9-16 (30 min.

) Variable and absorption costing, explaining operating

income differences.
1. Key inputs for income statement computations are:

April May
Beginning inventory 0 150
Production 500 400
Goods available for sale 500 550
Units sold 350 520
Ending inventory 150 30

The unit fixed and total manufacturing costs per unit under absorption costing are:

April May
(a) Fixed manufacturing costs $2,000,000 $2,000,000
(b) Units produced 500 400
(c)=(a)÷(b) Unit fixed manufacturing costs $4,000 $5,000
(d) Unit variable manufacturing costs $10,000 $10,000
(e)=(c)+(d) Unit total manufacturing costs $14,000 $15,000

9­1
9-16 (Cont'd.)

(a) Variable costing

April 19_7 May 19_7

Revenuesa $8,400,000 $12,480,000
Variable costs
Beginning inventory $ 0 $1,500,000
Variable cost of goods manufacturedb 5,000,000 4,000,000
Cost of goods available for sale 5,000,000 5,500,000
Ending inventoryc 1,500,000 300,000
Variable manufacturing cost of goods sold 3,500,000 5,200,000
Variable marketing costs 1,050,000 1,560,000
Total variable costs 4,550,000 6,760,000
Contribution margin 3,850,000 5,720,000
Fixed costs
Fixed manufacturing costs 2,000,000 2,000,000
Fixed marketing costs 600,000 600,000
Total fixed costs 2,600,000 2,600,000
Operating income $1,250,000 $3,120,000

a $24,000 × 350; 520

b $10,000 × 500; 400
c $10,000 × 150; 30

9­2
9-16 (Cont'd.)

(b) Absorption costing

April 19_7 May 19_7

Revenuesa $8,400,000 $12,480,000
Cost of goods sold
Beginning inventory 0 $2,100,000
Variable manufacturing costsb $5,000,000 4,000,000
Fixed manufacturing costsc 2,000,000 2,000,000
Cost of goods available for sale 7,000,000 8,100,000
Ending inventoryd 2,100,000 450,000
Cost of goods sold 4,900,000 7,650,000
Gross margin 3,500,000 4,830,000
Marketing costs
Variable marketing costse 1,050,000 1,560,000
Fixed marketing costs 600,000 600,000
Total marketing costs 1,650,000 2,160,000
Operating income $1,850,000 $ 2,670,000
a $24,000 × 350; 520
b $10,000 × 500; 400
c ($4,000 × 500); ($5,000 × 400)
d ($14,000 × 150; $15,000 × 30)
e ($3,000 × 350; $3,000 × 520)

9­3
9-16 (Cont’d.)
Fixed manufactur ing 
 
2. – = –  costs in 
 beginning inventory 
 

April:

$1,850,000 – $1,250,000 = ($4,000 × 150) – ($0)

$600,000 = $600,000

May:

$2,670,000 – $3,120,000 = ($5,000 × 30) – ($4,000 × 150)

– $450,000 = $150,000 – $600,000
– $450,000 = – $450,000

The difference between absorption and variable costing is due solely to moving fixed manufacturing
costs into inventories as inventories increase (as in April) and out of inventories as they decrease (as
in May).

9­4
9-17 (20 min.) Throughput costing (continuation of Exercise 9-16).

1. April 19_7 May 19_7

Revenuesa $8,400,000 $12,480,000
Variable direct materials costs
Beginning inventory $ 0 $1,005,000
Direct materials in goods manufacturedb 3,350,000 2,680,000
Cost of goods available for sale 3,350,000 3,685,000
Ending inventoryc 1,005,000 201,000
Total variable direct materials costs 2,345,000 3,484,000
Throughput contribution 6,055,000 8,996,000
Other costs
Manufacturing 3,650,000d 3,320,000e
Marketing 1,650,000f 2,160,000g
Total other costs 5,300,000 5,480,000
Operating income $ 755,000 $3,516,000

a $24,000 × 350; 520 e ($3,300 × 400) + $2,000,000 = $3,320,000

b $6,700 × 500, 400 f ($3,000 × 350) + $600,000
c $6,700 × 150, 30 g($3,000 × 520) + $600,000
d($3,300 × 500) + $2,000,000 = $3,650,000

9­5
9-17 (Cont'd.)

2. Operating income under:

April May
Absorption costing $1,850,000 $2,670,000
Variable costing 1,250,000 3,120,000
Throughput costing 755,000 3,516,000

Throughput costing puts greater emphasis on sales as the source of operating income than does
either absorption or variable costing.

3. Throughput costing puts a penalty on producing without a corresponding sale in the same
period. Costs other than direct materials that are variable with respect to production are expensed to
that period, whereas under variable costing they would be capitalized.

9-18 (40 min.) Variable and absorption costing, explaining operating

income differences.
1. Key inputs for income statement computations are:

January February March

Beginning inventory 0 300 300
Production 1,000 800 1,250
Goods available for sale 1,000 1,100 1,550
Units sold 700 800 1,500
Ending inventory 300 300 50

The unit fixed and total manufacturing costs per unit under absorption costing are:
January February March
(a) Fixed manufacturing costs $400,000 $400,000 $400,000
(b) Units produced 1,000 800 1,250
(c)=(a)÷(b) Unit fixed manufacturing costs $400 $500 $320
(d) Unit variable manufacturing costs $900 $900 $900
(e)=(c)+(d) Unit total manufacturing costs $1,300 $1,400 $1,220

9­6
9-18 (Cont'd.)

(a) Variable Costing

January 19_8 February 19_8 March 19_8
Revenuesa $1,750,000 $2,000,000 $3,750,000
Variable costs
Beginning inventoryb $ 0 $270,000 $ 270,000
Variable cost of goods manufacturedc 900,000 720,000 1,125,000
Cost of goods available for sale 900,000 990,000 1,395,000
Ending inventoryd 270,000 270,000 45,000
Variable manufacturing cost of goods sold 630,000 720,000 1,350,000
Variable marketing costse 420,000 480,000 900,000
Total variable costs 1,050,000 1,200,000 2,250,000
Contribution margin 700,000 800,000 1,500,000
Fixed costs
Fixed manufacturing costs 400,000 400,000 400,000
Fixed marketing costs 140,000 140,000 140,000
Total fixed costs 540,000 540,000 540,000
Operating income $ 160,000 $ 260,000 $ 960,000

a $2,500 × 700; 800; 1,500

b $? × 0; $900 × 300; $900 × 300
c $900 × 1,000; 800; 1,250
d $900 × 300; 300; 50
e $600 × 700; 800; 1,500

9­7
9-18 (Cont'd.)

(b) Absorption Costing

January 19_8 February 19_8 March 19_8
Revenuesa $1,750,000 $2,000,000 $3,750,000
Cost of goods sold
Beginning inventoryb $ 0 $ 390,000 $ 420,000
Variable manufacturing costsc: 900,000 720,000 1,125,000
Fixed manufacturing costsd: 400,000 400,000 400,000
Cost of goods available for sale 1,300,000 1,510,000 1,945,000
Ending inventorye 390,000 420,000 61,000
Cost of goods sold 910,000 1,090,000 1,884,000
Gross margin 840,000 910,000 1,866,000
Marketing costs
Variable marketing costsf 420,000 480,000 900,000
Fixed marketing costs 140,000 140,000 140,000
Total marketing costs 560,000 620,000 1,040,000
Operating income $ 280,000 $ 290,000 $ 826,000

a $2,500 × 700; 800; 1,500

b ($?× 0; $1,300 × 300; $1,400 × 300)
c $900 × 1,000, 800, 1,250
d ($400 × 1,000); ($500 × 800); ($320 × 1,250)
e ($1,300 × 300); ($1,400 × 300); ($1,220 × 50)
f $600 × 700; 800; 1,500

9­8
9-18 (Cont’d.)

2. –= –

January: $280,000 – $160,000 = $120,000 – $0

$120,000 = $120,000

February: $290,000 – $260,000 = $150,000 – $120,000

$30,000 = $30,000

March: $826,000 – $960,000 = $16,000 – $150,000

– $134,000 = – $134,000

The difference between absorption and variable costing is due solely to moving fixed
manufacturing costs into inventories as inventories increase (as in January) and out of inventories as
they decrease (as in March).

9­9
9-19 (20–30 min.) Throughput costing (continuation of Exercise 9-18).

1.
January February March
Revenuesa $1,750,000 $2,000,000 $3,750,000
Variable direct materials costs
Beginning inventoryb $ 0 $150,000 $ 150,000
Direct materials in goods manufacturedc 500,000 400,000 625,000
Cost of goods available for sale 500,000 550,000 775,000
Ending inventoryd 150,000 150,000 25,000
Total variable direct materials costs 350,000 400,000 750,000
Throughput contribution 1,400,000 1,600,000 3,000,000
Other costs
Manufacturinge 800,000 720,000 900,000
Marketingf 560,000 620,000 1,040,000
Total other costs 1,360,000 1,340,000 1,940,000
Operating income $ 40,000 $ 260,000 $1,060,000

a $2,500 × 700; 800; 1,500

b ($? × 0; $500 × 300; $500 × 300)
c $500 × 1,000; 800; 1,250
d $500 × 300; 300; 50
e ($400 × 1,000) + $400,000
($400 × 800) + $400,000
($400 × 1,250) + $400,000
f ($600 × 700) + $140,000
($600 × 800) + $140,000
($600 × 1,500) + $140,000

9­10
9-19 (Cont'd.)

2. Operating income under:

January February March
Absorption costing $280,000 $290,000 $826,000
Variable costing 160,000 260,000 960,000
Throughput costing 40,000 260,000 1,060,000

Throughput costing puts greater emphasis on sales as the source of operating income than
does absorption or variable costing.

3. Throughput costing puts a penalty on producing without a corresponding sale in

the same period. Costs other than direct materials that are variable with respect to
production are expensed to that period, whereas under variable costing they would be
capitalized as an inventoriable cost.

9­11
9-20 (40 min) Variable vs. absorption costing.

1.

Beginning inventory, January 1, 2001 85,000 units

Ending inventory, December 31, 2001 34,500 units
Sales 345,400 units
Selling price (to distributor) $22.00 per unit
Variable manufacturing cost per unit $5.10
Variable marketing cost per unit sold $1.10 per unit sold
Fixed manufacturing overhead $1,440,000
Denominator level machine hours 6,000 machine hours
Standard production rate 50 units per machine-hour
Fixed marketing and SG&A costs $1,080,000

Income Statement for the Zwatch Company, Variable Costing
for the year ended December, 31, 2001

Revenues: $22 × 345,400 $7,598,800

Variable costs
Beginning inventory: $5.10 × 85,000 $ 433,500
Variable manufacturing costs: $5.10 × 294,900     1,503,990 
Cost of good available for sale 1,937,490
Ending inventory: $5.10 × 34,500 175,950
Variable cost of goods sold 1,761,540
Variable marketing and SG&A costs: $1.10 × 345,400 379,940
Total variable costs (at standard costs) 2,141,480
Adjustment for variances 0
Total variable costs 2,141,480
Contribution Margin 5,457,320

Fixed Costs
Fixed manufacturing overhead costs 1,440,000
Fixed marketing and SG&A costs 1,080,000
Adjustment for variances 0
Total fixed costs 2,520,000
Operating income $2,937,320

9­12
9-20 (Cont’d.)

Absorption Costing Data

Fixed manufacturing overhead allocation rate =

Fixed manufacturing overhead/Denominator level machine hours =
$1,440,000/6,000 = $240 per machine hour

Fixed manufacturing overhead allocation rate per unit =

Fixed manufacturing overhead allocation rate/standard production rate =
$240/50 = $4.80 per unit

Income Statement for the Zwatch Company, Absorption Costing
For the year ended December 31, 2001
Revenues: $22 × 345,400 $7,598,800
Cost of goods sold
Beginning inventory ($5.10 + $4.80) × 85,000 $   841,500
Variable manuf. costs: $5.10 × 294,900 1,503,990
Fixed manuf. costs: $4.80 × 294,900 1,415,520
Cost of goods available for sale $3,761,010
Ending inventory: ($5.10 + $4.80) × 34,500 341,550
Adjust for manuf. variances ($4.80 × 5,100)a 24,480
Cost of goods sold 3,443,940
Gross margin 4,154,860
Operating costs
Variable marketing costs: $1.10 × 345,400 $ 379,940
Fixed marketing costs 1,080,000
Adjust for operating cost variances 0
Total operating costs 1,459,940
Operating income $2,694,920
a
Production volume variance
= [(6,000 hours × 50) – 294,900) × $4.80
= (300,000 – 294,900) × $4.80
= $24,480

2. Zwatch’s pre-tax profit margins –

Under variable costing:
Revenues $7,598,800
Operating income 2,937,320
Pre-tax profit margin 38.7%

Under absorption costing:

Revenues $7,598,800
Operating income 2,694,920
Pre-tax profit margin 35.5%

9­13
9­14
9-20 (Cont’d.)

3.   Operating income using variable costing is about nine percent higher than 
operating income calculated using absorption costing.

Variable costing operating income – Absorption costing operating income =

$2,937,320 – $2,694,920 = $242,400

Fixed manufacturing costs in beginning inventory under absorption costing –

Fi×ed manufacturing costs in ending inventory under absorption costing =
($4.80 × 85,000) – ($4.80 × 34,500) = $242,400

4. The factors the CFO should consider include:

(a) Effect on managerial behavior, and
(b) Effect on external users of financial statements.

Absorption costing has many critics. However, the dysfunctional aspects associated with
absorption costing can be reduced by:

• Careful budgeting and inventory planning,

• Adding a capital charge to reduce the incentives to build up inventory, and
• Monitoring nonfinancial performance measures.

9­15
9-21 (10 min.) Absorption and variable costing.

The answers are 1(a) and 2(c). Computations:

1. Absorption Costing:

Revenuesa $4,800,000
Cost of goods sold:
Variable manufacturing costsb $2,400,000
Fixed manufacturing costsc 360,000 2,760,000
Gross margin 2,040,000
Marketing and administrative costs:
Variable marketing and administratived 1,200,000
Fixed marketing and administrative 400,000 1,600,000
Operating income $ 440,000

a $40 × 120,000
b $20 × 120,000
c Fixed manufacturing rate = $600,000 ÷ 200,000
= $3 per output unit
Fixed manufacturing costs = $3 × 120,000
d $10 × 120,000

2. Variable Costing:

Revenuesa $4,800,000
Variable costs:
Variable manufacturing costs of goods soldb $2,400,000
Variable marketing and administrative costsc 1,200,000 3,600,000
Contribution margin 1,200,000
Fixed costs:
Fixed manufacturing costs 600,000
Fixed marketing and administrative costs 400,000 1,000,000
Operating income $ 200,000
a $40 × 120,000
b $20 × 120,000
c $10 × 120,000

9­16
9-22 (40 min) Absorption vs. variable costing.

1. The number of Mimic pills sold in 2001 is:

44,800 × 365 × 3 = 49,056,000 pills

Ending inventory on December 31, 2000 is 5,694,000 pills:

Unit data
Beginning inventory 0
Production 54,750,000
Sales 49,056,000
Ending inventory 5,694,000

Variable cost data
Manufacturing costs per pill produced
Direct materials $0.05
Direct manufacturing labor 0.04
Manufacturing overhead 0.11
Total variable manufacturing costs $0.20

Fixed cost data
Manufacturing costs $ 7,358,400
R&D 4,905,600
SG&A 19,622,400

Wholesale selling price per pill $1.20

Fixed manufacturing costs allocation rate per pill $0.15

2.  Variable costing:

Revenues: $1.20 × 49,056,000 $58,867,200

Variable costs
Beginning inventory $ 0
Variable manuf. cost: $0.20 × 54,750,000 10,950,000
Cost of goods available for sale 10,950,000
Ending inventory: $0.20 × 5,694,000 1,138,800
Variable cost of goods sold 9,811,200
Variable marketing costs: $0.07 × 49,056,000 3,433,920
Adjust for variable-cost variance 0
Total variable cost 13,245,120
Contribution margin 45,622,080
Fixed costs
Fixed manufacturing costs 7,358,400
Fixed R&D 4,905,600
Fixed marketing 19,622,400
Total fixed costs 31,886,400

9­17
Operating income $13,735,680
Absorption costing:
9−22 (Cont’d.)

Absorption costing:

Revenues: $1.20 × 49,056,000  $58,867,200 

Costs of goods sold
Beginning inventory $ 0
Variable manuf. cost: $0.20 × 54,750,000  10,950,000
Fixed manuf. costs: $0.15 × 54,750,000 8,212,500
Cost of goods available for sale 19,162,500
Ending inventory: $0.35 × 5,694,000 1,992,900
Adjust for manuf. variances 854,100
Cost of goods sold 16,315,500
Gross margin 42,551,700
Operating costs
Variable marketing costs: $0.07 × 49,056,000 3,433,920
Fixed R&D 4,905,600
Fixed marketing 19,622,400
Adjustment for operating cost variances 0
Total operating costs 27,961,920
Operating income $14,589,780

3. The difference of $854,100 is due to:

 Fixed manufactur ing   Fixed manufactur ing 

   
= costs in ending inventory   −  costs in beginning inventory 
   
 under absorption costing   under absorption costing 

= ($0.15 × 5,694,000) − $0
= $854,100

9­18
9-23 (20 min.) Throughput costing (continuation of E×ercise 9-22).

1.

Revenues: $1.20 × 49,056,000 $58,867,200

Variable direct materials cost of goods sold
Beginning inventory $                0
Direct materials: $0.05 × 54,750,000 2,737,500
Cost of goods available for sale 2,737,500
Ending inventory: $0.05 × 5,694,000 284,700
Total variable direct materials COGS 2,452,800
Adjustment for variances 0
Total variable direct materials costs 2,452,800
Throughput contribution 56,414,400
Other costs
Variable manuf.: $0.15 × 54,750,000 8,212,500
Variable marketing: $0.07 × 49,056,000 3,433,920
Fixed manufacturing 7,358,400
Fixed R&D 4,905,600
Fixed marketing 19,622,400
Total other costs 43,532,820
Operating income $12,881,580

2. Use of throughput costing reduces incentives to transfer costs from period to period by
producing for inventory. A manager under throughput costing cannot increase operating
income by building for inventory as is possible with absorption costing.

9­19
9-24 (20-30 min.) Comparison of actual-costing methods.

The numbers are simplified to ease computations. This problem avoids standard costing
and its complications.

1. Variable-costing income statements:

2000 2001
Sales 1,000 units Sales 1,200 units
Production 1,400 units Production 1,000 units

Revenues ($3 per unit) $3,000 $3,600

Variable costs:
Beginning inventory $ 0 $ 200
Variable cost of goods manufactured 700 500
Cost of goods available for sale 700 700
Ending inventorya 200 100
Variable manuf. cost of goods sold 500 600
Variable marketing and admin. costs 1,000 1,200
Variable costs: 1,500 1,800
Contribution margin 1,500 1,800
Fixed costs
Fixed manufacturing costs 700 700
Fixed marketing and admin. costs 400 400
Fixed costs 1,100 1,100
Operating income $ 400 $ 700
a Unit inventoriable costs:
Year 1: $700 ÷ 1,400 = $0.50 per unit
Year 2: $500 ÷ 1,000 = $0.50 per unit

9­20
9-24 (Cont'd.)

2. Absorption-costing income statements:

2000 2001
Sales 1,000 units Sales 1,200 units
Production 1,400 units Production 1,000 units

Revenues ($3 per unit) $3,000 $3,600

Cost of goods sold:
Beginning inventory $ 0 $ 400
Variable manufacturing costs 700 500
Fixed manufacturing costsa 700 700
Cost of goods available for sale 1,400 1,600
Ending inventoryb 400 240
Cost of goods sold 1,000 1,360
Gross margin 2,000 2,240
Marketing and administrative costs:
Variable marketing and admin. costs 1,000 1,200
Fixed marketing and admin. costs 400 400
Marketing and admin. costs 1,400 1,600
Operating income $ 600 $ 640

a Fixed manufacturing costs:

Year 1: $700 ÷ 1,400 = $0.50 per unit
Year 2: $700 ÷ 1,000 = $0.70 per unit
b Unit inventoriable costs:
Year 1: $1,400 ÷ 1,400 = $1.00 per unit
Year 2: $1,200 ÷ 1,000 = $1.20 per unit

9­21
9-24 (Cont'd.)

3. 2000 2001
Variable Costing:
Operating income $400 $700
Ending inventory 200 100
Absorption Costing:
Operating income $600 $640
Ending inventory 400 240
Fixed manuf. overhead
• in beginning inventory 0 200
• in ending inventory 200 140

Year 1: $600 – $400 = $200 – $0

= $200
Year 2: $640 – $700 = $140 – $200
= –$60

The difference in reported operating income is due the amount of fixed

manufacturing overhead in the beginning and ending inventories. In Year I, absorption
costing has a higher operating income of $200 due to ending inventory having $200 more
in fixed manufacturing overhead than does beginning inventory. In Year 2, variable
costing has a higher operating income of $60 due to ending inventory having $60 less in
fixed manufacturing overhead than does ending inventory.

4. a.Absorption costing is more likely to lead to inventory build-ups than variable

costing. Under absorption costing, operating income in a given accounting
period is increased, because some fixed manufacturing costs are accounted for
as an asset (inventory) instead of a cost of the current period.
b. Although variable costing will counteract undesirable inventory build-ups,
other measures can be used without abandoning absorption costing. Examples
include budget targets and nonfinancial measures of performance such as
maintaining specific inventory levels, inventory turnovers, delivery schedules,
and equipment maintenance schedules.

9­22
9-25 (25 min.) Denominator-level problem

1. Budgeted fixed manufacturing overhead costs rates:

Budgeted Fixed Budgeted Fixed
Manufacturing Budgeted Manufacturing
Denominator Overhead per Denominator Overhead Cost
Level Concept Period Level Rate
Theoretical $ 3,800,000 2,880 $ 1,319.44
Practical 3,800,000 1,800 2,111.11
Normal 3,800,000 1,000 3,800.00
Master-budget 3,800,000 1,200 3,166.67

The rates are different because of varying denominator-level concepts. Theoretical and
practical capacity levels are driven by supply-side concepts, i.e. “how much can I
produce?” Normal and Master-budget capacity levels are driven by demand-side
concepts, i.e. “how much can I sell?” (or “how much should I produce?”)

2. In order to incorporate fixed manufacturing costs into unit product costs, fixed
manufacturing costs have to be unitized for inventory costing. Absorption costing is the
method used for tax reporting to the IRS and for financial reporting using generally
accepted accounting principles.

The choice of a denominator level becomes relevant under absorption costing because
fixed costs are accounted for along with variable costs at the individual product level.
Variable and throughput costing account for fixed costs as a lump sum, expensed in the
period incurred.

3. The variances that arise from use of the theoretical or practical level concepts will
signal that there is a divergence between the supply of capacity and the demand for
capacity. This is useful input to managers. As a general rule, however, it is important
not to place undue reliance on the production volume variance as a measure of the
economic costs of unused capacity.

4. Under a cost-based pricing system, the choice of a master-budget level denominator

will lead to high prices when demand is low (more fixed costs allocated to the individual
product level), further eroding demand; conversely it will lead to low prices when
demand is high, forgoing profits. This has been referred to as the downward demand
spiral—the continuing reduction in demand that occurs when the prices of competitors
are not met and demand drops, resulting in even higher unit costs and even more
reluctance to meet the prices of competitors.

9­23
9-26 (30 min.) Variable and absorption costing and breakeven
points.

1. Production = Sales + Ending Inventory - Beginning Inventory

= 242,400 + 24,800 − 32,600
= 234,600

2. Breakeven point in cases:

a. Variable Costing:

Total Fixed Costs + Target Operating Income

QT = Contributi on Margin Per Unit

($ 3,753 ,600 + $6,568 ,800 ) + $0

QT = $94 − ($ 16 + $10 + $6 + $14 + $2)

$10 ,322 ,400

QT =
$46

QT = 224,400 cases

b.  Absorption costing:

QT =
Total Fixed Target  Fixed Manuf.  Breakeven Units  
+ + ×  −  
Cost IO  Cost Rate  Sales in Units Produced 
Contribution Margin Per Unit

$10 ,322 ,400 + [$16 (QT − 234 ,600 )]

QT =
$46

$10 ,322 ,400 +16 QT − 3,753 ,600

QT =
$46

$6,568 ,800 +16 QT

QT =
$46

46 QT − 16 QT = $6,568,800

30 QT = $6,568,800

QT = 218,960 cases.

9­24
9−26 (Cont’d.)

3. If grape prices increase by 25%, the cost of grapes per case will increase from $16 in
2001 to $20 in 2002. This will decrease the unit contribution margin from $46 in 2001 to
$42 in 2002.

a.  Variable Costing:

$10 ,322 ,400

QT =
$42

= 245,772 cases

b.  Absorption Costing:

$6,568 ,800 + $16 QT

QT =
$42

$42 QT = $6,568,800 + $16 QT

$26 QT = $6,568,800

QT = 252,647 cases

9­25
9-27 (40 min.) Variable costing versus absorption costing.

1. Absorption Costing:
Mavis Company Income Statements For the Year 2001

Revenues (540,000 × $5.00)

$2,700,000
Cost of goods sold:
Beginning inventory (30,000 × $3.70a) $ 111,000
Variable manufacturing costs (550,000 × $3.00) 1,650,000
Fixed manuf. overhead costs (550,000 × $0.70) 385,000
Cost of goods available for sale 2,146,000
Ending inventory (40,000 × $3.70) 148,000
Cost of goods sold (at std. costs) 1,998,000
Gross margin (at standard costs) 702,000
Adjustment for variances (50,000b × $0.70) 35,000
Gross margin 667,000
Marketing and administrative costs:
Variable marketing and admin. costs (540,000 × $1) 540,000
Fixed marketing and admin. costs 120,000
Adjustment for variances 0
Marketing and administrative costs 660,000
Operating income $ 7,000

a $3.00 + ($7.00 ÷ 10) = $3.00 + $0.70 = $3.70

b [(10 × 60,000) – 550,000)] = 50,000 units

9­26
9-27 (Cont'd.)

2. Variable Costing:
Mavis Company Income Statement For the Year 2001

Revenues $2,700,000
Variable costs:
Beginning inventory (30,000 × $3.00) $ 90,000
Variable cost of goods manufactured
(550,000 × $3.00) 1,650,000
Cost of goods available for sale 1,740,000
Ending inventory (40,000 × $3.00) 120,000
Variable manufacturing cost of goods sold 1,620,000
Variable marketing and administrative costs 540,000
Total variable costs (at std. cost) 2,160,000
Adjustment for variances 0
Total variable costs 2,160,000
Contribution margin 540,000
Fixed costs:
Fixed manufacturing overhead costs 420,000
Fixed marketing and administrative costs 120,000
Adjustment for variances 0
Total fixed costs 540,000
Operating income $ 0

3. The difference in operating income between the two costing methods is:

$7,000 – $0 = [(40,000 × $0.70) – (30,000 × $0.70)]

$7,000 = $28,000 – $21,000
$7,000 = $7,000

The absorption-costing operating income exceeds the variable costing figure by $7,000
because of the increase of $7,000 during 2001 of the amount of fixed manufacturing costs
in ending inventory vis-a-vis beginning inventory.

9­27
9-27 (Cont'd.)

4.
Total fixed
manufacturing
costs

Actual & budget line

$420,000
$385,000
Underallocated
{ Allocated line
@ $7.00

55,000 60,000
Machine­hours

5. Absorption costing is more likely to lead to buildups of inventory than does variable
costing. Absorption costing enables managers to increase reported operating income
by building up inventory which reduces the amount of fixed manufacturing overhead
included in the current period's cost of goods sold.

Ways to reduce this incentive include:

(a) Careful budgeting and inventory planning,
(b) Change the accounting system to variable costing or throughput costing,
(c) Incorporate a carrying charge for carrying inventory,
(d) Use a longer time period to evaluate performance than a quarter or a year, and
(e) Include nonfinancial as well as financial measures when evaluating management
performance.

9­28
9-28 (10-20 min.) Breakeven under absorption costing (continuation of
Problem 9-27).

1. The unit contribution margin is $5 – $3 – $1 = $1. Total fixed costs ($540,000)

divided by the unit contribution margin ($1.00) equals 540,000 units. Therefore, under
variable costing 540,000 units must be sold to break even.

2. If there are no changes in inventory levels, the breakeven point can be the same,
540,000 units, under both variable costing and absorption costing. However, as the
preceding problem demonstrates, under absorption costing, the breakeven point is not
unique; operating income is a function of both sales and production. Some fixed
overhead is "held back" when inventories rise (10,000 units × $0.70 = $7,000), so
operating income is positive even though sales are at the breakeven level as commonly
conceived.

 F m   Bi x a re n e d u a f k . e v e n
 T f   iT o x  ta e a  r d l g U  e n t i t s
  + o +  po  xevs i − rane a l r et h i s ne ag d
=
c   io n  s c  t  os p m r o e d u c e d
   r  a u t ne i t s
 
U c o mo n n n i a t t r g i b i n u t i
Let N = Breakeven sales in units

$540 ‚000 + $0 + $0.70 ( N − 550 ‚000 )

N =
$1.00

N =

$0.30N = $155,000

N = 516,667 units (rounded)

Therefore, under absorption costing, when 550,000 units are produced, 516,667
units must be sold for the income statement to report zero operating income.

9­29
Proof of 2001 breakeven point:

Gross margin, 516,667 units × ($5.00 – $3.70) $671,667

Output level MOH variance, as before $ 35,000
Marketing and administrative costs:
Variable, 516,667 units × $1.00 516,667
Fixed 120,000 671,667
Operating income $ 0

9­30
9-28 (Cont'd.)

3. If no units are sold, variable costing will show an operating loss equal to the fixed
manufacturing costs, $420,000 in this instance. In contrast, the company would break
even under absorption costing, although nothing was sold to customers. This is an
extreme example of what has been called "selling fixed manufacturing overhead to
inventory."

A final note: We find it helpful to place the following comparisons on the board, keyed
to the three parts of this problem:

1. Breakeven = f (sales)
2. Breakeven = f (sales and production)
3. Breakeven = f (0 units sold and 540,000 units produced), an extreme case

9­31
9-29 (40 min.) The All-Fixed Company in 2001.

This problem always generates active classroom discussion.

1. The treatment of fi×ed manufacturing overhead in absorption costing is affected

primarily by what denominator level is selected as a base for allocating fixed
manufacturing costs to units produced. In this case, is 10,000 tons per year, 20,000 tons,
or some other denominator level the most appropriate base?

We usually place the following possibilities on the board or overhead projector and
then ask the students to indicate by vote how many used one denominator level versus
another. Incidentally, discussion tends to move more clearly if variable-costing income
statements are discussed first, because there is little disagreement as to computations
under variable costing.

a.Variable-Costing Income Statement:

2000 2001 Together

Revenues (and contribution margin) $300,000 $300,000 $600,000
Fixed costs:
Manufacturing costs $280,000
Marketing and administrative cost 40,000 320,000 320,000 640,000
Operating income $(20,000) $(20,000) $(40,000)

b. Absorption-Costing Income Statement:

The ambiguity about the 10,000- or 20,000-unit denominator level is intentional. IF

YOU WISH, THE AMBIGUITY MAY BE AVOIDED BY GIVING THE STUDENTS
A SPECIFIC DENOMINATOR LEVEL IN ADVANCE.

Alternative 1. Use 20,000 units as a denominator; fi×ed manufacturing overhead per unit
is $280,000 ÷ 20,000 = $14.

2000 2001 Together

Revenues $300,000 $ 300,000 $600,000
Manufacturing costs @ $14 280,000 -- 280,000
Deduct ending inventory 140,000 -- --
Cost of goods sold 140,000 140,000* 280,000
Underallocated manuf. overhead--
output level variance -- 280,000 280,000
Marketing and administrative costs 40,000 40,000 80,000
Total costs 180,000 460,000 640,000
Operating income $120,000 $(160,000) $( 40,000)

* Inventory carried forward from 2000 and sold in 2001.

9­32
9-29 (Cont'd.)

Alternative 2. Use 10,000 units as a denominator; fi×ed manufacturing overhead per

unit is $280,000 ÷ 10,000 = $28.

2000 2001 Together

Revenues $300,000 $300,000 $600,000
Manufacturing costs @ $28 560,000 -- 560,000
Deduct ending inventory 280,000 -- --
Cost of goods sold 280,000 280,000* 560,000
Underallocated manuf. overhead--
output level variance -- 280,000 --
Overallocated manuf. overhead --
output level variance (280,000) -- --
Marketing and administrative costs 40,000 40,000 80,000
Total costs 40,000 600,000 640,000
Operating income $260,000 $(300,000) $ (40,000)
*Inventory carried forward from 2000 and sold in 2001.

Note that operating income under variable costing follows sales and is not affected
by inventory changes.

Note also that students will understand the variable-costing presentation much more
easily than the alternatives presented under absorption costing.

Breakeven point
2. under vari able = =
costing

= 10,667 tons per year or 21,333 for two years.

If the company could sell 667 more tons per year at $30 each, it could get the
extra $20,000 contribution margin needed to break even.

Most students will say that the breakeven point is 10,667 tons per year under both
absorption costing and variable costing. The logical question to ask a student who
answers 10,667 tons for variable costing is: "What operating income do you show for
2000 under absorption costing?" If a student answers $120,000 (alternative 1 above), or
$260,000 (alternative 2 above), ask: "But you say your breakeven point is 10,667 tons.
How can you show an operating income on only 10,000 tons sold during 2000?"

The answer to the above dilemma lies in the fact that operating income is affected
by both sales and production under absorption costing.

9­33
9-29 (Cont'd.)

Optional: Given that sales would be 10,000 tons in 2000, solve for the production
level that will provide a breakeven level of zero operating income. Using the formula in
the chapter, sales of 10,000 units, and a fixed manufacturing overhead rate of $14 (based
on $280,000 ÷ 20,000 units denominator level = $14):

Let P = Production level

 F m   Bi x a re n e d u a f k . e v e n
 T f   iT o x  ta e a  r d lg U  e n t i t s
  + o +  po  xevs i − rane a l r et h i s ne ag d
=
c   io n  s c  t  so p m r o e d u c e d
   r  a u t ne i t s
 
U c o mo n n n i a t t r g i b i n u t i
$320 ‚000 + $0 + $14 (10 ‚000 − P )
10,000 tons =
$30

$300,000 = $320,000 + $140,000 – $14P

$14P = $160,000
P = 11,429 units (rounded)

Proof:
Gross margin, 10,000 × ($30 – $14) $160,000
Output level variance,
(20,000 – 11,429) × $14 $120,000
Marketing and administrative costs 40,000 160,000
Operating income $ 0

Given that production would be 20,000 tons in 2000, solve for the breakeven unit
sales level. Using the formula in the chapter and a fi×ed manufacturing overhead rate of
$14 (based on a denominator level of 20,000 units):

Let N = Breakeven sales in units

9­34
  F m  i x a  e n d u f .
 T f  i To x  t a e a  r d lUg   e n t i t s
  + o + p o  e vNx − r e  a r t h i n e ga d
N =
 c   io n s r c t  a  s op t   emr o e d u c e d
  
U c o mo n n n i a t t r gi b i nu t i
$320 ‚000 + $0 + $14 ( N - 20 ‚000 )
N =
$30
$30N = $320,000 + $14N – $280,000
$16N = $40,000
N = 2,500 units

9­35
9-29 (Cont'd.)

Proof:
Gross margin, 2,500 × ($30 – $14) $40,000
Output level MOH variance $ 0
Marketing and administrative costs 40,000 40,000
Operating income $ 0

We find it helpful to put the following comparisons on the board:

Variable costing breakeven = f(sales)

= 10,667 tons

Absorption-costing breakeven = f(sales and production)

= f(10,000 and 11,429)
= f(2,500 and 20,000)

3. Absorption costing inventory cost: Either $140,000 or $280,000 at the end of 2000
and zero at the end of 2001.

Variable costing: Zero at all times. This is a major criticism of variable costing and
focuses on the issue of the definition of an asset.

4. Operating income is affected by both production and sales under absorption costing.
Hence, most managers would prefer absorption costing because their performance in any
given reporting period, at least in the short run, is influenced by how much production is
scheduled near the end of a period.

9­36
9­37