ACC 2242

Chapter 8 IN CLASS QUESTIONS

8-1 Absorption and variable costing differ in how they handle fixed manufacturing overhead. Under absorption costing, fixed manufacturing
overhead is treated as a product cost and hence is an asset until products are sold. Under variable costing, fixed manufacturing overhead is
treated as a period cost and is expensed on the current period’s income statement.

8-2 Advocates of variable costing argue that variable costing simplifies short-term planning since the income statement under variable costing
is presented in the contribution format. In this format, contribution margin, an important short-term measure of profit, is prominently featured
and therefore, provides information in a simpler format to support the manager’s preparation of cost-volume-profit and other analyses focused on
the short-term. In addition, since fixed costs do not change in the short-term, an income statement that focuses the manager on changes in
variable cost is useful for short-term decision making.

8-3 If production and sales are equal,

operating income should be the same under
absorption and variable costing. When production equals sales, inventories do not increase or decrease and therefore under absorption costing
fixed manufacturing overhead cost cannot be deferred in inventory or released from inventory.

8-4 If production exceeds sales, absorption costing will usually show higher operating income than variable costing. When production exceeds
sales, inventories increase and under absorption costing part of the fixed manufacturing manufacturing overhead cost of the current period is
deferred in inventory to the next period. In contrast, all of the fixed manufacturing overhead cost of the current period is immediately expensed
under variable costing.

Exercise 8-1 (15 minutes)

1. Under absorption costing, all manufacturing costs (variable and fixed) are included in product costs.
Direct materials................................... R120
Direct labour....................................... 140
Variable manufacturing overhead......... 50
Fixed manufacturing overhead
(R600,000 ÷ 10,000 units)................    60
Unit product cost................................ R370
2. Under variable costing, only the variable manufacturing costs are included in product costs.
Direct materials................................... R120
Direct labour....................................... 140
Variable manufacturing overhead.........    50
Unit product cost................................ R310
Note that selling and administrative expenses are not treated as product costs under either
absorption or variable costing; that is, they are not included in the costs that are inventoried. These
expenses are always treated as period costs and are charged against the current period’s revenue.

Exercise 8-2 (30 minutes)

1. 2,000 units × R60 per unit fixed manufacturing overhead = R120,000

2. The variable costing income statement appears below:

Sales.................................................. R4,000,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory....................... R            0
Add variable manufacturing costs
(10,000 units × R310 per unit)....  3,100,000
Goods available for sale................. 3,100,000
Less ending inventory
(2,000 units × R310 per unit)......     620,000
Variable cost of goods sold*............. 2,480,000
Variable selling and administrative
(8,000 units × R20 per unit)..........     160,000  2,640,000
Contribution margin............................ 1,360,000
Fixed expenses:
 Fixed manufacturing overhead.......... 600,000
Fixed selling and administrative.........     400,000  1,000,000
Operating income............................... R  360,000
* The variable cost of goods sold could be computed more simply as:
8,000 units sold × R310 per unit = R 2,480,000.
The difference in operating income between variable and absorption costing can be explained by the
deferral of fixed manufacturing overhead cost in inventory that has taken place under the absorption
costing approach. Note from part (1) that R120,000 of fixed manufacturing overhead cost has been
deferred in inventory to the next period. Thus, operating income under the absorption costing
approach is R120, 000 higher than it is under variable costing.

Exercise 8-3 (20 minutes)

1. Year 1 Year 2 Year 3
Beginning inventories
(units).............................. 150 180 160
Ending inventories (units).... 160 150 200
Change in inventories
(units).............................. 10  (30)  40

Variable costing operating

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

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

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

Exercise 8-5 (30 minutes)

1. Under variable costing, only the variable manufacturing costs are included in product costs.
Direct materials..................................... $ 8
Direct labour......................................... 10
Variable manufacturing overhead...........    2
Unit product cost................................... $20
Note that selling and administrative expenses are not treated as product costs; that is, they are not
included in the costs that are inventoried. These expenses are always treated as period costs and are
charged against the current period’s revenue.
2. The variable costing income statement appears below:
Sales (21,500 × $35).......................... $752,500
Variable expenses:
Variable cost of goods sold:
Beginning inventory....................... $            0
Add variable manufacturing costs
(25,000 units × $20 per unit)......  500,000
Goods available for sale................. 500,000
Less ending inventory (3,500 units
× $20 per unit)...........................     70,000
Variable cost of goods sold*............. 430,000
Variable selling and administrative
(21,500 units × $4 per unit)...........     86,000  516,000
Contribution margin............................ 236,500
Fixed expenses:
Fixed manufacturing overhead.......... 75,000
Fixed selling and administrative.........     110,000     185,000
Operating profit.................................. $51,500

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

3. The break-even point in units sold can be computed using the contribution margin per unit as
follows:

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

Variable product cost per unit........  20
Variable selling and admin cost per
unit……………………………………….. 4
Contribution margin per unit......... $ 11
Exercise 8-6 (20 minutes)
1. Under absorption costing, all manufacturing costs (variable and fixed) are included in product costs.
Direct materials..................................... $ 8
Direct labour......................................... 10
Variable manufacturing overhead........... 2
Fixed manufacturing overhead
($75,000 ÷ 25,000 units)....................    3
Unit product cost................................... $23

2. The absorption costing income statement appears below:

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

Note: Operating income is larger under absorption costing because the company holds
back $10,500 ($3 x 3,500 units) worth of fixed costs in ending inventory.

Exercise 8-7 (30 minutes)

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

b. The absorption costing income statement:

Sales (21,000 units × $65 per unit)............ $1,365,000
Cost of goods sold:
Beginning inventory (first year of opera-
tions)................................................... $         0
Add cost of goods manufactured
(25,000 units × $48 per unit)................  1,200,000
Goods available for sale.......................... 1,200,000
Less ending inventory
(4,000 units × $48 per unit).................  192,000  1,008,000
Gross margin............................................. 357,000
Selling and administrative expenses............  215,000 *
Operating income...................................... $ 142,000
*(21,000 units × $5 per unit) + $110,000 = $215,000.
2. a. The unit product cost under variable costing would be:
Direct materials..............................................................
$25
Direct labour..................................................................
12
Variable manufacturing overhead....................................    3
Unit product cost............................................................
$40

b. The variable costing income statement:

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

Exercise 8-9 (20 minutes)

 Sales (40,000 units × $33.75 per unit)………… $1,350,000
Variable expenses:
Variable cost of goods sold
(40,000 units × $16 per unit*)………………….. $640,000
Variable selling and administrative expenses
(40,000 units × $3 per unit) ………………………  120,000    760,000
Contribution margin………………………………….. 590,000
Fixed expenses:
Fixed manufacturing overhead……………………. 250,000
Fixed selling and administrative expenses……..  300,000     550,000
Operating income……………………………………… $    40,000

* Direct materials…………………………. $10

Direct labour……………………………… 4
Variable manufacturing overhead…    2
Total variable manufacturing cost.. $16
2. The difference in operating income can be explained by the $50,000 in fixed manufacturing
overhead deferred in inventory under the absorption costing method:

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

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