Chapter 7, Problem 1PA

(a)

To determine

Calculate the income statement according to the absorption costing concept for the Company KF.

Explanation of Solution

Absorption Costing

Absorption costing is compulsory under Generally Accepted Accounting Principles (GAAP) for financial statements circulated to the external users. Under absorption costing, the cost of goods manufactured includes direct materials, direct labor, and factory overhead costs. Fixed factory overhead and variable factory overhead included as a part of factory overhead.

Variable Costing

Managers frequently use variable costing for internal purposes for taking decision making. The cost of goods manufactured includes direct materials, direct labor, and variable factory overhead. Fixed factory overhead treated as period (fixed) expense.

Calculate the income statement according to the absorption costing concept for the Company KF as shown below:

Company KF
Absorption costing income statement for the month ended
August, 31
Particulars	$	$
Sales		10,800,000
Less: Cost of goods sold
Cost of goods manufactured	9,600,000
Ending inventory (2)	(960,000)
Total cost of goods sold		8,640,000
Gross profit		2,160,000
Less: Selling and administrative expenses		1,260,000
Income from operations		900,000

Table (1)

Working note (1):

Calculate the value of ending inventory per unit.

$\begin{array}{c}\text{Ending inventory =}\frac{\text{Cost of good sold}}{\text{Units manufactured}}\\ =\frac{\$9,600,000}{80,000\text{ Units}}\\ =\$120\end{array}$

Working note (2):

Calculate the value of ending inventory

$\begin{array}{c}\text{Ending inventory = }\left[\begin{array}{l}\text{Units manufactured }\times \\ \text{Ending inventory rate per unit (1)}\end{array}\right]\\ =80,000\text{ Units}\times \text{\$120}\\ \text{=\$960,000}\end{array}$

Conclusion

Therefore, income from operations under absorption costing concept of Company KF is $900,000.

(b)

To determine

Calculate the income statement according to the variable cost concept for the Company KF.

Explanation of Solution

Calculate the income statement according to the variable costing concept for the Company KF as shown below:

Company KF
Variable costing income statement for the month ended
August, 31
Particulars	$	$
Sales		10,800,000
Less: Variable cost of goods sold
Variable cost of goods manufactured (3)	9,280,000
Ending inventory (5)	(928,000)
Total variable cost of goods sold		8,352,000
Manufacturing margin		2,448,000
Less: Variable selling and administrative expenses		1,080,000
Contribution margin		1,368,000
Less: Fixed costs
Fixed manufacturing costs	320,000
Fixed selling and administrative expenses	180,000
Total fixed cost		500,000
Income from operations		868,000

Table (2)

Working note (3):

Calculate cost of goods manufactured

$\begin{array}{c}\text{Cost of goods manufactured = }\left[\begin{array}{l}\text{Total manufacturing cost}-\\ \text{Fixed manufacturing cost}\end{array}\right]\\ =\$9,600,000-\$320,000\\ =\$9,280,000\end{array}$

Working note (4):

Calculate the value of ending inventory per unit.

$\begin{array}{c}\text{Ending inventory =}\frac{\text{Cost of good sold}}{\text{Units manufactured}}\\ =\frac{\$9,280,000}{80,000\text{ Units}}\\ =\$116\end{array}$

Working note (5):

Calculate the value of ending inventory

$\begin{array}{c}\text{Ending inventory = }\left[\begin{array}{l}\text{Units manufactured }\times \\ \text{Ending inventory rate per unit (4)}\end{array}\right]\\ =80,000\text{ Units}\times \text{\$116}\\ \text{=\$928,000}\end{array}$

Conclusion

Therefore, income from operations under variable costing concept of Company KF is $868,000.

(c)

To determine

Identify the reason for the difference between in the amount of income from operations reported in absorption costing income statement and variable costing income statement.

Explanation of Solution

The difference between the absorption and variable costing income from operations of $32,000 $\left(\$900,000–\$868,000\right)$ can be explained as follows:

Increase in inventory = 8,000 units $\left(80,000\text{ Units}-72,000\text{ Units}\right)$

Fixed factory overhead per unit = $4$\left(\frac{\$320,000}{80,000\text{ Units}}\right)$

$\begin{array}{c}\begin{array}{l}\text{Difference in income}\\ \text{ from operations}\end{array})\text{=}\left(\begin{array}{l}\text{Increase in inventory}\times \text{Fixed }\\ \text{factory overhead per unit}\end{array}\right)\\ \text{=}8,0\text{00}\text{units }\times \text{\$4}\text{per unit}\\ \text{=}\text{\$32,000}\end{array}$

Under absorption costing method, the fixed factory overhead cost included in the cost of goods sold is coordinated with the incomes. As an effect, 8,000 units that were produced, but unsold it includes fixed factory overhead cost, which is not involved in the cost of goods sold.

Under variable costing, all of the fixed factory overhead cost is subtracted in the period in which it is incurred, regardless of the amount of inventory change. Therefore, when inventory rises, the absorption costing income statement will have a higher income from operations than will the variable costing income statement.