Chapter 6, Problem 6E

EXERCISE 6-6 Variable and Absorption Costing Unit Product Costs and Income Statements L06-1, LO6-2

Lynch Company manufactures and sells a single product. The following costs were incurred during the company's first year of operations:

Variable costs per unit
Manufacturing:
Direct materials				$24
Direct labor				$14
Variable manufacturing overhead			$2
Variable selling and administrative			$4
Fixed costs per year
Fixed manufacturing overhead			$800,00
Fixed selling and administrative expense		$496,000

During the year, the company produced 25,000 units and sold 20,000 units. The selling price of the company's product is $50 per unit.
Required:
Assume that the company uses absorption costing:
Compute the unit product cost.
Prepare an income statement for the year.
Assume that the company uses variable costing:
Compute the unit product cost.
Prepare an income statement for the year.

To determine

The absorption costing is a technique where the all the cost relating to manufacturing (whether fixed or variable) shall be taken in to consideration, whereas in variable costing, only variable cost of manufacturing is taken into consideration while valuing inventory.

Requirement1a:

The cost per unit produced under absorption costing method.

Answer to Problem 6E

Solution: The cost per unit produced under absorption costing method is $30.

Explanation of Solution

Under Absorption costing, the total cost of manufacturing the goods includes the direct material cost, direct labour cost and manufacturing overheads (whether fixed and variable). On the basis of total cost of manufacturing, the cost per unit produced shall be computed.

Under Absorption costing, the product unit cost shall be computed as under:

STATEMENT SHOWING UNIT PRODUCT COST UNDER ABSORPTION COSTING
	AMOUNT $
Total cost of manufacturing:
Direct Material (25000 units @$6 per unit)	150,000
Direct Labour (25000 units@ $9 per unit)	225000
Variable manufacturing Overheads (25000 units@ $3)	75000
Fixed manufacturing Overheads	300,000
TOTAL MANUFACTURING COST	750,000
Divide by: Number of units produced	25,000
PRODUCT UNIT COST	30

Conclusion

To conclude, it must be said that the total cost under Absorption costing includes all the direct material, direct labour and total manufacturing overheads (whether fixed or variable).

To determine

To show: The Income Statement as per Absorption costing.

Answer to Problem 6E

Solution: The Income Statement as per Absorption costing shall be made as under:

INCOME STATEMENT UNDER ABSORPTION COSTING
	AMOUNT $
Sales Revenue (20000 units@ $ 50 per unit)	1000000
Less: Cost of Goods sold (20,000 units @30)	600000
Gross Margin	400,000
Less: Selling overheads
Variable selling overheads (20,000 units@ $ 4)	80,000
Fixed Selling overheads	190,000
NET OPERATING INCOME	130,000

Explanation of Solution

Under Absorption costing, the cost of goods sold shall be prepared on the basis of product unit cost as computed above. The Gross margin shall be the net of revenue over cost of goods sold. Then the total selling overheads shall be deducted from Gross margin to arrive at the Net operating income under Absorption costing.

Conclusion

To conclude, it must be said that the net operating income shall be generated by deducting the cost of goods sold and total selling overheads from the sales revenue under Absorption costing.

To determine

The unit product cost under variable costing.

Answer to Problem 6E

Solution: The unit product cost under variable costing is $18.

Explanation of Solution

Under variable costing, the total cost of manufacturing shall be considered on the basis of direct material cost, direct labour cost and variable manufacturing overheads and per unit cost of goods produced shall be determined accordingly.

The direct material and direct labour cost is a cost related to manufacturing which is variable in nature and is included in the total cost of manufacturing in both absorption and variable costing techniques. The difference between both the techniques is the inclusion of manufacturing overheads in the total cost of manufacturing. Under absorption costing, all manufacturing overheads are taken into consideration while computing total cost of manufacturing. In variable costing, only variable manufacturing overheads are taken into consideration for computing the total cost of manufacturing.

The product unit cost under variable costing shall be computed as under:

STATEMENT SHOWING UNIT PRODUCT COST UNDER VARIABLE COSTING
	AMOUNT $
Total cost of manufacturing:
Direct Material (25000 units @$6 per unit)	150,000
Direct Labour (25000 units@ $ 9 per unit)	225000
Variable manufacturing Overheads (25000 units@ $3)	75000
TOTAL MANUFACTURING COST	450,000
Divide by: Number of units produced	25,000
PRODUCT UNIT COST	18

Conclusion

To conclude, it must be said that the manufacturing cost includes the cost of manufacturing of variable nature only and does not include fixed manufacturing overheads.

To determine

To prepare: The income statement under Variable costing.

Answer to Problem 6E

Solution: The Income statement under Variable costing shall be made as under:

INCOME STATEMENT UNDER VARIABLE COSTING
	AMOUNT $
Sales Revenue (20,000 units@ $ 50 per unit)	1,000,000
Less: Variable cost
Cost of goods sold (20,000 units @$18 per unit)	360,000
Selling Overheads (20,000 units@$4 per unit)	80,000
Contribution margin	560,000
Less: Fixed cost
Fixed Manufacturing overheads	300,000
Fixed Selling overheads	190,000
NET OPERATING INCOME	70,000

Explanation of Solution

Under Variable costing, the cost of goods sold is valued at unit product cost computed. The contribution margin earned shall be computed by deducting the cost of goods sold and variable selling overheads from Sales revenue. The Total fixed cost including the manufacturing overheads shall be deducted from the contribution margin to compute the net operating income.

Conclusion

To conclude, it must be said that the difference between absorption and variable costing technique is the inclusion of fixed manufacturing overheads in absorption costing in valuation of Ending inventory which is not so in case of Variable costing technique.