91Ó°ÊÓ

The Mavis Company uses an absorption-costing system based on standard costs. Total variable manufacturing cost, including direct material cost, is \(\$ 3\) per unit; the standard production rate is 10 units per machine-hour. Total budgeted and actual fixed manufacturing overhead costs are \(\$ 420,000\). Fixed manufacturing overhead is allocated at \(\$ 7\) per machine-hour \((\$ 420,000 \div\) 60,000 machine-hours of denominator level). Selling price is \(\$ 5\) per unit. Variable operating (nonmanufacturing) cost, which is driven by units sold, is \(\$ 1\) per unit. Fixed operating (nonmanufacturing) costs are \(\$ 120,000\). Beginning inventory in 2012 is 30,000 units; ending inventory is 40,000 units. Sales in 2012 are 540,000 units. The same standard unit costs persisted throughout 2011 and 2012 . For simplicity, assume that there are no price, spending, or efficiency variances. 1\. Prepare an income statement for 2012 assuming that the production-volume variance is written off at year-end as an adjustment to cost of goods sold. 2\. The president has heard about variable costing. She asks you to recast the 2012 statement as it would appear under variable costing. 3\. Explain the difference in operating income as calculated in requirements 1 and 2. 4\. Graph how fixed manufacturing overhead is accounted for under absorption costing. That is, there will be two lines: one for the budgeted fixed manufacturing overhead (which is equal to the actual fixed manufacturing overhead in this case) and one for the fixed manufacturing overhead allocated. Show how the production-volume variance might be indicated in the graph. 5\. Critics have claimed that a widely used accounting system has led to undesirable buildups of inventory levels. (a) Is variable costing or absorption costing more likely to lead to such buildups? Why? (b) What can be done to counteract undesirable inventory buildups?

Step by step solution

01

Calculate the Cost of Goods Sold (COGS)

Under absorption costing, the COGS includes all manufacturing costs, both variable and fixed. The total variable manufacturing cost is $3 per unit. The fixed manufacturing overhead is allocated based on machine-hours. Given that there is a beginning inventory of 30,000 units and an ending inventory of 40,000 units, the production for the period must have been 540,000 - 30,000 + 40,000 = 550,000 units. Calculate the COGS using the beginning inventory, production, and the allocated fixed manufacturing overhead.

02

Prepare the Absorption Costing Income Statement

Summarize the income statement items under absorption costing: sales revenue, cost of goods sold, and operating expenses. Sales revenue is calculated as the number of units sold (540,000) times the selling price per unit ($5). COGS includes both variable and fixed costs. Subtract operating expenses to determine the operating income.

03

Recast the Income Statement under Variable Costing

Under variable costing, only variable manufacturing costs are included in the COGS. Fixed manufacturing overhead is treated as a period expense. Calculate the COGS using only variable costs. The operating income is then determined by subtracting total variable and fixed expenses from sales revenue.

04

Calculate the Difference in Operating Income

Determine the difference in operating income between the absorption and variable costing methods. The key difference arises from the treatment of fixed manufacturing overhead. Under absorption costing, part of the fixed manufacturing overhead is deferred in inventory, while under variable costing, it is entirely expensed in the period.

05

Graph the Fixed Manufacturing Overhead Accounting

Create a graph to illustrate the treatment of fixed manufacturing overhead under absorption costing. Show the budgeted fixed manufacturing overhead as a horizontal line and the allocated overhead based on machine-hours. Indicate the production-volume variance, which is the difference between the budgeted and allocated overhead.

06

Address Undesirable Inventory Buildups

Discuss which costing method is more prone to inventory buildups. Absorption costing can incentivize inventory buildups as fixed costs are spread over units produced, potentially reducing COGS per unit. Suggestions to counteract undesirable buildups include implementing just-in-time inventory management and improving demand forecasting.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Variable Costing

Variable costing is a method in managerial accounting where only the variable production costs are included in the Cost of Goods Sold (COGS). This means that costs like direct materials, direct labor, and variable manufacturing overhead become part of the product's cost. Fixed manufacturing overhead, on the other hand, is not included in product costs. Instead, it is treated as a period expense and directly affects the income of that period.

This approach can be beneficial because it highlights the impact of fixed costs on overall profitability, making it easier for managers to see the true variable cost of producing additional units. This helps in decision-making processes such as pricing, production levels, and discontinuing products. A major advantage of variable costing is the avoidance of artificial profit inflation due to unsold inventory, something that can be an issue with absorption costing.

Cost of Goods Sold (COGS)

The Cost of Goods Sold (COGS) is a crucial financial metric in understanding a business's production and sales costs. It refers to the direct costs attributable to the production of the goods sold by a company. This includes the cost of materials and labor directly used to create the product. Under absorption costing, COGS also includes a share of the fixed manufacturing overhead.

In our scenario, if using absorption costing, we calculate COGS by incorporating total manufacturing costs — both variable and fixed. The beginning inventory, production, and ending inventory levels play an essential role in its calculation. Under variable costing, however, COGS will include only the variable manufacturing costs, giving a different perspective on actual variable expenses incurred.

Fixed Manufacturing Overhead

Fixed Manufacturing Overhead represents production expenses that do not change with the level of production, such as the factory rent or salaries of permanent staff. Unlike variable costs, fixed costs remain constant regardless of the number of units produced, which can offer stability but also poses challenges in cost management.

Under absorption costing, fixed manufacturing overhead is allocated to each unit produced. This means that the overhead is spread out over the total number of units, potentially altering the cost per unit depending on the production level. If fewer units are produced, the cost per unit rises, and vice versa. In contrast, under variable costing, fixed overhead is not allocated to units; instead, it is expensed in the period in which it is incurred.

Income Statement Preparation

Income statement preparation under different costing methods can lead to varying results, especially when analyzing the income or profitability. The primary difference between absorption and variable costing income statements is how fixed manufacturing overhead costs are treated.
Under absorption costing, fixed manufacturing overhead costs are included in the product costs and become part of the inventory costs. This means these costs are only recognized when the inventory is sold. In contrast, variable costing treats fixed manufacturing overhead as period costs, expensing them as they occur, regardless of the sales.

This fundamental difference can lead to variations in operating income. Absorption costing can create situations where an increase in inventory level leads to deferred fixed costs, possibly causing higher operating income, even if sales have not increased. Thus, understanding each method's impact is vital for accurate financial analysis and strategic planning.