91Ó°ÊÓ

The Tomlinson Company manufactures trendy, high-quality, moderately priced watches. As Tomlinson's senior financial analyst, you are asked to recommend a method of inventory costing. The CF0 will use your recommendation to prepare Tomlinson's 2017 income statement. The following data are for the year ended December 31,2017 : Assume standard costs per unit are the same for units in beginning inventory and units produced during the year. Also, assume no price, spending, or efficiency variances. Any production-volume variance is written off to cost of goods sold. 1\. Prepare income statements under variable and absorption costing for the year ended December 31 2017 2\. What is Tomlinson's operating income as percentage of revenues under each costing method? 3\. Explain the difference in operating income between the two methods. 4\. Which costing method would you recommend to the CF0? Why?

Step by step solution

01

Understand the key differences between variable and absorption costing

Variable costing includes only variable costs (direct materials, direct labor, and variable manufacturing overhead) in the cost of goods sold, while absorption costing also includes fixed manufacturing overhead. This difference affects the calculation of cost of goods sold, gross margin, and operating income in the income statements.

02

Prepare the income statements under variable and absorption costing

Unfortunately, there is not enough data provided in the exercise to create income statements for Tomlinson Company under variable and absorption costing. The data provided needs to include amounts for revenue, direct materials, direct labor, variable manufacturing overhead, fixed manufacturing overhead, and other expenses, in order to complete this step.

03

Calculate the operating income as a percentage of revenues

Once you have prepared the income statements using both costing methods, you can calculate the operating income as percentage of revenues for both methods by dividing the operating income by the revenue for each method and multiplying the result by 100. Operating Income percentage (Variable Costing) = (Operating Income_VC / Revenue) * 100 Operating Income percentage (Absorption Costing) = (Operating Income_AC / Revenue) * 100

04

Explain the difference between the two methods

The primary difference between variable and absorption costing is the inclusion of fixed manufacturing overhead in the cost of goods sold under absorption costing. This results in a higher cost of goods sold and a lower gross margin in absorption costing when compared to variable costing. In turn, this impacts the operating income, which will also be lower under absorption costing. The difference between the two methods lies in the way fixed manufacturing overhead is accounted for: in variable costing, it is treated as a period expense, while in absorption costing, it is included in the cost of goods sold and allocated to the inventory.

05

Recommend a costing method and justify the recommendation

After analyzing the differences between variable and absorption costing, noting the impact on the income statements and operating income percentages, and considering the company's context and financial goals, we can make a recommendation. For example, if the CFO wants to emphasize cost control and better understand the impact of variable costs on the company's gross margin and operating income, it might be more appropriate to recommend variable costing. On the other hand, if the company wants to adhere to Generally Accepted Accounting Principles (GAAP) and better allocate fixed manufacturing overhead to product costs, absorption costing would be the better choice. In any case, your recommendation should be clear and justified based on the analysis conducted in previous steps.

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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 managerial accounting method that captures only variable production costs—direct materials, direct labor, and variable manufacturing overhead—in the cost of goods sold. It treats fixed manufacturing overhead as a period expense, which is deducted along with selling and administrative expenses to determine operating income.

Within this framework, the cost of producing an additional unit is simply the sum of the variable costs. The main advantage of variable costing is that it provides clarity on how costs behave with changes in production volume, which can be crucial for decision-making and strategic planning.

It's essential to understand that variable costing doesn't conform to GAAP for external reporting, but is extremely useful for internal analysis as it avoids distortion in profit due to changes in inventory levels, which can happen with absorption costing.

Absorption Costing

In contrast to variable costing, absorption costing includes all manufacturing costs in the cost of goods sold, both variable and fixed. Under this method, fixed manufacturing overhead is allocated to each unit produced, meaning that the inventory 'absorbs' a portion of the fixed overhead.

This accounting practice aligns with GAAP requirements and is typically used to prepare financial statements for external reporting. One consequence of absorption costing is that it can lead to fluctuations in operating income if production levels vary significantly from sale levels; producing more units than sold can falsely inflate income due to more fixed costs being allocated to inventory rather than being expensed out.

Operating Income Calculation

Calculating operating income is a fundamental process in assessing a company's financial performance. To determine operating income under both costing methods, one must first identify the revenue, then subtract the cost of goods sold, and finally deduct operating expenses. The formula for calculating the operating income percentage is: \[\text{Operating Income percentage} = \left(\frac{\text{Operating Income}}{\text{Revenue}}\right) \times 100\] When comparing variable costing to absorption costing, operating income can differ due to the different treatment of fixed manufacturing overhead. With variable costing, because fixed overhead is not included in the cost of goods sold, operating income can appear higher, especially in periods where production exceeds sales.

Standard Cost Accounting

Standard cost accounting involves setting predetermined costs for products and services, which are then used for valuing inventory and measuring cost control efficiency. These standard costs are based on expected direct material, direct labor, and overhead rates.

The major benefit of using standard cost accounting is that it simplifies bookkeeping, makes budgeting easier, and provides a clear benchmark for performance evaluation. Variances from standard costs can signal areas where management may need to investigate inefficiencies or anomalies. As noted in the problem, Tomlinson Company assumes no variances, meaning actual costs matched their standard costs.