Solution to Problem 9.

33

a) The following table provides the required income statements.

Contribution Margin Statement

Item Amount (current year) Amount (next year)
Revenue $ 1,500,000 $ 1,700,000
Cost of Goods sold (25% of sales) $ 375000 $ 425000
Contribution $ 1,125,000 $ 1,1275,000
Fixed costs $ 900000 $ 900000
Profit before taxes $ 225000 $ 375000

Notice that fixed costs remain at $900,000 even though the volume of operations has increased. This is a reasonable
assumption while fixed costs might increase some, they are not likely to increase dramatically because of a modest
increase in sales.

b) The following table provides the required statement.

Contribution Margin Statement

Item Amount (current year) Amount (next year)
Revenue $ 1,500,000 $ 2,800,000
Cost of Goods sold (25% of sales) $ 375000 $ 700,000
Contribution $ 1,125,000 $ 2,100,000
Fixed costs $ 900000 $ 1,600,000
Profit before taxes $ 225000 $ 500,000

operations of about $1.5 million. His fixed costs of $900,000 support operations at this level. However, the capacity
provided by this expenditure is unlikely to support a much higher volume of sales. For instance, David might need
to make more trips, spend more on stocking and tracking inventory, hire additional sales persons, open a branch
outlet, and so on. All of these actions contribute to higher fixed costs.

frame. These costs do become controllable if we significantly change the volume of operations or consider a long
time frame. In Da
fixed costs are 60% of sales revenue ($900,000/$1,500,000). Then, at a volume of $2.8 million in sales, David would
estimate fixed costs at $1,680,000.

Note: Part (b) provides an estimate of $1.6 million toward fixed costs. The difference underscores that using an

likely that, because of scale economies, fixed costs do not increase proportionately with sales volume. Methods
such as direct estimation are better equipped to deal with such effects, but require more effort and expertise.

Solution to Problem 9.35

 a) Let us begin by constructing the income statement. The allocation rate is $1,400,000/300,000 units = $4.67 per
unit. We have (rounding numbers to the nearest $):

Standard Deluxe Total

Number of Units 2,50,000 50,000 3,00,000
Revenue ($14*250,000 ; $18*50,000) $3,500,000 $900,000 $4,400,000
Variable costs ($8*250,000 ;
$9*50,000) $2,000,000 $450,000 $2,450,000
Contribution margin $1,500,000 $450,000 $1,950,000
Common fixed costs ($4.67 per unit) $1,167,500 $233,500 $1,401,000
Profit before taxes $332,500 $216,500 $549,000

Let us repeat the exercise with the new product mix. Notice that the common cost for each segment now is the new
product volume × the allocation rate of $4.67 per unit. We have:

Standard Deluxe Total

Number of Units 1,50,000 1,50,000 3,00,000
Revenue $2,100,000 $2,700,000 $4,800,000
Variable costs $1,200,000 $1,350,000 $2,550,000
Contribution margin $900,000 $1,350,000 $2,550,000
Common fixed costs $700,000 $700,000 $1,400,000
Profit before taxes $200,000 $650,000 $850,000

The new product mix consists of 50% Standard and 50% Deluxe. To avoid rounding errors, we can simply allocate 50% of
the common fixed costs to each product (50% × $1,400,000 = $700,000)

b) Let us repeat the exercise with the new product mix. We have to compute the allocation rate for labor hours
though. Using the data for the current year, we have total cost = $1,400,000 and total labor hours = (2 hrs ×
250,000 units) + (50,000 units × 4 hours per unit) = 700,000. Thus, the rate is $2 per labor hour
($1,400,000/700,000). With this rate, the following table provides the projected income statement. Notice that the
common cost for each segment now is the new product volume × number of labor hours per product × the
allocation rate of $2 per labor hour.

Standard Deluxe Total

Number of Units 1,50,000 1,50,000 3,00,000
Revenue $2,100,000 $2,700,000 $4,800,000
Variable costs $1,200,000 $1,350,000 $2,550,000
Contribution margin $900,000 $1,350,000 $2,550,000
Common fixed costs ($2*2*1,50,000 ;
$2*4*1,50,000) $600,000 $1,200,000 $1,800,000
Profit before taxes $300,000 $150,000 $450,000

c) We believe that the pessimistic estimate in part (b) is likely more accurate than the optimistic estimate in part (a).
This is because the allocation in part (a) assumes that each product, whether it is standard or deluxe, consumes the
same amount of capacity resource. This is not likely a good assumption because the deluxe product takes twice the
 amount of labor taken to make a standard product. While some costs surely vary by units, other costs (perhaps the
majority of costs) bear a closer relation to labor hours. Thus, neither the estimate in part (a) nor the estimate in
part (b) is likely to be accurate. However, the estimate in part b (using labor hours as the basis) is likely more
accurate. Based on this analysis, Bradshaw might rethink its decision to alter its product mix.

Solution to Problem 9.37

a) Under variable costing, inventoriable costs only include variable manufacturing costs. In particular, the value does
not contain any allocation for fixed manufacturing overhead. Thus, the inventoriable cost is $200 + $350 = $550 per
unit. Notice that selling expenses are not included because they only pertain to units sold.

b) Under absorption costing, inventoriable costs includes variable manufacturing costs PLUS any allocation for fixed
manufacturing overhead. Thus, the inventoriable cost is $200 + $350 + $500 = $1,050 per unit.

c) The ending inventory of 50 units contains $25,000 = 50 units * $500 per unit in fixed manufacturing cost. Because
Tip-top began with zero inventories, this amount is also the change in the fixed overhead contained in the
inventory. Thus, absorption costing income will be higher by $25,000 relative to variable costing income.

Solution to Problem 9.41

a) tement and ending inventory value under

variable costing:

Creative Tiles
Contribution Margin Statement & Ending Inventory Value
Revenue/Cost per unit
Sales volume (in units) 13,500
Production volume (in units) 15,000
Revenue $450 $6,075,000
Variable costs
Direct materials $70 $945,000
Direct labor $140 $1,890,000
Marketing & sales $50 $675,000
Contribution Margin $190 $2,565,000
Fixed costs
Manufacturing $1,500,000
Marketing & sales $625000
Profit before taxes $440,000
Inventory
Units in ending inventory 1,500
Value per unit $70 + $140 $210
Value of ending inventory $315,000
b) Under absorption costing, we must allocate fixed manufacturing costs. Creative uses batches as the allocation basis
to perform this allocation. Given total fixed manufacturing costs of $1,500,000 and 15,000 batches produced, we
have the overhead rate as:
$1,500,000/15,000 batches = $100 per batch.

Creative Tiles
Gross Margin Statement & Ending Inventory Value
Revenue/Cost per unit
Sales volume (in units) 13,500
Production volume (in units) 15,000
Revenue $450 $6,075,000
Cost of Goods sold
Direct materials $70 $945,000
Direct labor $140 $1,890,000
Allocated fixed manufacturing costs $100 $1,350,000
Total Cost of Goods Sold $310 $4,185,000
Gross Margin $140 $1,890,000
Period costs
Variable Marketing & sales $50 $675,000
Fixed Marketing & sales $625000
Profit before taxes $590,000
Inventory
Units in ending inventory 1,500
Inventoriable cost per unit $70 + $140+$100 $310
Value of ending inventory $465,000

c) The income reported under the two formats differs because of their differing treatment of fixed manufacturing
costs. We expense these costs under variable costing, whereas we allocate them under absorption costing.
Moreover, under absorption costing, fixed overhead travels with the units produced, first passing through
inventory and then to cost of goods sold. If any units stay in inventory, the associated overhead cost also stays in
inventory, temporarily boosting reported income.
We can reconcile the income reported under the two formats as follows:

Item Calculation Amount

Income reported under variable costing $440,000
1,500 units × $100 per
+ fixed overhead in ending inventory unit $150,000
- fixed overhead in opening inventory 0 units × $100 per unit 0
= Income reported under absorption
costing $590,000

Solution to Problem 9.44

a) Contribution margin is price less all variable costs.

For Xenon, variable costs include materials, labor, and variable overhead. We know the cost of materials and labor
but need allocations to determine the cost of variable overhead.
Total variable overhead costs = 1/3 of total overhead
= 1/3 × $1,500,000 = $500,000.
 Dividing through by the total labor cost,
we have:
Variable overhead per labor $ = $500,000/$1,000,000
=$0.50/labor $
Because the pump has $30 of labor cost, Xenon will allocate $30 × $0.50 = $15 toward variable overhead.
Collecting this information, we have:

Sales Price $90.00 per unit

Less: Materials 12 Given
Labor 30 Given
Variable overhead 15 $30.00 × $0.50 / labor $
Equals Contribution margin 33.0 per unit

b) Gross Margin is price less all manufacturing related costs, including variable and fixed overhead. We know the cost
of materials and labor but need allocations to determine the cost of variable and fixed overhead.

From part [a], we know that variable overhead rate is $0.50 per labor $.

Additionally, total fixed overhead costs = 2/3 of total overhead

= 2/3 × $1,500,000

= $1,000,000.

Dividing through by the total labor cost, we have:

Fixed overhead per labor $ = $1,000,000/$1,000,000

= $1.00/labor $.

Because the pump has $30 of labor cost, Xenon will allocate $30 × $1.00 = $30 per pump toward fixed overhead.

Collecting this information, we have:

Sales Price $90.00 per unit

Less: Materials 12 Given
Labor 30 Given
Variable overhead 15 $30.00 × $0.50 / labor
Fixed overhead 30 $30.00 × $1.00 / labor
Inventories Cost $ 87.00 per unit
Equals Gross margin $3.00 per unit

always the case. For

example, the gross margin could exceed the contribution margin if allocated fixed manufacturing costs are less than
variable selling costs.
 c) Now, Xenon has to compute two separate fixed overhead rates, corresponding to the two cost pools.

We have:

Cost Volume as Denominator Rate

Materials related pool $240,000 $600,000 $0.40 / materials
Labor related pool $760,000 $1,000,000 $0.76 / labor

Using these rates, we compute:

$90.00 per
Sales Price unit
Less: Materials & Components 12 Given
Labor 30 Given
Variable overhead 15 $30.00 × $0.50 / labor
Fixed overhead $12.00 × $0.40
(materials) 4.8 /material
Fixed overhead (labor) 22.8 $30.00 × $0.76 /labor
Inventories Cost 84.6
Equals Gross margin $5.40

We can understand the difference in gross margins (inventoriable costs) by appealing to the property that the
allocated cost is proportional to the driver volume in a cost object. When Xenon allocates cost using labor $, the
overhead allocated to the pump is a multiple of the labor $ in the pump. The percent of overhead allocated to the
pump equals the percent labor contained in the pump.
Globally, materials cost is 60% of labor cost (60% = $600,000/$1,000,000), meaning that an average product has
$0.60 of materials cost for each $1 of labor cost. However, the pumps only have $12 of materials for $30 of labor,
meaning that pumps use proportionately less materials than the average product ($12/$30 = 40%).

cost to total labor cost. Thus, when Xenon breaks out some overhead (in this case $240,000) and allocates this
amount using materials $, the amount allocated to the pumps will decrease. Naturally, inventoriable cost also
decreases, thereby increasing gross margin.

9.53

a.
Let us begin by calculating unit contribution and profit margins.

Item Standard Custom

Price $130 $175
Unit Contribution margin $65 $105
Unit profit margin $25 $65
Variable cost = (1- CMR) * price $65 $70
Allocated fixed cost = Contribution $40 $40
margin profit margin

Comparing the allocated fixed cost for the Standard and the Custom products, it seems
that Sunder employs the number of units as the allocation basis. This is the mechanism
that would lead to an identical allocated amount for each product. (If Sunder used
machine hours instead, the custom product should receive twice the allocation received
by the standard product.)

b.
We now need to calculate the rate per machine hour. For this calculation, we need the
total overhead cost and the total number of machine hours.

We can use the allocated rate per unit (in part a) to back out total overhead. The rate is
$40 per unit and there are 100,000 units (= 75,000+25,000). Thus, the overhead cost must
be 100,000 × $40 = $4,000,000. We compute total machine hours as (75,000 standard × 2
hours /unit) + (25,000 deluxe × 4 hours /unit) = 250,000 hours. Combining the two
estimates, we have the rate per machine hour as $16 per machine hour. Thus, we have:

Item Standard Custom

Price $130 $175
Variable cost $ 65 $ 70
Unit Contribution margin $ 65 $105
Allocated fixed cost $ 32 $ 64
(2 hours × $16 ; 4 hours × $16)
Unit profit margin $ 33 $ 41

Notice that the profit margin for the standard product has increased from $25 to $33

total profit is still (75,000 * $33) + (25,000 * $41) = $3,500,000. This equivalence
emphasizes that the allocation only divides the cost. The total is unaltered.

c.
The following table provides the required information. Notice that we treat capacity
costs as controllable for this decision. As the number of units changes, the capacity costs
change proportionately because the rate per unit stays the same.

Item Standard Custom

New Units 50,000 50,000
Profit Margin per unit $ 25 $ 65
Total profit $1,250,000 3,250,000

Thus, Sunder expects to make $4,500,000 in profit with the new product mix. Also, notice
that total capacity costs stay at $4,000,000 although we changed the mix. We get this
result because the total number of units did not change even though the mix changed.
Further, our allocation scheme is as if each unit consumes the same amount of capacity
resources, regardless of the type of product.
Based on this projection, changing the product mix appears to be a good idea as it
increases expected profit.

d.
The following table provides the required information. Notice that we treat capacity costs
as controllable for this decision. As the number of units made changes, the capacity costs
change proportionately because the rate per unit stays the same.

Item Standard Custom

New Units 50,000 50,000
Profit Margin per unit $ 33 $ 41
Total profit $1,650,000 2,050,000

Thus, Sunder expects to make $3,700,000 in profit with the new product mix. Also notice
that total capacity costs increases to $4,800,000. Total machine hours are (50,000 × 2) +
(50,000 × 4) = 300,000 hours, and the rate is $16 per machine hour.

Even though the total number of units did not change, the change in mix increased
the number of machine hours, increasing the total expected capacity cost.

While switching product mix still increases profit, the idea is not so compelling now. The
change in results underscores the importance of picking the right driver to estimate the
change in capacity costs. In this instance, machine hours probably are better suited as
deluxe products seem to require more work than standard products do.
9.54

Residential Commercial Total

Number of customers 200 300 500
Number of pickups per week 200 300 ×5 = 1,500 1,700
Revenue* $320,000 $3,600,000 $3,920,000
Variable costs* 56,000 720,000 776,000
Contribution margin $264,000 $2,880,000 3,144,000
Traceable fixed costs 150,000 225,000 375,000
Segment margin $114,000 $2,655,000 $2,769,000
Common fixed costs NA NA 1,100,000
Profit before taxes $1,669,000
* Residential Revenue = 200 × ($800,000/500 customers)
Commercial Revenue = 300 × ($1,200,000/100 customers)
* Residential Variable costs = 200 × ($140,000/500 customers)
Commercial Variable costs = 300 × ($240,000/100 customers)
b.
Let us first construct the allocation rates. We have $1.1 million in common fixed costs and
$2 million in total revenue. Thus, the allocation rate (for charging to segments) is $1.1/$2.0
= 55% of revenue. With this rate, we have the current income statement as:

Residential Commercial Total

Number of customers 500 100 600
Number of pickups per week 500 500 1,000
Revenue $800,000 $1,200,000 $2,000,000
Variable costs $140,000 $240,000 $380,000
Contribution margin $660,000 $960,000 1,620,000
Traceable fixed costs 150,000 225,000 375,000
Segment margin $510,000 $735,000 $1,245,000
Common fixed costs 440,000 660,000 1,100,000
($800,000×.55;$1,200,000×.55)
Profit before taxes $70,000 $75,000 $ 145,000

Now, let us re-do the income statement, except let us assume that both segment and
common fixed costs vary in proportion to sales revenue. That is, sales revenue is the
driver for fixed costs. Then, as we calculated above, the rate for common fixed costs is
55% of revenue. With respect to traceable fixed costs, the rates are $150,000/$800,000 =
18.75% for residential customers and $225/$1,200 = 18.75% for commercial customers.
With these rates, we have:

Residential Commercial Total

Number of customers 200 300 500
Number of pickups per week 200 300 ×5 = 1,700
1,500
Revenue $320,000 $3,600,000 $3,920,000
Variable costs 56,000 720,000 776,000
Contribution margin $264,000 $2,880,000 3,144,000
Traceable fixed costs 60,000 675,000 735,000
($320,000×.1875;$3,600,000×.1875)
Segment margin $204,000 $2,205,000 $2,409,000
Common fixed costs 176,000 1,980,000 2,156,000
($320,000×.55;$3,600,000×.55)
Profit before taxes $ 28,000 225,000 $253,000

While profit increases relative to current levels, it is substantially lower than the estimate
in part (a). The key difference, of course, is framing the problem as a long-run instead of a
short-term problem. This change means that fixed costs are potentially controllable, and
we estimate the new level using sales revenue as the cost driver.

c.
Now, let us re-do the income statement, except let us assume that both segment and
common fixed cost vary in proportion to the number of pickups. That is, pickups are the
driver for fixed costs. Then, the rate for common fixed costs is $1,100,000/1,000 =
$1,100 per weekly pick up. With respect to traceable fixed costs, the rates are
$150,000/500 =
$300 per weekly residential pickup and $450 per weekly commercial pickup.
With these rates, we have:

Residential Commercial Total

Number of customers 200 300 500
Number of pickups per week 200 300 ×5 = 1,500 1,700
Revenue $320,000 $3,600,000 $3,920,000
Variable costs 56,000 720,000 776,000
Contribution margin $264,000 $2,880,000 3,144,000
Traceable fixed costs* 60,000 675,000 735,000
Segment margin $204,000 $2,205,000 $2,409,000
Common fixed costs* 220,000 1,650,000 1,870,000
Profit before taxes $ (16,000) $ 555,000 $539,000

d.
The estimate in part (a), $1,669,000, is not reliable. The estimate assumes that capacity
costs would not change either in response to the change in the product mix or the change
in sales volume. This assumption seems odd because it is likely that commercial and
residential customers differ in terms of their resource demands. For example, commercial
clients need five times as many pickups as residential clients.

The estimates in parts (b) and (c) compute the expected change in capacity costs by using
allocations. However, they differ in terms of the driver used. It is difficult to uniquely
identify the single best driver some costs might be driven by sales volume while others
might more closely relate to the number of pickup. Thus, neither measure is completely
accurate although we expect that the number of pickups is a better estimate than sales
revenue.

business would increase their profit. The best estimate might be a weighted average of
the estimates in parts (b) and (c),
belief that the underlying activity (pickups or revenue) is the true driver of capacity
costs.