Solution manual cost and managerial accounting by barfield 3rd absorption(variable) costing and cost volume profit analysis

The two basic differences between absorption and variable costing lie in the treatment of fixed factory overhead and the presentation of costs/expenses on the income statement.. Absorpti

Absorption/Variable Costing and Cost-Volume-Profit

Analysis

Questions

1 The two basic differences between absorption and variable

costing lie in the treatment of fixed factory overhead and the presentation of costs/expenses on the income statement

Absorption costing treats fixed factory overhead as a product cost and allocates it to the units produced during the period;variable costing treats fixed overhead as a period expense and charges the full amount incurred to the income of the period Absorption costing presents costs on the income statement in their functional categories without regard to cost behavior while variable costing presents costs on the income statement

as either fixed or variable as well as product or period

2 The underlying cause of the difference between absorption and

variable costing is the definition of an asset Asset cost should include all costs necessary to get an item into place and ready for sale or use Absorption costing considers fixed overhead to be an inventoriable cost (asset) because products could not be produced without the basic manufacturing capacityrepresented by fixed overhead cost Variable costing

proponents, however, believe that fixed overhead is not an inventoriable cost because it is incurred regardless of

whether production is achieved This is not a problem for which there is a single correct answer since both positions have logical and rational arguments to support them

3 A functional classification requires cost to be classified based

on the reason it was incurred, i.e., selling, administrative,

or production A behavioral classification of costs requires

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costs to be classified according to the way the cost behaves with changes in product volume, i.e., variable or fixed

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4 Absorption costing is required for external reporting The

rationale is that fixed manufacturing overhead is regarded as aproduct cost and that it should therefore be included with thevariable production costs and be shown as an expense only in the period in which the related products are sold

5 Use of monetary, quantitative information varies greatly

between external and internal users External users emphasizeprofitability potential; internal users emphasize information that helps make sales, production, and capital expenditure decisions

Both absorption and variable costing have a place in decision making Accountants and decision makers need to

understand the applications and limitations of the two

techniques within the context of past, present, and future cost information needs No matter which type of costing a firmuses, the firm’s total revenue must cover all costs—both

variable and fixed—and also generate a satisfactory profit if a firm is to survive in the long run

The methods of cost accumulation and cost presentation used for reporting are determined by what is acceptable to those parties for whom the reports are intended External reporting is guided by the characteristics of reliability, uniformity, and consistency Internal reporting is guided by flexibility in helping managers with planning, controlling, decision making, and performance evaluation

6 Absorption costing requires a functional classification of

costs, with two major cost groupings: product and period Variable costing requires costs to be classified according to their behavior: fixed or variable In addition, variable costing can employ a dual categorization of costs; costs are first classified by their behavior and then, within the

behavioral classes, costs are further classified as to their function

7 Variable overhead is highly correlated with production,

meaning that it statistically changes directly and

proportionately with production Because it behaves with

respect to production the same way as direct material and direct labor, and treats only these three costs as product costs, many accountants have called it direct costing

Variable costing is a better term because all three costs are variable; however, variable overhead must be allocated and is,

therefore, not direct.

8 Many important organizational decisions involve a

consideration of impacts on volume of production and sales, and/or tradeoffs between variable and fixed costs A scheme that requires costs to be classified by their behavior lends itself to these types of decisions

9 Student answers will vary No solution provided.

10 When the production level exceeds the sales level, absorption

costing income will be higher than variable costing income because some of the fixed factory overhead incurred during the period will be deferred into inventory rather than going to the income statement Since no fixed overhead is inventoried under variable costing, there will be more dollars of expense

on the income statement under variable costing than there will

be under absorption costing

When the production level is less than the sales level, some of the fixed overhead deferred in previous periods will becharged against income as part of cost of goods sold under absorption costing in addition to the current period fixed overhead Thus, there will be greater income charges under absorption costing than under variable, resulting in a smallerincome amount

11 The break-even point is the starting point for CVP analysis

because before a company can earn profits, it must first cover all of its variable and fixed costs; the point at which all costs are just covered is the break-even point

12 Contribution margin is selling price minus variable cost

Contribution margin is the amount that is available to cover fixed costs and generate profits for the company It fluctuates

in direct proportion with sales volume because the two

elements used in its computation (selling price and variable cost) are both variable and, thus in total, fluctuate directly with sales volume

13 The usefulness of CVP analysis is its ability to clearly

forecast income expected to result from the short-run

interplay of cost, volume, price, and quality It is often useful in analyzing current problems regarding product mix, make or buy, sell or process further, and pricing

In the long run, however, all of these factors and their relationships and the assumptions that underlie CVP regarding these factors are likely to change This emphasizes that CVP only holds true for the short run Results must be

recalculated periodically to maintain validity

14 The variable costing income statement is depicted by the

following equation: Sales - variable costs - fixed costs = pre-tax income At any operating level, total revenues are

equal to total expenses plus profits (or minus losses) Total expenses can be illustrated by the formula for a straight line(y=a+bX) At the break-even point, y (total costs) is equal tototal revenues By adding an additional amount for desired profit, it is "as if another cost needs to be covered,

requiring revenues to increase to that extent."

15 If fixed costs increase and selling price and variable costs

remain constant, contribution margin will not change because fixed costs do not enter into the computation of contribution margin Because a larger amount of fixed costs must now be covered by the same amount of contribution margin per unit, the break-even point will rise

16 Contribution margin per unit can be divided into fixed costs to

compute break-even point in units Contribution margin

percentage can be divided into fixed costs to compute even point in sales dollars

break-17 The contribution margin ratio is simply the contribution

margin per unit divided by the sales price per unit The break-even point is obtained by dividing total fixed costs by the contribution margin ratio

18 Since taxes will reduce income before taxes by $.40 of each

dollar, the income that will remain to be considered net

income or profits will only be $.60 of each dollar Therefore,

to generate $.60 of net income, the company will need to

produce $1.00 of income before taxes - dividing what is

desired by the remaining portion after taxes yields the

corresponding value before taxes

19 The "bag" or "basket" assumption means that a multi-product

firm will consider that the products it sells are sold in a constant, proportional sales mix - as if in a bag of goods It

is necessary to make this assumption in order to determine thecontribution margin for the entire company product line, sinceindividual products' contribution margins may differ

significantly A single contribution margin must be used in CVPanalysis so the "bag" or "basket" assumption allows CVP

computations to be made

20 The margin of safety is a measure that presents the difference

between the actual or pro forma level of sales and its even point, BEP Remember that the BEP is not a commercial objective, but rather a reference point against which actual

break-or pro fbreak-orma sales can be compared, and the margin of safety measures either the comfort or risk, depending on whether the margin of safety is greater than or less than the BEP

Therefore, the margin of safety is the relationship of actual

or pro forma sales to the BEP reference point

21 Operating leverage refers to the amount of fixed costs relative

to variable costs in a company's cost structure Higher

operating leverage is associated with a higher proportion of fixed costs; lower operating leverage is associated with a lower level of fixed costs The level of operating leverage isdependent on the level of revenues Further, operating

leverage provides information about how profit will change whenrevenue changes High operating leverage indicates that the level of profit is very sensitive to a change in revenue level.The reverse is true for low operating leverage

Margin of safety is the difference between actual or projected sales and break-even level sales It identifies the amount by which sales could fall and still leave the firm's bottom line in the black

22 Break-even charts are prepared to show, in graphic form, the

relationships between revenues, expenses, volume, and profits (losses) The traditional break-even chart does not present contribution margin, whereas the contemporary break-even chartdoes On the contemporary break-even chart, contribution

margin is indicated by the area between the revenue line and the variable cost line The profit-volume graph plots profit against volume

Exercises

23 a (20,000 - 18,400) × $8.50 = $13,600

b (20,000 - 18,400) × ($8.50 - $1.50) = $11,200

c Absorption costing would have produced the higher net

income because it would have required $2,400 (1,600 ×

$1.50) of fixed manufacturing overhead to be inventoried rather than to be charged against income

24 The only difference between variable and absorption net income

is due to the difference in treatment of fixed manufacturing overhead

Fixed overhead expensed:

Variable costing $500,000Absorption costing ($500,000 × (37,500÷40,000)) 468,750

NI difference $ 31,250The company's net income would have been $31,250 higher

Absorption cost per unit $0.77

b Variable cost of goods sold = 99,000 × $0.65 = $64,350

c Cost of goods sold = 99,000 × $0.77 = $76,230

d Ending inventory (variable costing) = 1,000 × $0.65

= $650Ending inventory (absorption costing) = 1,000 × $0.77

= $770

e Fixed overhead charged to expense (variable costing)

= $12,000Fixed overhead charged to expense (absorption costing)

Income Statement (Absorption Costing Basis)

For the Month ended April 2002

($000 omitted)

Less cost of goods sold:

Cost of goods sold at standard $3,400

Less production volume variance

Less fixed selling & administrative expenses (800)

2 Difference in incomes = $600 - $650 = ($50)

This amount is equal to the increase in inventory of5,000 units × $10 per unit fixed overhead deferred inending inventory under absorption costing

b The vice-president of marketing should find the variable

costing approach to income determination desirable for many reasons, including these:

•Variable costing income varies with units sold, not units produced

•Fixed manufacturing overhead costs are charged against revenue in the period in which they are incurred;

consequently, manufacturing cost per unit does not change with a change in production level

•The contribution margin offers a useful tool for making decisions that consider changes in relationships among costs, volume levels, and profit figures

(CMA adapted)

28 a Estimated fixed overhead = $0.16 × 200,000 = $32,000

b Actual (and estimated) fixed overhead $32,000

Applied fixed overhead (180,000 × $.16) 28,800Underapplied fixed overhead (absorption) $ 3,200

There would be no under- or overapplied fixed overhead under variable costing since fixed overhead is not applied

Cost per unit (absorption) $0.49

d Absorption Cost of Goods Sold (195,000 × $0.49) $ 95,550

Selling and administrative costs:

Variable (195,000 × $0.14) $ 27,300

Variable cost of goods sold (195,000 × $0.33) $ 64,350

Variable selling expenses (195,000 × $0.14) 27,300

e Income will be higher under variable costing because the

sales level is greater than the production level It will be higher by the fixed overhead per unit ($0.16) times the change in inventory (15,000 unit decline) or

$2,400

29 a Total revenue rises by $50 + $42 = $92

b Total costs rise by the amount of variable costs, $42

c Total pretax profit rises at the rate of the CM per unit,

Next, let P represent the number of playhouses that must

be sold to generate $761,560 in pretax income:

$3,000P - $1,800P - $280,420 = $761,560 $1,200P = $1,041,980

= 869 playhouses

(rounded)

b Find after-tax equivalent of 20%: 20% ÷ (1 - 0.35) =

30.77% Variable costs as a percentage of sales: $1,800

÷ $3,000 = 60%

Let R = the level of revenue that generates a pretax return of 30.77%:

R - 0.60R - $280,420 = 0.3077R 0.0923R = $280,420

R = $3,038,137 (rounded)

33 a Sales ($4.50 × 200,000) $900,000

Variable Costs ($2.70 × 200,000) (540,000)Contribution Margin $360,000Fixed Costs (316,600)Net Income $ 43,400BEP = $316,600 ÷ 4 = $791,500

Margin of safety, dollars: $900,000 - $791,500 = $108,500Margin of safety in units: $108,500 ÷ $4.50 = 24,111 units

b $360,000 ÷ $43,400 = 8.29

c Income will increase by: 8.29 × 30% = 249%

Proof:

Sales ($4.50 × 200,000 × 1.30) $1,170,000Variable Costs ($2.70 × 200,000 × 1.30) (702,000)Contribution Margin $ 468,000Fixed Costs (316,600)Net Income $ 151,400($151,400 - $43,400) ÷ $43,400 = 249%

d BEP = ($316,600 + $41,200) ÷ 0.4 = $894,500

Sales ($4.50 × 200,000 × 1.15) $1,035,000Variable Costs ($2.70 × 200,000 × 1.15) (621,000)Contribution Margin $ 414,000Fixed Costs (357,800)Net Income $ 56,200Operating leverage = $414,000 ÷ $56,200 = 7.37

34 a Each "bag" contains 2 units of M and 4 units of N Thus,

each bag generates contribution margin of:

(2 × $10) + (4 × $5) = $40 The break-even point would be: $90,000 ÷ $40 = 2,250 bags Since each bag contains

4 units of N, at the break-even point 2,250 × 4 = 9,000 units of N would be sold

b At the break-even point, total CM = total FC; and the CM

per unit would be $800 ÷ 2,000 = $0.40 If one unit is sold beyond the break-even point, net income would rise

by $0.40

Alternatively, the BEP can be computed based on dollars rather than units Total revenue per bag is (3 × $10) +(1 × $15) = $45 The CM% = $17 ÷ $45 = 37.78%

BEP = $200,000 ÷ 0.3778 = $529,381 Note that due to rounding, this answer differs slightly from the answer obtained using the units approach

Bats: 21,931 × 2 × $4 = $175,448Gloves: 21,931 × 1 × $5 = 109,655 $285,103 Fixed costs 200,000

Profit $ 85,103

The actual profit is lower than the expected profit becauseeach dollar of sales generated less contribution margin than the planned sales This is proven below:

Actual Bag Planned Bag

Sales $35 $45

CM 13 17

CM% 37.14% 37.78%

Total costs

Profit area

Lossarea

BreakevenPoint

Fixed Cost

Breakeven Point

Total revenue curve

Profitarea

Total costs

Fixed costs

VariablecostsLoss area

Breakevenpoint

Contemporary CVP Graph

0 20000

Breakeven point

d Graph (a) demonstrates how total costs and total revenues behave as volume changes In graph (a), variable costs are not explicitly shown but can be inferred as the distance between the total cost and fixed cost lines Profit or loss is the distance between the total revenue and total cost lines Graph (b) is similar

to graph (a) but it doesn't explicitly show fixed costs; however the amount of fixed costs can be determined by looking at the area between the total cost line and the variable cost line Graph (c) shows only how profit changes with changes in volume The shaded area to the right of the profit curve is the profit area; the shaded area to the left is the loss area No actual revenues orcosts can be determined by looking at this graph

Profit curve

Profit area

Loss area

Profit-Volume Graph

-40000 -20000 0 20000 40000 60000 80000

Units of production

37 a George Jones Enterprises

Income Statement (Absorption) For the Year Ended December 31, 2002

b The difference in the amounts is equal to the fixed

overhead of ($1,500,000 ÷ 1,750 units) approximately

$857.14 per unit times the 250 units produced but not sold during the year This $214,286 is contained in ending inventory under absorption costing, whereas it appears as part of total fixed overhead expense on the variable costing income statement

c It is not only ethical, it is required for the statements

to be in conformity with generally accepted accounting principles

d 1 George Jones Enterprises

Income Statement (Variable) For the Year Ended December 31, 2003

Variable cost of goods sold (1,850 × $1,300) (2,405,000)

Variable selling & administrative ($180 × 1,850) (333,000)

Fixed selling & administrative 190,000 (523,000)

3 The difference in the net incomes is equal to the

incremental decrease in the ending balances of the inventory accounts when compared to the

beginning balances Another way to look at this moreeasily is to multiply the 100 units sold in excess

of the 1,750 units produced by the fixed overhead application rate

39 a Kirkfield Fashions

Income Statement (Variable)

For the Year Ended December 31, 2003

Selling & administrative 125,000 (242,000)

b Kirkfield Fashions

Income Statement (Absorption)

For the Year Ended December 31, 2003

Sales (20,000  $40) $800,000Cost of goods sold (20,000 x $18.90) $378,000

Manufacturing variances (unfavorable) 27,400* 405,400)Gross margin $394,600Less Selling and administrative costs (125,000)Income before taxes $269,600

*From before $ 4,000 variable Underapplied OH 23,400 [(30,000 - 24,000) × $117,000 ÷ $27,400 U 30,000]

c Inventory increased 4,000 units Each added unit absorbs

$3.90 in allocated fixed overhead or a total of $15,600 The presumption in the problem is that the books are maintained on a variable costing basis Assuming only the current year needs to be adjusted (the beginning inventory of 2003 was charged with the appropriate fixed overhead), then the entry would be:

Underapplied Overhead 23,400 Factory Overhead 117,000

d Advantages:

The fixed costs are reported at incurred values (and not applied), thus increasing the likelihood of better control of those costs

Profits are directly influenced by changes in sales volume (and not influenced by building inventory)

The impact of fixed costs on profits is emphasized

Product line, territory, etc., marginal contribution is emphasized and more readily ascertainable

The income statements are in the same form as the cost-volume- profit relationships

The consequences of fixed costs would be more obvious

Inventory swings would not influence profits

Disadvantages:

Costs are not matched with revenues

The difficulty in separating fixed and variable costs might cause statements to be misleading

Statements would confuse investors used to absorption costing statements

Confidential information (on the nature of costs) could

be disclosed to competitors

(CMA adapted)