs:Production (10,000)Selling and administrative (25,000)

Operating Income (Loss) $(1,000 )

Revenue (850 units × $89) $75,650Cost of goods sold

850 units × ($40 + $10) (42,500 )

Gross Margin 33,150

Selling and administrative($25,000 + $9 × 850 units) (32,650)

Operating Income $ 500

Ending inventory($40 × 150 units) $6,000

Ending inventory[$40+($10,000/1,000)]×150 units $7,500

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C. With no beginning inventory, the reconciliation of variable costing to absorption costing income is affected by only ending inventory:

Variable costing operating income (loss) $(1,000)Fixed manufacturing overhead added to ending inventory under

absorption costing [(150 units × ($10,000/1,000 units)] 1,500Absorption costing operating income $ 500

15.24 Absorption and Variable Inventory and Income, Reconciliation

Calculations for both costing methods:Selling price: $200,000 revenue last year / 5,000 units sold last year = $40 per unitVariable manufacturing cost: $40,000/5,000 units produced = $8 per unitUnits in ending inventory = 5,000 units produced – 4,500 units sold = 500 unitsVariable selling and administration cost: $30,000/5,000 units sold last year = $6 per unit

A. Variable costing(1) Ending inventory: $8 variable manufacturing cost per unit * 500 units = $4,000

(2) Variable costing income statementRevenue ($40 *4,500 units) $180,000Variable costs:

Manufacturing costs ($8 * 4,500 units) 36,000Selling and administration($6 * 4,500 units) 27,000

Contribution margin 117,000Fixed costs:

Manufacturing costs 60,000Selling and administration 50,000

Operating Income $ 7,000

B. Absorption costingFixed production cost allocation rate: $60,000/5,000 units = $12 per unitAbsorption cost per unit = $8 variable manufacturing cost per unit + $12 fixed

manufacturing cost per unit = $20 per unitNote: No information is provided about any capacity levels other than actual

production volume, so these calculations assume that actual costing is used.

(1) Ending inventory: $20 absorption cost per unit × 500 units = $10,000

(2) Absorption Costing Income StatementRevenue ($40 *4,500 units) $180,000Cost of goods sold ($20 * 4,500 units) 90,000

Gross margin 90,000Selling and administration[$50,000 + ($6 * 4,500 units)] 77,000

Operating Income $ 13,000

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C. With no beginning inventory, the reconciliation of variable costing to absorption costing income is affected by only ending inventory:

Variable costing operating income $ 7,000Fixed manufacturing overhead added to ending inventory under

absorption costing ($12 × 500 units) 6,000Absorption costing operating income $13,000

15.25 Absorption and Variable Income – Vintage Co.

A.Total variable manufacturing costs = $250,000 + $190,000(.55) = $354,500Variable manufacturing cost per unit = $354,500/4,000 = $88.625Cost of ending finished goods inventory = 1,000 × $88.625 = $88,625

B.Under absorption costing, fixed manufacturing overhead would be included in ending finished goods inventory, but it would not be included under variable costing. Therefore, net profit would increase by the following amount: Variable manufacturing overhead / total units produced * ending inventory=($190,000 * 45%)/4,000 * 1,000= $21,375 decrease in COGS under absorption costing = $21,375 increase in operating income

Alternative calculation:Net profit under absorption costing:Revenue – [Total production costs / units produced * units sold] – selling and administrative = $600,000 - [($250,000 + $190,000) /4,000 * 3,000] - $150,000 = $600,000 - $330,000 - $150,000 = $120,000

Net profit under variable costing:Revenue – [Variable production costs/units produced * units sold – fixed production costs – selling and administrative = $600,000 - [($250,000+($190,000*55%)]/4,000*3,000] - ($190,000*45%) - $150,000 = $600,000 - $265,875 - $85,500 - $150,000 = $98,625

Difference = $120,000 - $98,625 = $21,375 increase

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15.26 Absorption and Variable Income – The Wye Co. Ltd.

A. Which income statement was prepared using actual absorption costing?

Under actual absorption costing, cost of goods sold is calculated as the actual rate * actual inputs used for both direct and indirect costs. Therefore, no variances would be calculated and the income statement is E.

B. Which income statement was prepared using standard variable costing?

Under standard variable costing, cost of goods sold is calculated as the standard variable cost * the standard inputs allowed for actual outputs. Therefore, there may be variable cost variances but no fixed cost variances and the income statement is B.

C. How many units of product RGW were actually produced during the year?

Operating income statement D includes all variance therefore it is standard absorption costing. COGS $378,000 / $42 = 9,000 units

Operating income statement B (i.e. standard variable costing) $514,000Operating income statement D (i.e. standard absorption costing) 508,000Fixed overhead in ending inventory $6,000$6,000 / $6 standard fixed overhead per unit = 1,000 ending inventory units

Number of units sold 9,000Number of units produced 10,000

15.27 Absorption and Variable Costing Income – Hamilton Limited

A.Variable costs = $9 + $12 + $15 + $6 = $42Profit/loss = 70,000 units* ($72 - $42) - $1,800,000 - $600,000 = $2,100,000 - $2,400,000 = $300,000 loss

B.100,000 units sold - 70,000 units produced = 30,000 units in inventoryInventory under absorption costing includes a portion of fixed manufacturing costs, whereas no fixed manufacturing costs are inventoried under variable costing. Therefore, income would be 30,000 * $18 = $540,000 higher under absorption costing than under variable costing. ($300,000) + $540,000 = $240,000

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15.28 Throughput Inventory and Income, Reconciliation

Continuation of 15.24

A. Throughput costingDirect cost per unit: $25,000/5,000 units produced = $5 per unitOther variable manufacturing costs per unit: ($40,000 – $25,000) /5,000 units

produced = $3 per unit

(1) Ending inventory: $5 direct cost per unit × 500 units = $2,500

(2) Throughput Costing Income StatementRevenue ($40 × 4,500 units) $180,000Direct material costs ($5 × 4,500 units) 22,500

Throughput contribution 157,500Other costs:

Manufacturing costs [$60,000 + ($3 *5,000 units)] 75,000Selling and administration[$50,000 + ($6 * 4,500 units)] 77,000

Operating Income $ 5,500

B. With no beginning inventory, the reconciliation of throughput costing to variable costing is affected by only ending inventory:

Throughput costing operating income $5,500Non-material variable manufacturing costs added to ending

inventory under variable costing ($3 × 500 units) 1,500Absorption costing operating income $7,000

15.29 Absorption and Variable Inventory and Income - Plains Irrigation

A. The value of inventory is higher when absorption costing is used because some fixed manufacturing overhead is allocated to inventory to match revenue with expense at the time of sale. If there is fixed manufacturing overhead, the value of inventory under absorption costing will always be higher than under variable costing.

B. To identify the costing method that would result in higher income, first calculate the change in inventory during October under both methods:

October inventory added under absorption costing ($2,598-$1,346) $1,252October inventory added under variable costing ($1,647-854) 793

Difference $ 459

Because $459 more cost was assigned to inventory under absorption costing, operating income during October would be higher by $459 under absorption than under variable costing.

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15.30 Absorption, Variable, and Throughput Inventory and Income - Asian Iron

A.1. Under variable costing:

Total variable production cost = (NT$2,300 + 3,300 + 2,800) = NT$8,400Variable cost per unit = NT$8,400/10,500 = NT$0.80 per unitUnits in ending inventory = 10,500 – 9,400 = 1,100 unitsEnding inventory = NT$0.80 x 1,100 units = NT$880

2. Under absorption costing:Fixed manufacturing overhead = NT$8,250/10,500 units = NT$0.7857 per unitTotal cost per unit = NT$0.80 + NT$0.7857 = NT$1.5857Ending inventory = NT$1.5857 x 1,100 units = NT$1,744

3. Under throughput costing:Total direct materials cost per unit = NT$2,300/10,500 units = NT$0.21905Ending inventory = NT$0.21905 x 1,100 units = NT$241

C. 1, 2, 3

Variable Costing Absorption Costing Throughput CostingRevenue NT$32,900Variable costs:

Production(NT$0.80 x 9,400) (7,520)

Selling (940)Contribution margin 24,440Fixed costs:

Production (8,250)Selling and admin. (14,560)

Operating income NT$ 1,630

Revenue NT$32,900Cost of goods sold

(NT$1.5857 x 9,400) (14,906)Gross margin 17,994Selling and admin.

(NT$940 + 14,560) (15,500)Operating income NT$ 2,494

Revenue NT$32,900Direct materials

(NT$0.21905 x 9,400) (2,059)Throughput margin 30,841Operating expenses (a) (29,850)Operating income NT$ 991

(a) NT$(3,300 + 2,800 + 940 + 8,250 + 14,560) = NT$29,850

Double-check computations for absorption versus variable costing:There were no beginning inventories. Therefore, the change in inventory is equal to the ending inventory (calculated in Part A).

Inventory under absorption costing NT$1,744Inventory under variable costing 880

Difference in inventory NT$ 864

Difference in operating income - NT$2,494 - NT$1,630 NT$ 864

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Double-check computations for absorption versus throughput costing:Inventory under absorption costing NT$1,744Inventory under throughput costing 241

Difference in inventory NT$1,503

Difference in operating income - NT$2,494 - NT$991 NT$1,503

C. It is first necessary to calculate the revenue and variable costs per unit:Revenue per unit = NT$32,900/9,400 = NT$3.50Variable production cost per unit = NT$0.80Variable selling cost per unit = NT$940/9,400 = NT$0.10

Revenue (12,110 x $3.50) NT$42,385Variable costs:

Production (12,110 x NT$0.80) (9,688)Selling (12,110 x NT$0.10) (1,211 )

Contribution margin 31,486Fixed costs:

Production (8,250)Selling and administrative (14,560)

Operating income NT$ 8,676

15.31 Calculations Using Balance Sheet Data – A Manufacturing Firm

A. Balance Sheet 2 has higher unit costs in inventory, so it must be an absorption costing statement.

B. Assuming that costs per unit did not decrease, the decrease in total cost of inventory from January 1 to January 31 indicates that more units were sold than produced.

C. Difference between variable costing income and absorption costing income:Fixed costs in beginning absorption inventory ($38,000 – $17,000) $21,000Fixed costs in ending absorption inventory ($19,000 – $8,000) 11,000

Variable costing income higher than absorption costing income $10,000

15.32 Calculations Using Income Statement Data

A. Absorption costing will have the larger cost per unit for cost of goods sold, so Income Statement 2 must be the absorption costing statement and Income Statement 1 must be the variable costing statement.

B. Absorption costing income is higher than variable costing income, so the quantity of units in inventory must have increased during the period. Thus, production exceeded sales.

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C. The difference between the two income statements is the treatment of fixed manufacturing overhead costs. Under absorption costing, manufacturing overhead cost per unit is included in cost of goods sold. Under variable costing, the total amount of manufacturing overhead costs incurred during the current period is included in other expenses. Thus, the total amount of fixed overhead can be calculated from the difference in other expenses shown on the two income statements: $4,180 – $3,100 = $1,080

Note that fixed overhead cannot be derived by comparing cost of goods sold because some of the fixed overhead will be deferred into ending inventory under absorption costing. The amount deferred this period is: $1,080 – ($4,032 – 3,000) = $48

15.33 Absorption, Variable, and Throughput Income, Reconcile Incomes - Happy Bikers Motorcycle Company

A, B, C.

Variable Costing Absorption Costing Throughput CostingRevenue (a) $150,000Variable costs:

Production (b) (45,000)Selling (c) (3,750)

Contribution margin 101,250Fixed costs:

Production (40,000)Selling and admin. (40,000)

Operating income $ 21,250

Revenue (a) $150,000Cost of goods sold (d) (105,000)Volume variance (e) 26,667Gross margin 71,667Selling and admin. (f) (43,750)Operating income $ 27,917

Revenue (a) $150,000Raw materials (g) (30,000)Throughput margin 120,000Operating expenses (h) (101,750)Operating income $ 18,250

Calculation details:(a) Revenue = 15 motorcycles * $10,000 = $150,000(b) Variable production costs = 15 motorcycles * ($2,000 + $1,000) = $45,000(c) Variable selling and administrative costs = 15 motorcycles * $250 = $3,750(d) Absorption cost of goods sold:

Normal capacity = 10 motorcycles per monthEstimated fixed overhead per motorcycle = $40,000/10 = $4,000Total fixed and variable production cost per unit = $4,000 + $2,000 + $1,000

= $7,000Cost of goods sold = 15 motorcycles* $7,000 = $105,000

(e) Volume variance:Fixed production overhead $ 40,000Allocated overhead (18 motorcycles * $4,000) 72,000

Overapplied overhead $(32,000)Because the volume variance is material relative to actual production costs, it will be prorated between cost of goods sold and ending inventory. The portion allocated to cost of goods sold is:

$32,000 * (15/18 motorcycles) $(26,667)(f) Total selling and administrative expense = $40,000 + 15 motorcycles * $250 =

$43,750© 2012 John Wiley and Sons Canada, Ltd.

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Chapter 15: Measuring and Assigning Costs for Income Statements 133

(g) Total raw materials = 15 motorcycles * $2,000 = $30,000(h) Total operating expenses:

Direct labour and variable overhead (18 motorcycles * $1,000) $ 18,000Fixed production costs 40,000Variable selling and administrative (15 motorcycles * $250) 3,750Fixed selling and administrative 40,000

Total $101,750

D. Here is a schedule to reconcile the three income statements. Recall that inventory increased during the month by 3 units (18 motorcycles manufactured – 15 motorcycles sold).

Throughput costing operating income $18,250Direct labour and variable overhead costs added to ending variable

costing inventory (3 motorcycles * $1,000) 3,000Variable costing operating income 21,250Fixed overhead costs allocated to ending absorption costing

income (after the volume variance adjustment, this is equalto actual fixed overhead cost per unit)[3 motorcycles x ($40,000/18)] 6,667

Absorption costing operating income $27,917

15.34 Variable and Absorption Costing, Multiyear Analysis – LeFiell Manufacturing

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A. and B. Below are the income statements produced using the spreadsheet.2010 2011 2012

Units Sold 14,000 15,000 16,000 Units Produced 15,000 15,000 15,000

Fixed Production Costs $500,00

0 $500,000 $500,000

Variable production costs per unit 75 75 7

5

Selling price per unit

200 200 20

0 Fixed selling and administrative expenses 100,000 100,000 100,000

Absorption Costing 2010 2011 2012

Revenue (a) $2,800,0

00 $3,000,0

00 $3,200,0

00

Cost of Goods Sold (b) 1,516,66

7 1,625,00

0 1,733,33

3 Gross Margin $1,283,3 $1,375,0 $1,466,6

© 2012 John Wiley and Sons Canada, Ltd.

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134 Cost Management

33 00 67 Selling and Administrative 100,000 100,000 100,000

Operating Income $1,183,3

33 $1,275,0

00 $1,366,6

67

© 2012 John Wiley and Sons Canada, Ltd.

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Variable Costing 2010 2011 2012

Revenue (a) $2,800,0

00 $3,000,0

00 $3,200,0

00

Variable Production Costs (c) 1,050,00

0 1,125,00

0 1,200,00

0

Contribution Margin $1,750,0

00 $1,875,0

00 $2,000,0

00 Fixed Costs:

Production 500,000 500,000 500,000 Selling and Administrative 100,000 100,000 100,000

Operating Income $1,150,0

00 $1,275,0

00 $1,400,0

00

Calculations Details: (a) Revenue = units sold x $200 (b) Absorption Cost of Goods Sold: * Fixed Production Cost per unit = $500,000 / 15,000 units=

$33.33333

Total Production Cost per unit = $75 + $33.33333 = $108.33333 Absorption cost of Goods Sold = $108.33 x units sold (c ) Variable Production Costs = $75 x units sold

*Since fixed overhead costs and production were constant each month the fixed overhead production cost per unit was calculated using the 15,000 units produced each month.

Ending Inventory Value: 2010 2011 2012Absorption Costing $108.3333 x units remaining in inventory

2010 = 1,000 units $108,333

.33

2011 = 1,000 units $108,333

.33 2012 = 0 units $0

Variable Costing $75 x units remaining in inventory

$75,000.00

$75,000.00 $0

C.

© 2012 John Wiley and Sons Canada, Ltd.

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136 Cost Management

Difference in Operating Income 2010 2011 2012

Absorption Costing Income $1,183,3

33 $1,275,0

00 $1,366,66

7

Variable Costing Income 1,150,00

0 1,275,00

0 1,400,000

Difference in Operating Income 33,333

0 (33,333) Difference in Change in Inventory Absorption costing:

Ending Inventory $108,333

.33 $108,333

.33 $ 0

Beginning Inventory

0 108,333.

33 108,333.3

3

Increase (decrease) 108,333.

33

0 (108,333.

33)

© 2012 John Wiley and Sons Canada, Ltd.

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Variable Costing:

Ending Inventory $75,000.

00 $75,000.

00 $

0

Beginning Inventory

0 75,000.0

0 75,000.00

Increase (decrease) 75,000.0

0

0 (75,000.0

0)

Difference 33,333.3

3

0 (33,333.3

3)

The net income under the absorption costing method is higher in 2010 because a portion of the fixed production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under absorption costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2011 the net incomes were the same because production and sales were equal and the higher inventory costs carried over to the balance sheet again. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $ 3,825,000 under both methods.

15.35 Throughput Costing, Multiyear Approach – LeFiell Manufacturing (Continued)

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A and B: Below is the income statement produced using the spreadsheet.2010 2011 2012

Units Sold 14,0

00 15,0

00 16,0

00

Units Produced 15,0

00 15,0

00 15,0

00 Fixed Production Costs $500,000 $500,000 $500,000

Variable production costs per unit

75

75

75

Selling price per unit 2

00 2

00 2

00 Fixed selling and administrative expenses

100,000

100,000

100,000

Direct materials per unit

50

50

50

Throughput Costing Revenue (a) $2,800,00 $3,000,00 $3,200,00

© 2012 John Wiley and Sons Canada, Ltd.

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138 Cost Management

0 0 0

Direct material costs (b) 700,0

00 750,0

00 800,0

00

Throughput contribution $2,100,00

0 $2,250,00

0 $2,400,00

0 Other costs:

Other production costs (c) 875,0

00 875,0

00 875,0

00 Selling and administrative expenses (d)

100,000

100,000

100,000

Operating Income $1,125,00

0 $1,275,00

0 $1,425,00

0

© 2012 John Wiley and Sons Canada, Ltd.

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Calculations Details (a) Revenue = units sold x $200 (b) Direct material costs = units sold x $50 (c ) Other Production Costs = [($75 - 50) x units produced] + $500,000 (d) Selling and administrative expenses = $100,000

Ending Inventory Value: Throughput Costing Direct materials per unit x units remaining in inventory

2010 = 1,000 units $50,000.0

0

2011 = 1,000 units $50,000.

00

2012 = 0 units -

Difference in Operating Income 2010 2011 2012

Throughput Costing Income $1,125,00

0 $1,275,0

00 $1,425,0

00

Variable Costing Income (15.34) 1,150,0

00 1,275,0

00 1,400,0

00

Difference in Operating Income (25,0

00)

- 25,0

00 Difference in Change in Inventory Throughput costing:

Ending Inventory 50,000.

00 50,000.

00

-

Beginning Inventory

- 50,000.

00 50,000.

00

Increase (decrease) 50,000.

00

- (50,000.

00) Variable Costing:

Ending Inventory 75,000.

00 75,000.

00

-

Beginning Inventory

- 75,000.

00 75,000.

00

Increase (decrease) 75,000.

00

- (75,000.

00) Difference (25,000. 25,000.

© 2012 John Wiley and Sons Canada, Ltd.

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140 Cost Management

00) - 00

The net income under the variablecosting method is higher in 2010 because a portion of the variable production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under variable costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2011 the net incomes were the same because production and sales were equal and the higher inventory costs carried over to the balance sheet again. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $ 3,825,000 under both methods.

15.36 Variable and Absorption Costing, Multi-year Approach – MacHine Company

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A. and B.2010 2011 2012

Units Sold 5,000 5,

500 6,

000

Units Produced 5,500 6,

000 5,

000

Fixed Production Costs $200,000 $200,

000 $200,00

0

Variable production costs per unit 55

55

55

Selling price per unit 175

175

175 Fixed selling and administrative expenses 50,000

50,000

50,000

Absorption Costing 2010 2011 2012

Revenue (a) $875,000

.00 $962,500.

00 $1,050,000

.00

Cost of Goods Sold (b) 456,818.

18 487,348.4

8 563,333.33

Gross Margin $418,181

.82 $475,151.

52 $486,666.6

7

Selling and Administrative 50,000.0

0 50,000.00 50,000.

00

Operating Income $368,181

.82 $425,151.

52 $436,666.6

7

© 2012 John Wiley and Sons Canada, Ltd.

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Variable Costing 2010 2011 2012

Revenue (a) $875,000

.00 $962,500.

00 $1,050,000

.00

Variable Production Costs (c) 275,000.

00 302,500.0

0 330,000.00

Contribution Margin $600,000

.00 $660,000.

00 $720,000.

00 Fixed Costs:

Production 200,000.

00 200,000.0

0 200,000.00

Selling and Administrative 50,000.0

0 50,000.00 50,000.00

Operating Income $350,000

.00 $410,000.

00 $470,000.0

0

Calculations Details: 2010 2011 2012 (a) Revenue = units sold x $175 (b) Absorption Cost of Goods Sold: *Fixed Production Cost per unit (allocated based on actual production) = $200,000 / actual production each year

36.36364 33.33333 40.00000

Total Production Cost per unit

= $55 + fixed prod cost per unit 91.3636

4 88.33333 95.00000 **Absorption cost of Goods Sold 2010 = units sold x Total prod cost/unit

456,818.18

2011 = 500 u (end inv in 2007) x $91.36364 + 5,000 u x $88.33333

487,348.48

2012 = 1,000 u (end inv in 2008) x $88.33333 + 5,000 u x $95

563,333.33

(c) Variable Production Costs = $55 x units sold

*Since fixed overhead costs and production were not constant each month the fixed overhead production cost per unit was calculated using the actual units produced each month. Alternatively the average could have been calculated based on a normal capacity but this information was not given in the question.

**Since the production costs are not the same each year, the cost of goods sold must take into account that the ending inventory from the prior year has a different cost than the current year production. Since the company uses a FIFO costing system the assumption was

© 2012 John Wiley and Sons Canada, Ltd.

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142 Cost Management

made that the beginning inventories were sold first at last year’s cost and then the remaining units sold were from current year’s production.

Ending Inventory Value: 2010 2011 2012Absorption Costing = total production cost / unit x units remaining in inventory

2010 = 500 units x $91.36364 $45,681.8

2

2011 = 1,000 units x $88.33333 $88,333.3

3 2012 = 0 units $ 0

Variable Costing $55 x units remaining in inventory

$27,500.00

$55,000.00 $ 0

C.Difference in Operating Income 2010 2011 2012

Absorption Costing Income $368,181.

82 $425,151.

52 $436,666.

67

Variable Costing Income 350,000.0

0 410,000.0

0 470,000.0

0

Difference in Operating Income 18,181.82 15,151.52 (33,333.3

3) Difference in Change in Inventory Absorption costing:

Ending Inventory $45,681.8

2 $88,333.3

3 $

0

Beginning Inventory

0 45,681.82 88,333.33

Increase (decrease) 45,681.82 42,651.52 (88,333.3

3)Variable Costing:

Ending Inventory 27,500.00 55,000.00

0

Beginning Inventory

0 27,500.00 55,000.00

Increase (decrease) 27,500.00 27,500.00 (55,000.0

0)

Difference 18,181.82 15,151.52 (33,333.3

3)

© 2012 John Wiley and Sons Canada, Ltd.

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The net income under the absorption costing method is higher in 2010 and 2011 because a portion of the fixed production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under absorption costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2012 the net income was lower using absorption costing by an amount equal to the two previous years when the net income was higher using absorption costing. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $1,230,000 under both methods.

15.37 Throughput Costing, Multiyear Approach – MacHine Company (Continued)

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A. and B.2010 2011 2012

Units Sold 5,0

00 5,5

00 6,0

00

Units Produced 5,5

00 6,0

00 5,0

00

Fixed Production Costs $200,0

00 $200,0

00 $200,0

00 Variable production costs per unit

55

55

55

Selling price per unit 1

75 1

75 1

75 Fixed selling and administrative expenses

50,000

50,000

50,000

Direct materials per unit

20

20

20

Throughput Costing

Revenue (a) $875,000.

00 $962,500.

00 $1,050,000

.00

Cost of Materials (b) 100,000.

00 110,000.

00 120,000.

00

Throughput Margin $775,000.

00 $852,500.

00 $930,000.

00

Other Production Costs (c) 392,500.

00 410,000.

00 375,000.

00

Selling and Administrative 50,000.

00 50,000.

00 50,000.

00 Operating Income $332,50 $392,50 $505,000

© 2012 John Wiley and Sons Canada, Ltd.

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144 Cost Management

0.00 0.00 .00

Variable Costing (15.36)

Revenue (a) $875,000.

00 $962,500.

00 $1,050,000

.00

Variable Production Costs (d) 275,000.

00 302,500.

00 330,000.

00

Contribution Margin $600,000.

00 $660,000.

00 $720,000.0

0 Fixed Costs:

Production 200,000.

00 200,000.

00 200,000.

00

Selling and Administrative 50,000.

00 50,000.

00 50,000.

00

Operating Income $350,00

0.00 $410,000

.00 $470,000.

00

Calculations Details (a) Revenue = units sold x selling price per unit (b) Throughput Cost of Materials = $20 x units sold (c) Throughput Other Production Costs Fixed Production Cost + (Variable cost per unit - direct materials per unit) x units produced (d ) Variable Production Costs = $55 x units sold

Ending Inventory Value: Throughput Costing = materials cost per unit x units remaining in inventory

2010 = 500 units x $20 $10,000.

00

2011 = 1,000 units x $20 $20,000.

00 2012 = 0 units -

Variable Costing $55 x units remaining in inventory

$27,500.00

$55,000.00 -

Difference in Operating Income 2010 2011 2012Throughput Costing Income $332,500. $392,500. $505,000.0

© 2012 John Wiley and Sons Canada, Ltd.

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00 00 0

Variable Costing Income 350,000.

00 410,000.

00 470,000.

00

Difference in Operating Income (17,500.

00) (17,500.

00) 35,000.

00 Difference in Change in Inventory Throughput costing:

Ending Inventory 10,000.

00 20,000.

00 -

Beginning Inventory

- 10,000.

00 20,000.

00

Increase (decrease) 10,000.

00 10,000.

00 (20,000.0

0) Variable Costing:

Ending Inventory 27,500.

00 55,000.

00 -

Beginning Inventory

- 27,500.

00 55,000.

00

Increase (decrease) 27,500.

00 27,500.

00 (55,000.0

0)

Difference (17,500.

00) (17,500.

00) 35,000.

00

The net income under the variable costing method is higher in 2010 and 2011 because a portion of the direct materials production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under variable costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2012 the net income was lower using variable costing by an amount equal to the two previous years when the net income was higher using variable costing. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $1,230,000 under both methods.

© 2012 John Wiley and Sons Canada, Ltd.

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146 Cost Management

PROBLEMS

15.38 Absorption and Variable Costing Income Statements, Reconciliation of Net Incomes – Okanagan Company

It is useful to set out the given information in the following format prior to addressing the requirements (there are no WIP inventories).

Absorption Costing Variable CostingSales $900,000 Sales

$900,000COGS Variable costs

Beginning FG ? Manufacturing ?+ COGM ? + SG&A 0 − Ending FG ? = Total variable costs ?

− COGS ? Contribution margin 360,000Gross margin $162,000 Fixed costs manufacturing 132,000SG&A (all fixed) 42,000 Fixed costs SG&A 42,000 Operating profit $120,000 Operating profit $186,000

A. 1) From the information given in the variable costing income statement, total variable cost of goods sold = Sales – CM = $900,000 – 360,000 = $540,000. There are no variable SG&A expenses. Given that unit variable manufacturing cost is $6, total units sold are: $540,000 / 6 = 90,000.

2) From the absorption costing income statement:

COGS = Sales – Gross margin = $900,000 − $162,000 = $738,000. Since 90,000 units were sold, the product cost per unit is $738,000 / 90,0000 = $8.20

3) Unit fixed costs are $8.20 − $6 = $2.20. Since total fixed costs are $132,000 in 2009, production must be $132,000 / 2.2 = 60,000 units.

B. and C.Production and sales quantities are provided for this part. The product cost of manufacturing

can thus be determined and the income statements constructed.

(b) (c)Absorption Costing Variable Costing

Sales $900,000 Sales$900,000

COGS Variable costsBeginning FG 246,0002 Manufacturing 540,000 (A1)+ COGM 492,0001 + SG&A 0 © 2012 John Wiley and Sons Canada, Ltd.

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− Ending FG 03 = Total variable costs 540,000 − COGS 738,000 (A2) Contribution margin 360,000Gross margin $162,000 Fixed costs manufacturing 132,000SG&A (all fixed) 42,000 Fixed costs SG&A 42,000 Operating profit $120,000 Operating profit $186,000

Notes:1COGM = 60,000 * $8.20 = $492,000. See A3 and A2 above2Beginning FG = COGS – COGM = $738,000 − $492,000 = $246,000 represents the difference

between beginning FG and ending FG. Thus Units in beginning inventory – Units in ending inventory = $246,000 / $8.2 = 30,000 units

3 Ending FG = 30,000 beginning inventory units + 60,000 units produced – 90,000 units sold = 0 units

D. Reconciliation

Absorption costing operating profit $120,000+ FC released from beginning inventory (30,000 * $2.20) 66,000− FC held back in ending inventory (0 * $2.20 0 = Variable costing operating profit $186,000

15.39 Absorption and Variable Costing Income Statements, Reconciliation of Net Incomes – Hermione Corporation

A.Absorption costing income statement

HERMIONE CORPORTATIONPro-forma Income Statement — Absorption Costing Basis

Year Ended December 31, 2012

Sales (96,000 * $12.00) $1,152,000Costs of goods soldBeginning inventory (4,000 * $5.00) $ 20,000Variable manufacturing cost (100,000 * $7.50) $750,000Fixed overhead, manufacturing 80,000Cost of goods manufactured 830,000Cost of goods available for sale $850,000Ending inventory [8,000 * ($7.50+($80,000/100,000)] (66,400)Cost of goods sold 783,600 Gross margin 368,400Variable selling and administrative (96,000 * $1.00) $ 96,000Fixed selling and administrative 55,000Total selling and administrative 151,000 Net income $ 217,400

© 2012 John Wiley and Sons Canada, Ltd.

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148 Cost Management

Variable costing income statement

HERMIONE CORPORTATIONPro-forma Income Statement — Variable Costing Basis

Year ended December 31, 2012

Sales $1,152,000Costs of goods soldBeginning inventory $ 20,000Variable manufacturing cost 750,000Variable manufacturing cost of goods available for sale 770,000Variable cost of manufacturing in ending inventory (60,000)Variable cost of goods sold $710,000Variable selling and administrative 96,000Total variable cost 806,000 Contribution margin $ 346,000Fixed overhead, manufacturing $80,000Fixed selling and administrative 55,000Total fixed costs 135,000 Net income $ 211,000

CalculationsEnding inventory 4,000 purchased units + 100,000 manufactured units – 96,000 sold units 8,000 units

ReconciliationAbsorption costing net income (NI) – Variable costing NI = Fixed cost in ending inventory – Fixed cost in beginning inventory

$217,400 - $211,000 = $6,400 8,000 units x 0.80 = $6,400

Note:Fixed manufacturing costs per unit = $80,000/100,000 = $0.80

There are no fixed costs in beginning inventory since it was purchased from an outside supplier. Those units were not manufactured.

© 2012 John Wiley and Sons Canada, Ltd.

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Chapter 15: Measuring and Assigning Costs for Income Statements 149

15.40 Absorption and Variable Costing Income Statements – KopyKat Company

A. The following calculations will be used in the solution.

i) Units in beginning and ending inventoryOctober November

Beginning inventory 10,000 units 20,000 unitsProduction 25,000 ----Good available for sale 35,000 20,000Sales 15,000 20,000Ending inventory 20,000 0

ii) Product cost per unitSeptember October November

Variable manufacturing $ 18 $ 18 $ 18Fixed manufacturing $ 101 $ 122 N/A3

$ 28 $ 30 $ 18

1Total product of beginning inventory is given in the question: $280,000 / 10,000 units = $28 per unit total product cost. $28 - $18 variable costs = $10 fixed costs allocated to beginning inventory.

2 Total fixed manufacturing cost/production =

$300,000= $12

25,000

3Since there is no production in November, fixed costs for the period cannot be unitized.

Absorption FormatIncome Statement

October November

Sales1 $ 750,000 $1,000,000Cost of goods sold

Beginning inventory2 280,000 600,000Costs of goods manufactured3 750,000 300,000Ending inventory4 (600,000 ) ( 0 ) Cost of goods sold $430,000 $ 900,000

Gross margin $ 320,000 $ 100,000Selling and administration costs

Variable5 45,000 60,000Fixed 260,000 260,000

Total selling and administrative costs $ 305,000 $ 320,000Net income $ 15,000 $ (220,000)

© 2012 John Wiley and Sons Canada, Ltd.

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150 Cost Management

1 October: 15,000 * $50November: 20,000 * $50

2 October: GivenNovember: Same as October ending inventory

3 October: 25,000 * $30November: This is the fixed manufacturing cost; no production occurred, thus no variable costs were incurred.

4 October: 20,000 * $30November: 0

5 October: 15,000 * $3November: 20,000 * $3

B.October November

Absorption costing net income $ 15,000 $ (220,000)Plus fixed cost in beginning inventory1 $ 100,000 $ 240,000Minus fixed cost in ending inventory2 $ 240,000 0 Equals variable costing net income $(125,000) $ 20,000

1 October: Unit fixed cost * Units in inventory = $10 * 10,000 = $100,000November: Unit fixed cost * Units in inventory = $12 * 20,000 = $240,000

2 October: Unit fixed cost * Units in inventory = $12 * 20,000 = $240,000November: Unit fixed cost * Units in inventory = $12 * 0 = $0

C. The CEO’s confusion stems from the fact that in November the sales were filled entirely from inventory, and thus the costs in inventory that were deferred in October flow to the income statement as a cost in November. Additionally, since there is no production in November, the company must still cover the fixed manufacturing costs from the sales. Thus the cost of goods sold is $900,000. With no excess production in November to absorb the fixed costs, all of this cost is expensed and net income is affected negatively.

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15.41 Absorption and Variable Inventory and Income, Reconcile Incomes - Wild Bird Feeders

A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A and B. Absorption and variable costing ending inventoryThe problem states the 2012 actual costs for direct materials, direct labour, and variable manufacturing overhead are the same as the planned costs (i.e., $3,120,000/130,000 units = $24.00 for direct materials, $2,340,000/130,000 units = $18.00 for direct labour, and $520,000/130,000=$4.00 for variable manufacturing overhead). The problem also states that all over- or underapplied overhead is assigned directly to cost of goods sold. Therefore, the 2012 overhead costs assigned to inventory are the same as the planned costs. Thus, the prior year inventory costs are the same as the current year inventory costs, and it does not matter which cost flow assumption the company uses.

COST OF ENDING INVENTORYAbsorption Variable Absorption Variable

Production cost per unit: Costing Costing Costing Costing Direct materials (actual) $24.00 $24.00 $24.00 $24.00 Direct labour (actual) 18.00 18.00 18.00 18.00 Variable manufacturing overhead (allocated=actual) 4.00 4.00 4.00 4.00 Fixed manufacturing overhead (allocated) 5.00 5.00 Total $51.00 $46.00 $51.00 $46.00

Units: Beginning inventory 30,000 Production 130,000 Sales (125,000) 5,000 Ending inventory 35,000

Cost of ending inventory $1,785,000 $1,610,000

20122011

C. Manufacturing and total contribution margin

VARIABLE COSTINGRevenue $12,375,000Variable production costs (5,750,000) Manufacturing contribution margin 6,625,000Other variable costs: Variable selling $1,750,000 Variable administrative 125,000 (1,875,000) Total contribution margin 4,750,000Fixed costs: Manufacturing overhead $710,000 Selling 980,000 Administrative 850,000 (2,540,000) Operating income $2,210,000

D. This question asks for the total fixed costs on the income statement and then proceeds to develop that cost in steps as follows.1. Fixed selling and administration = ($980,000 + $850,000) = $1,830,000

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2. Fixed manufacturing overhead allocated to COGS:Fixed overhead at given allocation rate (125,000 x $5) $625,000

3. As noted in the answer to Parts A and B, the cost per unit during 2011 was the same as the cost per unit assigned to inventory during 2012. Therefore, the cost per unit assigned to cost of goods sold and to inventory is not affected by whether the company’s inventory levels increased or decreased during 2012. In other words, sales of units that were produced last year do not need to be considered.

4. Calculation of overapplied (underapplied) overhead: Overhead allocated to production $625,000Actual overhead 710,000

(Underapplied) overhead $ (85,000)

5. Total fixed costs on income statement = $1,830,000 + $625,000 + $85,000 (because the underapplied overhead is closed to COGS) = $2,540,000.

E. Variable costs on variable costing income statement (see the solution to Part C): $5,750,000 + $1,875,000 = $7,625,000.

F. Absorption income would be higher than variable income because the company produced more units that it sold, and the units remaining in ending inventories include an allocation of fixed manufacturing overhead cost under absorption costing. Therefore, total overhead expense on the income statement is less under absorption than under variable costing, where the total fixed cost for the period is expensed.

G. There are two ways to answer this question. The first method is to calculate the amount of fixed overhead added to inventory under absorption costing. The fixed overhead allocation rate is $5 per unit, and 5,000 units were added to inventory. Therefore, absorption costing income should be $25,000 higher than variable costing income.

The second method is to prepare the two income statements and compare the results. The difference in income is (income statements are available on the sample spreadsheet for this problem):

Absorption costing operating income $2,235,000Variable costing operating income 2,210,000

Difference $ 25,000

15.42 Differences in Income, Choice of Absorption and Variable Costing – Nova Scotia Lobsters Company

A. Absorption income statements assign all direct production costs and allocate all indirect production costs to inventory. At the time of sale, per unit revenue is matched with per unit expense on the income statement. Variable income statements categorize costs into fixed and variable, and production related and non-production related costs.

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B. If the company has no shareholders, the company may have no need for GAAP-based income statements. The variable income statement would be more useful for internal management use.

C. If the company wishes to apply for external funds, such as a bank loan, the company may be required to prepare GAAP-basis financial statements.

D. It is easy to prepare both types of statements. However, for decision-making purposes the variable statements are better.

E. If Nova Scotia Lobsters wants other family members to know how the business is doing, GAAP statements would be prepared in a manner that would allow comparison with other businesses.

15.43 Absorption, Variable, and Throughput Income; Normal Capacity; Choice of Denominator - Giant Jets

A. Production and sales data:Year 2010 2011 2012Production 10 6 8Sales 10 4 10

Variable costing income statements:2010 2011 2012

Revenues (jets sold x €1,000,000) €10,000,000 €4,000,000 €10,000,000Variable costs:

Production [jets sold *( €200,000 +€150,000 + €50,000)] (4,000,000) (1,600,000) (4,000,000)

Selling (jets sold * €100,000) (1,000,000) (400,000) (1,000,000)Contribution margin 5,000,000 2,000,000 5,000,000

Fixed costs:Production (600,000) (600,000) (600,000)Administrative and selling (100,000) (100,000) (100,000)

Operating income € 4,300,000 €1,300,000 € 4,300,000

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B. Throughput costing income statements:2010 2011 2012

Revenues (jets sold * €1,000,000) €10,000,000 €4,000,000 €10,000,000Direct materials (jets sold * €200,000) (2,000,000) (800,000) (2,000,000)

Throughput margin 8,000,000 3,200,000 8,000,000Operating expenses:

Direct labour(jetsproduced * €150,000) (1,500,000) (900,000) (1,200,000)Variable production overhead

(jets produced * €50,000) (500,000) (300,000) (400,000)Variable selling (jets sold * €100,000) (1,000,000) (400,000) (1,000,000)Fixed production overhead (600,000) (600,000) (600,000)Fixed administrative and selling (100,000) (100,000) (100,000)

Operating income € 4,300,000 € 900,000 € 4,700,000

C. Cost per jet under absorption costing:2010 2011 2012

Direct materials €200,000 €200,000 €200,000Direct labour 150,000 150,000 150,000Variable production overhead 50,000 50,000 50,000Fixed production overhead per unit:

€600,000/units produced 60,000 100,000 75,000Total cost per jet €460,000 €500,000 €475,000

Jets sold 10 4 10Jets produced 10 6 8

Cost of goods sold: Units produced this year €4,600,000 €2,000,000 €3,800,000Units produced last year 0 0 1,000,000

Total €4,600,000 €2,000,000 €4,800,000

Absorption costing income statements:2010 2011 2012

Revenues (jets sold * €1,000,000) €10,000,000 €4,000,000 €10,000,000Cost of goods sold (4,600,000) (2,000,000) (4,800,000)

Gross margin 5,400,000 2,000,000 5,200,000Administrative and selling

[€100,000 + (jets sold * €100,000)] (1,100,000) (500,000) (1,100,000)Operating income € 4,300,000 €1,500,000 € 4,100,000

D. Normal capacity is an average capacity over time. It represents the volume of production that is expected to occur in a typical year.

E. There are likely to be differences of opinion on the normal volume. One way to estimate the normal volume is to calculate the average over the three years presented, or 8 jets per year. The following income statement is calculated using 8 jets as the normal volume.

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Cost per jet under absorption costing:Direct materials €200,000Direct labour 150,000Variable production overhead 50,000Fixed production overhead per unit:

€600,000/8 jets 75,000Total cost per jet €475,000

Volume variance:2010 2011 2012

Jets produced 10 6 8Fixed production overhead allocated €750,000 € 450,000 €600,000Actual fixed production overhead 600,000 600,000 600,000

Over (under)applied overhead €150,000 €(150,000) € 0

The volume variance does not appear to be material relative to total production costs in 2010 and 2011. Therefore, all of it is allocated to cost of goods sold.

Absorption costing income statements:2010 2011 2012

Revenues (jets sold x €1,000,000) €10,000,000 €4,000,000 €10,000,000Cost of goods sold (jets sold * €475,000) (4,750,000) (1,900,000) (4,750,000)Volume variance adjustment 150,000 (150,000) 0

Throughput margin 5,400,000 1,950,000 5,250,000Administrative and selling

[€100,000 + (jets sold * €100,000)] (1,100,000) (500,000) (1,100,000)Operating income € 4,300,000 €1,450,000 € 4,150,000

F. The textbook is not clear about which absorption costing income (the one in Part C or the one in Part E) to use in the reconciliation. Therefore, reconciliations are shown for both income statements.

2010 2011 2012Jets produced 10 6 8Jets sold 10 4 10Increase (decrease) in inventory of jets 0 2 (2)

Throughput costing income (Part B) €4,300,000 € 900,000 €4,700,000Direct labour and variable production

overhead added to (subtracted from)ending variable costing inventory[Change in inventory * (€150,000+€50,000)] 0 400,000 (400,000 )

Variable costing income (Part A) 4,300,000 1,300,000 4,300,000Fixed overhead costs allocated to ending

absorption costing incomeChange in inventory * €100,000 0 200,000 (200,000)

Absorption costing income (Part C) € 4,300,000 €1,500,000 € 4,100,000

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Variable costing income (Part A) €4,300,000 €1,300,000 €4,300,000Fixed overhead costs allocated to ending

absorption costing incomeChange in inventory * €75,000 (a) 0 150,000 (150,000)

Absorption costing income (Part E) € 4,300,000 €1,450,000 € 4,150,000

(a) Because the volume variance was allocated 100% to cost of goods sold, it can be ignored in this reconciliation.

15.44 Absorption, Variable, and Throughput Income and Inventory; Method for Manager Bonus - Fighting Kites

A, B, and C.Product costs: Variable Throughput Absorption

Direct materials $ 40,000 $40,000 $ 40,000Other variable production costs 60,000 60,000Fixed production costs (a) 80,000

Total product costs $100,000 $40,000 $180,000

(a) Absorption costing fixed production rate: $100,000/25,000 denominator level = $4 per kitFixed production cost allocated to kits produced: $4 * 20,000 kits = $80,000

Cost per kit (20,000 produced) $5 $2 $9

Cost for 2,000 kits from beginning inventory $10,000 $ 4,000* $15,000Cost for 16,000 kits produced and sold 80,000 32,000 144,000Cost of Goods Sold $90,000 $36,000 $159,000Cost for 4,000 kits added to inventory

4,000 kits * $5 $20,0004,000 kits * $2 $8,0004,000 kits * $9 + volume variance $4,000 $ 40,000

*The value of the beginning inventory assumes the same proportion of direct materials and other variable production costs as this year.

Variable Costing Throughput Costing Absorption CostingRevenue (a) $540,000Variable costs:

Production (above) (90,000)Selling (18,000)

Contribution margin 432,000Fixed costs:

Production (100,000)Selling and admin. (100,000)

Operating income $232,000

Revenue (a) $540,000Raw materials (above) (36,000)Throughput margin 504,000Operating expenses (b) (278,000)Operating income $226,000

Revenue (a) $540,000Cost of goods sold (above)(159,000)Volume variance (c) (16,000 ) Gross margin 365,000Selling and admin. (d) (118,000)Operating income $247,000

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Calculation details:(a) Revenue = 18,000 kits x $30 = $540,000(b) Throughput costing operating expenses:

Other variable production costs $ 60,000Fixed production costs 100,000Variable selling costs 18,000Fixed selling and administrative costs 100,000

Total $278,000(c) Volume variance:

Fixed production cost allocated ($4 x 20,000 kits) $ 80,000Actual fixed production cost 100,000

(Underallocated) fixed production costs $ (20,000)

Because the volume variance is material, it is prorated between cost of goods sold and ending inventory:

Cost of goods sold ($20,000 *16,000/20,000 kits) $(16,000)Ending inventory ($20,000 *4,000/20,000 kits) (4,000)

Total volume variance adjustment $(20,000)(d) Selling and administrative:

Variable selling costs $ 18,000Fixed selling and administrative costs 100,000

Total $118,000

Although the problem does not ask for a reconciliation of income across the three methods, it is useful to prepare a reconciliation to double-check the preceding computations:

Throughput costing operating income $226,000Direct labour and variable overhead costs added to ending variable

costing inventory ($60,000 x 4,000/20,000 kits) 12,000Direct labour and variable overhead costs resulting from beginning

inventory sold this year (assuming same ratio as this year) (6,000 ) Variable costing operating income 232,000Difference in fixed overhead costs assumed this year resulting from

beginning inventory sold this year (10,000 – 15,000) (5,000)Fixed overhead costs allocated to ending absorption costing

inventory (after the volume variance adjustment, this is equalto actual fixed overhead cost per unit)$100,000 x 4,000/20,000 kits 20,000

Absorption costing operating income $247,000

D. Student answers to this question should demonstrate that they have considered how the managers might use the absorption costing information, and they should also clarify their assumptions. If the managers’ primary goal in using absorption costing is to assign actual costs to inventory as accurately as possible, then next year’s expected production volume should be used as the denominator value. If demand and production volumes are

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expected to remain at 20,000, then a volume of 20,000 would be appropriate. If production volumes are not stable, then next year’s volume could be estimated using sales forecasts for next year and/or production volumes over several past years. On the other hand, the managers may wish to monitor use of capacity, particularly if production volumes vary. In that case, a volume such as practical capacity might be best.

E. Student responses will vary. Following is an example of a good response.

I recommend that Fighting Kites use variable income or throughput income because both of these methods provide less incentive to build up inventories and more incentive to control fixed and overhead costs. In addition, these statements provide information about current period costs to those individuals charged with evaluating managers’ performance. The variable income statement displays fixed and variable, production and nonproduction costs in such a manner that they are easily compared across time for meaningful performance evaluation. For example, if manufacturing fixed costs are considerably higher or lower in one period than in the prior periods, this information would be easy to identify and managers could be rewarded or encouraged to control costs better. In addition, the information from both variable and throughput costing income statements is broken down into categories that are useful for decision-making. When Fighting Kites needs to make a short or long term production decision, the variable costing income statement provides ample relevant information. When capacity constraints exist, throughput costing information may be better. If Fighting Kites guarantees its direct labour employees a 40-hour work week, then throughput costing information provides the best information for decision-making.

15.45 Absorption and Variable Income and Uses, Reconcile Incomes - Security Vehicles

A. Variable costing income statement for January:Revenue (3 vehicles * $100,000) $300,000Variable costs:

Production (3 vehicles * $60,000) (180,000)Administrative and selling (3 vehicles * $5,000) (15,000)

Contribution margin 105,000Fixed costs:

Production (60,000)Administrative and selling (20,000)

Operating income $ 25,000

B. Absorption costing income statement for January:Revenue (3 vehicles * $100,000) $300,000Cost of goods sold (a) (225,000)

Gross margin 75,000Operating expenses:

Administrative and selling [$20,000 + ($5,000 * 3 vehicles)] (35,000)Operating income $ 40,000

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(a) Absorption cost per unit (assuming that fixed costs are allocated based on actual costs and actual production volume):

Variable production costs $60,000Fixed production costs ($60,000/4 vehicles) 15,000

Total absorption cost per unit $75,000

Cost of goods sold (3 vehicles * $75,000) $225,000

C. This question calls for a reconciliation of February incomes under variable and absorption costing. First calculate February income under these two methods:

Variable Costing Absorption CostingRevenue (6 * $100,000) $600,000Variable costs:

Production (6 * $60,000) (360,000)Selling (6 * $5,000) (30,000)

Contribution margin 210,000Fixed costs:

Production (60,000)Administrative and selling (20,000)

Operating income $130,000

Revenue (6 * $100,000) $600,000Cost of goods sold (a) (435,000)Gross margin 165,000Administrative and selling

($20,000 + $5,000 * 6 vehicles) (50,000)Operating income $115,000

Computation details:(a) Absorption cost per unit (assuming that fixed costs are allocated based on actual

costs and actual production volume):Variable production costs $60,000Fixed production costs ($60,000/5 vehicles) 12,000

Total absorption cost per unit during February $72,000

Cost of goods sold:Vehicles produced during February (5 vehicles * $72,000) $360,000Vehicle produced during January (1 vehicle * $75,000) 75,000

Total $435,000

In February, under absorption cost income, one vehicle was sold from January’s production. In January, overhead allocated to production was $15,000, so February’s income under absorption costing is $15,000 less than variable costing.

D. An organization could produce absorption cost income statements for external users such as shareholders, creditors, and suppliers. For internal decision-making information, variable cost income statements could be produced.

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15.46 Throughput Costing, Reconciling Income – Security Vehicles (Continued)

A. Throughput costing income statement for January:Revenue (3 vehicles * $100,000) $300,000Materialcosts (3 vehicles * $50,000) (150,000 )

Contribution margin 150,000Other costs:

Other Variable Production (4vehicles * $10,000) (40,000)Fixed Production (60,000)Variable Administrative and selling (3 vehicles * $5,000) (15,000)Fixed Administrative and selling (20,000)

Operating income $ 15,000

B. This question calls for a reconciliation of February incomes under variable and throughput costing. First calculate February income under these two methods:

Variable Costing Throughput CostingRevenue (6 * $100,000) $600,000Variable costs:

Production (6 * $60,000) (360,000)Selling (6 * $5,000) (30,000)

Contribution margin 210,000Fixed costs:

Production (60,000)Administrative and selling (20,000)

Operating income $130,000

Revenue (6 * $100,000) $600,000Cost of materials (a) (300,000)

Throughput margin 300,000Other costs:

Other production (110,000)Administrative and selling (50,000)

Operating income $140,000

Computation details:(a) Throughput cost of materials ($50,000*6 vehicles) $300,000

(b) Other Costs:Production

Vehicles produced during February (5 vehicles * $10,000) $50,000Fixed production costs 60,000

Total $110,000

Administration and Selling:Variable administration and selling costs (6 vehicles * $5,000) $30,000Fixed administration and selling costs 20,000

Total $50,000

In February one vehicle from January inventory was sold.

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Throughput costing operating income $140,000January inventory variable costing (1 vehicle * $60,000) ($60,000)January inventory throughput costs (1 vehicle * $50,000) 50,000Variable costing operating income 130,000

15.47 Overapplied/Underapplied Overhead, Units Versus Machine Hours as Allocation Base - Northcoast Manufacturing Company

[Note: Parts B and C require students to use and evaluate overhead allocation methods introduced in Chapters 5 and 11.]

A. Among the 3 budgeted levels of activity presented in the problem, the one closest to the actual production of 500,000 units is for 540,000 units of production. Based on this budgeted level of activity, the amount of over/underapplied overhead is calculated as follows:

Overhead can be allocated based on labour hours or labour costs and the question does not indicate which base to use so both will be shown here. The over or under applied overhead is the same for either base.

Based on labour dollars:Estimated overhead allocation rate

= Total budgeted overhead/budgeted direct labour cost= $961,200/(36,000 * $15)= 178% of direct labour cost

Allocated overhead [(35,000 * $15) * 178%] $ 934,500Actual incurred overhead 1,130,000

Overapplied (Underapplied) Overhead $ (195,500)

This amount is material because it is over 11% of COGS ($195,500/$1,720,960)

Based on labour hours:Estimated overhead allocation rate

= Total budgeted overhead/budgeted direct labour hours= $961,200/36,000= $26.70 per labour hour

Allocated overhead (35,000 * $26.70) $ 934,500Actual incurred overhead 1,130,000

Overapplied (Underapplied) Overhead $ (195,500)

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B. If machine hours were used, the amount of over/underapplied overhead would have been:

Overhead allocation rate$961,200/108,000 machine hours = $8.90 per machine hour

Allocated overhead ($8.90 * 130,000 machine hours) $1,157,000Actual incurred overhead 1,130,000

Overapplied (Underapplied) Overhead $ 27,000

C. Machine hours would be a more appropriate allocation base for Northcoast Manufacturing’s fixed manufacturing overhead because the company appears to have a capital-intensive manufacturing process where each direct labourer operates two to four machines simultaneously. In this type of setting, the use of machines drives a large portion of overhead costs, such as depreciation, maintenance, and utilities. Consequently, using machine hours as the allocation base results in more reliable cost information and better decisions.

D. If units are used as the denominator volume, managers can shift costs from the income statement to the balance sheet by producing more inventory than is sold. Each unit of inventory carries with it a portion of fixed cost that is booked as an asset (inventory) on the balance sheet and so fixed overhead cost is not completely expensed for the accounting period.

15.48 Recommend Income Format - GameZ

A. Three choices are available for income statement formats, absorption costing, variable costing, and throughput costing. Absorption costing meets GAAP standards and is used for income statements required by banks and creditors. Variable and throughput costing income statements produce detailed information that can be used in decision-making.

B. Absorption costing matches revenues with expenses under accrual accounting. Because this is required for GAAP, these statements are appropriate for external reports to creditors and shareholders. Variable costing separates costs into fixed and variable categories and expenses all fixed costs as period costs. Income levels are not affected by changes in inventory levels so managers have no incentive to manipulate inventory when income is reported using variable costing. The same advantages and disadvantages apply to absorption costing.

C. As mentioned above, the bank and other creditors will want the absorption income statement, but the brother will want information produced by either the variable cost or throughput income statements. Variable cost statements provide more detail than throughput costing so variable income statements would likely be preferred for developing information for decision-making. For compensation purposes, variable or

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throughput income statements are best because income is less subject to manipulation through inventory level adjustments.

15.49 Cumulative Exercise (Chapter 3): Breakeven, Absorption and Variable Income, Volume Alternatives - Schatzberg Company

[Note: This exercise requires application of knowledge from Chapter 3.]

A. To determine the breakeven point, set profit to 0 and solve for the quantity Q:Revenue – Variable costs – Fixed costs = 0$25Q – ($10 + $5)Q – ($150,000 + $200,000) = 0$10Q = $350,000Q = 35,000 units at the breakeven point

B. Absorption costing income statement with volume variance closed to COGS

Fixed overhead rate = $150,000/50,000 = $3 per unitEnding inventory = ($3 per unit fixed + $10 per unit variable) = $13 per unitEnding inventory = 40,000 units produced – 35,000 units sold = 5,000 units

Revenue ($25 * 35,000 units) $875,000Cost of goods sold ($13 * 35,000) (455,000)Volume variance [(50,000 – 40,000) * $3] (30,000 )

Gross Margin 390,000Selling and administrative [$200,000 + ($5 * 35,000)] (375,000)

Operating income $ 15,000

C. Absorption costing income statement with volume variance prorated Revenue ($25 * 35,000) $875,000Cost of goods sold ($13 * 35,000) (455,000)Volume variance [$30,000 * (35,000/40,000)] (26,250)

Gross Margin 393,750Selling and administrative [$200,000 + ($5 * 35,000)] (375,000)

Operating income $ 18,750

Reconciliation of volume variance:Included in cost of goods sold (above) $26,250Added to inventory [$30,000 * (5,000/40,000)] 3,750

Total volume variance (in Part B) $30,000

D. Under U.S. GAAP (and IFRS), when volumes are abnormally lower than normal capacity, the volume variance should be closed to COGS. In this exercise, volume is lower than normal by 20% (10,000/50,000), which would probably be considered abnormal (i.e., it would be outside of the normal range for production). Thus, the volume variance should be closed to COGS.

E. Variable costing income statement

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Revenue ($25 * 35,000) $875,000Variable costs:

Production ($10 * 35,000) 350,000Selling and administration ($5 * 35,000) 175,000

Contribution margin 350,000Fixed costs:

Manufacturing 150,000Selling and administration 200,000

Operating income $ 0

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MINI-CASES

15.50 Bonuses and Production Decisions, Profit Variances, Income Statement Format - Pine Producers

A. Grand Forks plant manager’s bonus Third quarter = 5% of $2,338 = $116.90Fourth quarter = 5% of $12,646 = $632.30

Singapore plant manager’s bonus Third quarter = 5% of $3,190 = $159.50Fourth quarter = 5% of $5,791 = $289.55

Each plant manager would prefer higher income to receive higher bonus amounts. This may encourage them to produce in excess and build up inventories. The fixed costs would then be spread out over all units and a portion of the fixed costs would be allocated to the balance sheet causing larger incomes.

B. For the Grand Forks plant, sales increased but cost of goods sold decreased. Either cost reductions were instituted or there was a build-up of inventory over the period, which would reduce the amount of fixed overhead in cost of goods sold.

C. If variable costs are immaterial, the difference in inventory amounts between the last two quarters is assumed to be expense that is on the balance sheet instead of on the income statement.

Grand Forks Plant Singapore PlantFourth quarter income $12,646 $5,791Change in inventory (18,100) (2,508)Variable costing income (loss) $ (5,454) $3,283

D I would conclude that the Grand Forks plant manager’s performance was poor during the last quarter of the year, and certainly not as good as the performance of the Singapore plant manager.

E. There is no one answer to this part. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

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15.51 Communication of Information

The answers below provide suggestions for improved communication. Additional ideas can be found in the following article: Jim Cole, “Speak English Please! How to Communicate Financial Information to Non-Accountants,” SmartPros, October 2004, available at http://accounting.smartpros.com/x44566.xml.

A. Here are a few ideas for improving the conciseness and clarity of written and spoken communications; students may think of others.

• Practice eliminating unnecessary words. Re-read what you have written and remove words or phrases that do not add meaning. Think of ways to say the same thing with fewer words. Reflect on phrases or sentences you have spoken and identify ways to simplify them.

• Avoid using jargon and overly-technical language. Adopt words that will convey your professionalism and also communicate effectively.

• Read any written communication out loud to detect wordy passages or sentences with unclear meaning. If you stumble over a phrase, it should be rewritten to reflect simple, yet concise language.

• Learn from your listeners’ reactions. Requests to repeat what you have said might suggest that you mumble or speak too softly. Watch for nonverbal cues, such as frowns or puzzled faces, which indicate your audience does not understand.

• Avoid speaking too quickly, particularly when leaving telephone messages. Speak slowly and distinctly when providing information such as your name and telephone number. Also slow down when you are trying to make a point.

B.1. Audience members vary in terms of their expectations, prior experience with the

subject matter, learning styles, and so on. It is not possible to fully anticipate the needs of everyone in an audience.

2. Group brainstorming is an excellent way to learn about other peoples’ perceptions. Try this activity and see what you learn!

3. There will be many different types of answers to this question. The purpose is to help students recognize that communication styles should vary from setting to setting.

4. There are two major differences in communication among the three methods introduced in this chapter. First, each costing method assigns a different proportion of production costs to the cost of goods manufactured. All production costs are assigned to products under absorption costing, whereas only variable production costs are assigned to products under variable costing, and only direct materials costs are assigned under throughput costing. Under all three methods, costs not assigned to products are treated as period costs when calculating operating income. Second, each method presents a subtotal on the operating statement that has a unique meaning.

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Under absorption costing, the gross margin is the excess of revenues over the product cost of goods sold. Under variable costing, the contribution margin is the excess of revenues over both production and nonproduction variable costs. Under throughput costing, the throughput margin in the excess of revenues over direct material costs of goods sold.

C.1. Indirect messages are any part of communication that is not explicit but that may

convey meaning. Examples include posture, facial and other body expressions, tone of voice, connotation of words used, eye contact, personal appearance, quality of penmanship, and physical materials used for written communications.

2. Indirect messages can help communication by conveying information, emphasizing what is said, and improving interactions. Indirect messages can also hinder communication because they may be misinterpreted, particularly between people from different backgrounds who may fail to understand their intended meaning.

3. Effective communication over time involves engaging in continuous improvement in both communicating and understanding others’ communications and ensuring that interactions do not break down. Students’ examples for this question are likely to vary widely. The purpose is to help students use what they have learned from past communication experiences to actively promote more effective future communication.

4. Again, student responses will vary.

15.52 Integrating Across the Curriculum: Financial Accounting and Auditing – Channel stuffing, uncertainties, error versus fraud, fraud incentives and costs

A. Channel stuffing is the practice of coercing customers to take delivery of excess merchandise for the purpose of improving the seller’s reported financial results.

B. Sales volumes are uncertain for most companies because they are subject to a variety of economic factors that cannot be fully anticipated, such as shifts in customer tastes, changes in competition, introduction of substitute products, changes in customer perceptions about product quality, consumer spending habits, fluctuations in the economy, variations in the sales effort of product distributors, and so on. Uncertainties about sales quantities make it more difficult for companies to plan production volumes, particularly when they cannot be rapidly increased or decreased.

C. In the case of McAfee and Harley-Davidson, customers were dealers or distributors with whom they had developed long-term relationships. Accordingly, these customers were willing to accept excess inventories because they were afraid that sufficient future inventories could be in doubt if they failed to cooperate. Sometimes the threat is explicit. For example, in the Bausch & Lomb case discussed in chapter 1, the distributors were

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told that they would lose their distributorships if they refused to take additional shipments at the end of 1993.

D. Here is a possible paragraph, written from the perspective of a Coca-Cola manager:

The demand for our products has not slowed down. We have been investing in our company, products and our communities. Following is a list of our achievements in 20071:

• Launched more than 150 low- and no-calorie drinks in 2007, increasing our portfolio of low- and no-calorie beverages to more than 700 beverage products.

• Spent $366 million with diverse suppliers (first- and second-tier minority- and women-owned businesses) in 2007, a 23-percent increase over 2006.

• Invested $40 million to build the world’s largest PET bottle-to-bottle recycling plant. Expected to be operational in 2009 in Spartanburg, South Carolina, the plant will produce approximately 100 million pounds of PET plastic for reuse each year (the equivalent of 2 billion 20-ounce PET bottles).

• Achieved a 2 percent improvement in water use efficiency. Coca-Cola plants used an average of 2.47 litres of water to make one litre of beverage. Since 2002, the Coca-Cola system has improved water use efficiency by more than 20-percent, saving more than 160 billion litres of water.

• Announced plans to purchase and put into service 100,000 coolers that use CO2 as a refrigerant gas by the end of 2010 – the largest deployment of this new technology by anyone in the industry to date.

• Created more than 7,500 jobs in East Africa through the Company’s Manual Distribution Centres program, which has helped start more than 1,800 small distribution businesses and generated more than $500 million in revenue.

• Made $99 million in charitable contributions from The Coca-Cola Company and The Coca-Cola Foundation, funding programs in the areas of community and economic development, education, health and wellness, environment, arts and culture, disaster relief, and HIV/AIDS.

• Ranked No. 2 on DiversityInc magazine's "Top 50 Companies for Diversity" in 2008, up from the Company's No. 4 ranking in 2007.

• Increased its supplier audits by 28-percent for a total of 1,313 audits in 2007, over its 1,029 facility audits in 2006.

For several years, we have steadily increased our production to better meet customer demand. Our goal is to keep our customers happy, which includes reducing delivery time. In the past, we have lost sales to competitors because we could not deliver products fast enough. Now we are in a better position to compete, and we expect even stronger sales over the next few years.

E. The first step is to examine the CICA’s accounting standards. Then the SEC’s accounting guidelines will be examined. There are two major pronouncements by the CICA with implications for revenue recognition in cases of channel stuffing. The first deals with Revenue recognition which can be found in the accounting standards

1The Coca-Cola Company, http://www.thecoca-colacompany.com/presscentre/nr_20081021_sustainability_review.html© 2012 John Wiley and Sons Canada, Ltd.

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handbook section 3400. The appropriate sections have been included here for discussion purposes:2

3400.07 In a transaction involving the sale of goods, performance should be regarded as having been achieved when the following conditions have been fulfilled:

(a) the seller of the goods has transferred to the buyer the significant risks and rewards of ownership, in that all significant acts have been completed and the seller retains no continuing managerial involvement in, or effective control of, the goods transferred to a degree usually associated with ownership; and

(b) reasonable assurance exists regarding the measurement of the consideration that will be derived from the sale of goods, and the extent to which goods may be returned. [OCT. 1986]

3400.10 Revenue from a transaction involving the sale of goods would be recognized when the seller has transferred to the buyer the significant risks and rewards of ownership of the goods sold. When the seller retains significant risks of ownership, it is normally inappropriate to recognize the transaction as a sale. Examples of a significant risk of ownership being retained by a seller are: when there is a liability for unsatisfactory performance not covered by normal warranty provisions; when the purchaser has the right to rescind the transaction; when the goods are shipped on consignment.

3400.18 Uncertainties relating to the measurement of revenue may result from one or both of the following issues:

(a) ConsiderationWhen consideration is not determinable within reasonable limits, for example, when payment relating to goods sold depends on the resale of the goods by the buyer, revenue would not be recognized.

(b) ReturnsRevenue would not be recognized when an enterprise is subject to significant and unpredictable amounts of goods being returned, for example, when the market for a returnable good is untested. If an enterprise is exposed to significant and predictable amounts of goods being returned, it may be sufficient to provide therefore.

This is relevant in the situation of McAfee because they were accepting returns from their distributors through Net Tools Inc., a company that was a wholly owned subsidiary of McAfee.These returns were not being declared in the books of McAfee and this was a true intentional misrepresentation of their revenue earned.

The second indication that revenue should not have been recognized is brought forth by the Emerging Issues Committee Abstract of Issues Discussed EIC-1413. Following are excerpts from the Abstract that are relevant to channel stuffing:

2CICA Accounting Standards Handbook, section 3400.© 2012 John Wiley and Sons Canada, Ltd.

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3. Fixed or determinable sales price

Paragraph 3400.07(b) requires that the reasonable assurance exists regarding the measurement of the consideration (price) for the sale of goods, and the extent to which goods may be returned. Paragraph 3400.18 then provides brief guidance on uncertainties relating to measurement of the revenue.

(b) Right of return arrangements In some sales transactions, a product may be returned, whether as a matter of contract

or as a matter of existing practice, either by the ultimate customer or by a party who resells the product to others. The product may be returned for a refund of the purchase price, for a credit applied to amounts owed or to be owed for other purchases, or in exchange for other products. The purchase price or credit may include amounts related to incidental services, such as installation. The existence of a right of return raises significant concerns as to whether the enterprise has reasonable assurance with respect to whether the consideration that will be derived from the sale of the goods is fixed or determinable.

Reasonable estimate of future returns (item 3(b)(vi))

The Committee noted that the ability to make a reasonable estimate of the amount of future returns, as required by item (vi), depends on many factors and circumstances that will vary from one case to the next. However, the following factors may impair the ability to make a reasonable estimate:

(i) the susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand;

The existence of one or more of the above factors, in light of the significance of other

factors, may not be sufficient to prevent making a reasonable estimate; likewise, other factors, such as the following, may preclude a reasonable estimate:

(i) significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as "channel stuffing");

(ii) lack of "visibility" into or the inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users;

(c) Price protections and/or inventory credit arrangements

Under some sales arrangements, when an enterprise reduces its published price list for products, it provides cash refunds ("price protection") or credit on future purchases ("inventory credit") to customers (resellers) for products held in their inventories. In many instances, price protection and inventory credit arrangements are offered in lieu of

3 CICA Accounting Standards Handbook, Emerging Issues Committee (EIC) Abstracts, EIC-141 Revenue Recognition© 2012 John Wiley and Sons Canada, Ltd.

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or in addition to a right of return (i.e., the seller reduces the price that the customer paid for the goods in inventory to the price on the revised price list, rather than have the customer return the goods and then re-order the same goods at the new price). The existence of price protection and inventory credit arrangements raise similar concerns to right of return provisions as to whether the enterprise has reasonable assurance with respect to whether the consideration that will be derived from the sale of the goods is fixed or determinable. The Committee reached a consensus that an enterprise should recognize revenue on sales for which it offers, or reasonably expects to offer, price protection or inventory credit arrangements, only if the amount of price protection or inventory credit adjustments can be reasonably estimated, taking into consideration the above discussion of the factors relating to the ability to reasonably estimate product returns.

This is relevant here because McAfee offered “distributors a number of incentives, including deep price discounts, cash payments, and rebates, to continue to hold excess inventory.”4 The discounts and rebates along with the returns made to Net Tools Inc., discussed above, indicate that the SEC could claim that McAfee had improperly recognized revenue and channel stuffing violates GAAP. Because channel stuffing involves selling customers more merchandise than they need, a risk exists that the customers might later return the excess merchandise.

In recent years, the SEC has investigated numerous instances of channel stuffing, and its staff has expanded its revenue recognition guidelines to address this problem. The SEC’s accounting standards for revenues refer to FASB Concepts Statement No. 5 and FAS 48.5 The standards also contain a series of questions and answers about whether revenue should be recognize in various situations. Two of these issues may apply to channel stuffing and are discussed below.

Question 9

Facts: Paragraph 8 of SFAS No. 48 lists a number of factors that may impair the ability to make a reasonable estimate of product returns in sales transactions when a right of return exists. The paragraph concludes by stating "other factors may preclude a reasonable estimate."

Question: What "other factors," in addition to those listed in paragraph 8 of SFAS No. 48, has the staff identified that may preclude a registrant from making a reasonable and reliable estimate of product returns?

Interpretive Response: The staff believes that the following additional factors, among others, may affect or preclude the ability to make reasonable and reliable estimates of product returns: (1) significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as "channel stuffing"), (2) lack of "visibility" into or the

4Cost Management textbook, Focus on Ethical Decision Making – Channel Stuffing at McAfee Inc, page 6185 SEC Staff Accounting Bulletin, Codification of Staff Accounting Bulletins, Staff Accounting Bulletin 101: Revenue Recognition in Financial Statements, Revised as of December 2003, available at http://www.sec.gov/interps/account/sab101.htm.© 2012 John Wiley and Sons Canada, Ltd.

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inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users, (3) expected introductions of new products that may result in the technological obsolescence of and larger than expected returns of current products, (4) the significance of a particular distributor to the registrant's (or a reporting segment's) business, sales and marketing, (5) the newness of a product, (6) the introduction of competitors' products with superior technology or greater expected market acceptance, and other factors that affect market demand and changing trends in that demand for the registrant's products. Registrants and their auditors should carefully analyze all factors, including trends in historical data, that may affect registrants' ability to make reasonable and reliable estimates of product returns.

Persuasive evidence that an arrangement exists. The SEC states that companies should not recognize revenue unless they have reached a clear understanding with their customer about the nature and terms of the transaction. When channel stuffing occurs, the seller often requires the buyer to sign a purchase agreement. On the surface revenue recognition appears to be appropriate; however, the substance of the transaction may be different than its legal form. If the seller did not voluntarily agree to the terms, then it could be argued that no agreement exists and that revenue should not be recognized.

Inability to reasonably estimate product returns. The SEC staff expanded the list of conditions for FAS 48 to include additional factors that might prevent a company from making a reasonable estimate of its product returns and, therefore, from recognizing revenue. These factors include:

• Significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as “channel stuffing”).

• The inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users.

The SEC guidelines provide a more stringent test for evaluating whether revenue can be recognized in cases where channel stuffing might have occurred. These guidelines require managers and auditors to evaluate the trends in inventory levels not only at the company but also in its distribution channels. If customer inventory levels have increased significantly, then the revenue probably cannot be recognized.

F. As stated in the problem, an error is defined as an unintentional mistake, while fraud is intentional. Thus, the auditor must evaluate whether McAfee’s misstatement was intentional or unintentional. This is a difficult question, because one cannot read the minds of the managers. Were they simply aggressive in meeting sales goals? Or did they intentionally force customers to take inventories that they knew might later be returned?

The auditing standards provide some guidance in this area. According to CICA General Assurance and Auditing section, the auditor should maintain an attitude of professional scepticism as shown below. Thus, an auditor is likely to conclude that the McAfee misstatement constituted fraud.

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5135.024 ¨The auditor should maintain an attitude of professional scepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding the auditor's past experience with the entity about the honesty and integrity of management and those charged with governance. [JAN. 2006]6

G. Managers have many incentives to continue reporting sales and earnings growth. These incentives include performance-based bonuses, the value of the manager’s stock or stock options, manager reputation, and job security.

H. Behaviour such as channel stuffing imposes both direct and indirect costs on the company. Direct costs include higher income taxes, foregone opportunities to reduce production costs, and possible increases in customer bad debts. Indirect costs include loss of reputation, which in turn increases the company’s cost of capital, weakens its relationships with customers, and encourages higher employee turnover. In addition to the company’s own effects, the stockholders often experience a large decline in the value of their investment. This type of fraud can also lead to greater financial trouble for the company, which often increases employee layoffs and can cause financial distress for the company’s suppliers and customers.

6CICA Assurance Handbook/Assurance Recommendations, General Assurance and Auditing Section 5135 – the auditor’s responsibility to consider fraud, paragraph .023© 2012 John Wiley and Sons Canada, Ltd.