Chapter 6, Problem 19P

Answer 1:

To determine

Variable Costing: is also known as Direct costing method. In this method, those costs which vary directly with production are considered in product cost. Fixed Manufacturing Expenses are treated as period cost and not product cost. Selling Expenses (since they do not vary with production), both variable and fixed, are charged off completely in the period in which the expenses get incurred.

Unit product Cost for two years

Answer to Problem 19P

Solution:

Computation of Unit Product Cost under Variable Costing
	Year 1	Year 2
Direct Material	$ 4	$ 4
Direct Labour	$ 7	$ 7
Variable Manufacturing Overhead	$ 1	$ 1
Total Product Cost	$ 12	$ 12

Explanation of Solution

1. In variable costing, direct material, direct labour and variable manufacturing expenses are considered for unit product cost.

Given:

Direct Material, Direct Labor and Variable Manufacturing Overhead are given in the question.

Formula:

Total Product Cost = Direct material + Direct Labor + Variable Manufacturing Overhead

Conclusion

Total product cost under variable costing for year 1 is $ 12 and for Year 2 also is $ 12.

Income Statement under Variable Costing: This statement is used to compute net operating margin.

Answer 2

To determine

Net Operating Income under variable costing system for 2 years

Answer to Problem 19P

Solution:

Income Statement under Variable Costing
		Year 1	Year 2
A	Sales (Sales Volume X Sales Price)	1,000,000	1,250,000
B	Less: Cost of Goods Sold
C	Beginning Inventory Opening Inventory Quantity X Unit Product Cost of previous year	$ -	$ 60,000
D	Add: Variable Manufacturing Cost Production Quantity X Unit Product Cost	540,000	540,000
E	Less: Closing Inventory Closing Inventory Quantity X Unit Product Cost of current year	$ 60,000	$ -
B	Cost of Goods Sold (C+D-E)	$ 480,000	$ 600,000
F	Variable Selling & Admin Expenses (Sales quantity X Variable selling cost per unit)	$ 80,000	$ 100,000
G	Contribution Margin (A-B-F)Sales Value - (Cost of Goods Sold + Variable selling expenses)	$ 440,000	$ 550,000
H	Fixed Manufacturing Overhead	$ 270,000	$ 270,000
I	Fixed Selling Overhead	$ 130,000	$ 130,000
J	Net Operating Income	$ 40,000	$ 150,000

Working Notes:
	Year 1	Year 2	Remarks
Sales Volume	40,000	50,000	(as given in question)
Production Volume	45,000	45,000	(as given in question)
Opening Stock	-	5,000	(Closing Stock of previous year)
Closing Stock	5,000	-	(Opening Stock + Production - Sales)
Selling Price per unit	$25	$25	(as given in question)
Variable Selling Cost per unit	$2	$2

Explanation of Solution

1. In variable costing, direct material, direct labour and variable manufacturing expenses are considered for unit product cost;
2. The income statement under this method requires following computations:

  $\begin{array}{l}\text{Sales - Variable Cost = Contribution}\\ \text{Contribution - Fixed Cost = Net Operating Income}\end{array}$

Variable cost comprises of variable cost of goods sold and variable selling expenses

Fixed cost comprises of fixed manufacturing cost and fixed selling cost

Given:

Sales volume, production volume and selling price per unit are given in the question.

Formulas:

Variable Cost of Goods Sold:

  $\begin{array}{l}\text{Beginning Inventory Quantity X Unit Product Cost of previous period + }\\ \text{Current Production Quantity X Unit Product cost of current period -}\\ \text{Closing Inventory Quantity X Unit Product Cost of current period}\end{array}$

  $\text{Variable Selling \& Admin Expenses = Sales Quantity X Variable Selling Expenses per unit}$

  $\text{Contribution Margin = Sales Value - (Cost of Goods Sold + variable Selling Expenses)}$

Note: Unit product cost here is unit cost computed as per variable costing.

Answer 3:

To determine

Reconciliation: Reconciliation is done between Net Operating Income as per Variable Costing and that as per Absorption Costing.

The difference between the two net operating income figures would be on account of fixed cost element on inventory.

Under Variable costing, the inventory is valued at Unit product cost as per variable costing method which is direct material plus direct labour plus variable manufacturing expenses.

Whereas

Under Absorption costing, the inventory is valued at Unit product cost as per absorption costing method which is direct material plus direct labour plus variable manufacturing expenses plus fixed cost per unit.

Due to the inclusion of fixed cost in inventory in absorption costing, following is the impact:

1. Opening inventory is higher resulting in decrease in profit
2. Closing inventory is higher resulting in increase in profit

Reconciliation of net operating income under variable and absorption costing

Answer to Problem 19P

Solution:

Reconciliation
Particulars	Year 1	Year 2
Net Operating Income as per Variable Costing	$ 40,000	$ 150,000
Closing Stock Quantity	5,000	-
Opening Stock Quantity	-	5,000
Difference in Stock Quantity (Closing - Opening)	5,000	(5,000)
Fixed Overhead per unit	$6	$6
Fixed Overhead on Difference Stock	30,000	(30,000)
Net Operating Income as per Absorption Costing	$ 70,000	$ 120,000

Explanation of Solution

1. Net operating income under variable costing is taken as a base;
2. Difference of stock quantity is computed as closing stock less opening stock
3. This difference in stock is multiplied with fixed overhead per unit. This will the amount of fixed overhead which has been deferred over to the next period;
4. Adding this fixed overhead amount to Net Operating Income as per Variable Costing will give Net Operating Income as per Absorption Costing.

Formulas:

Fixed Overhead per unit = Total fixed cost / Production quantity

Year	Fixed Cost	Production Quantity	Fixed cost per unit
Year 1	$ 270,000	45,000	$ 6
Year 2	$ 270,000	45,000	$ 6

Conclusion

1. In year 1, there is no opening stock but there is closing stock, As such, profit under absorption costing is higher (opening stock decreases profit and closing stock increases profit under absorption costing)
2. In year 2, there is opening stock but there is no closing stock, As such, profit under absorption costing is lower (opening stock decreases profit and closing stock increases profit under absorption costing)