Chapter 7, Problem 22P

Answer 1:

To determine

Variable Costing: In this method, those costs which vary directly with production are considered in unit 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.

Absorption Costing: In this method, those costs which vary directly with production are considered in unit product cost. Also, fixed Manufacturing Expenses are treated as product cost only. 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 under variable costing and absorption costing.

Answer to Problem 22P

Solution:

Computation of Unit Product Cost under Variable Costing
	July	August
Direct Material	$ 7	$ 7
Direct Labour	$ 10	$ 10
Variable Manufacturing Overhead	$ 5	$ 5
Total Product Cost	$ 22	$ 22
Computation of Unit Product Cost under Absorption Costing
	July	August
Direct Material	$ 7	$ 7
Direct Labour	$ 10	$ 10
Variable Manufacturing Overhead	$ 5	$ 5
Fixed Manufacturing Overhead	$ 18	$ 18
Total Product Cost	$ 40	$ 40

Explanation of Solution

1. In variable costing, direct material, direct labor and variable manufacturing expenses are considered for unit product cost;
2. In absorption costing, direct material, direct labor, variable manufacturing expenses and fixed manufacturing cost per unit are considered for unit product cost;
3. Fixed cost per unit is computed as Total manufacturing fixed cost/ Production quantity.

• Given:

Direct Material, Direct Labor and overhead costs are given in the question.

• Formulas:

  $\text{Fixed Cost per unit = }\frac{\text{Total manufacturing fixed cost}}{\text{Production Quantity}}$

• Calculation:

$\text{Fixed Cost per unit for July = }\frac{\text{\$ 315,000}}{\text{17,500 units}}$ = $ 18 per unit

$\text{Fixed Cost per unit for August = }\frac{\text{\$ 315,000}}{\text{17,500 units}}$ = $ 18 per unit

Conclusion

Unit Product cost under variable cost for July and August is $ 22 per unit and under absorption costing, it is $ 40 per unit for both July and August.

Answer 2:

To determine

Contribution format Income Statement: This is a statement prepared to assess net operating margin of a company.

Income Statements in Variable costing

Answer to Problem 22P

Solution:

Denton Company Income Statement (Contribution Format)

	July	August
Sales (A)	$ 900,000	$ 1,200,000
Cost of Goods Sold (B)	$ 330,000	$ 440,000
Variable selling and administrative expenses (C)	$ 45,000	$ 60,000
Contribution Margin (D = A − B − C)	$ 525,000	$ 700,000
Fixed Expenses (Manufacturing + Selling) (E)	$ 560,000	$ 560,000
Net Operating Income (D − E)	$ (35,000)	$ 140,000

Explanation of Solution

• Given:

Sales value, Variable selling expenses per unit

• Formulas:

$\text{Cost of Goods Sold = Sales Quantity }\times \text{ Unit Product Cost}$

$\text{Variable Selling Expense = Sales Quantity }\times \text{ variable Selling expenses per unit}$

$\text{Contribution = Sales Value }-\text{ Variable Cost of Goods Sold }-\text{ variable Selling Expenses}$

$\text{Net Operating Margin = Contribution Margin - Total fixed manufacturing and selling expenses}$

• Calculation:

$\text{Cost of Goods Sold for July = 15,000 units }\times \text{ \$ 22 per unit = \$ 330,000}$

$\text{Cost of Goods Sold for August = 20,000 units }\times \text{ \$ 22 per unit = \$ 440,000}$

$\text{Variable Selling Expense for July = 15,000 units }\times \text{ \$ 3 per unit = \$ 45,000}$

$\text{Variable Selling Expense for August = 20,000 units }\times \text{ \$ 3 per unit = \$ 60,000}$

$\text{Fixed Expenses for July \& August = \$ 315,000 + \$ 245,000 = \$ 560,000}$

$\text{Net Operating Income for July = \$ 525,000 }-\text{ \$ 560,000 = \$(35,000)}$

$\text{Net Operating Income for August = \$ 700,000 - \$ 560,000 = \$140,000}$

Conclusion

Net Operating Income for July is $ (35,000) and for August is $ 140,000 ’

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 22P

Solution:

Reconciliation
	July	August
Net Operating Income as per Variable Costing	$ (35,000)	$ 140,000
Closing Stock	2,500	-
Opening Stock	-	2,500
Difference in Stock (Closing - Opening)	2,500	(2,500)
Fixed Overhead per unit	$ 18	$ 18
Fixed Overhead on Difference Stock	45,000	(45,000)
Profit as per Absorption Costing	$ 10,000	$ 95,000

Explanation of Solution

• Given:

Net operating income, stock, fixed overhead per unit under variable costing have been taken from computations made above.

• Calculation:

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 (which is considered in unit product cost under absorption costing system). This will the amount of fixed overhead which has been deferred over to the next period;

  $\text{Fixed Overhead on difference stock for July = 2,500 units X \$ 18 per unit = \$ 45,000}$

$\text{Fixed Overhead on difference stock for August = (2,500) units X \$ 18 per unit = \$ (45,000)}$

$\text{Profit for July = \$ (35,000) + \$ 45,000 = \$ 10,000}$

$\text{Profit for August = \$ 140,000 - \$ 45,000 = \$ 95,000}$

Conclusion

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

Answer 4

To determine

Correctness of break-even point

Answer to Problem 22P

Solution:

Break-even point computed here is 16,000 units. Here, fixed manufacturing expenses have been considered as fixed cost only i.e. period cost. As such, this Break-even point can be used in Variable Costing.

In variable costing, the results are as under:

	July	August
Net Operating Income	$ (35,000)	$ 140,000
Sales Quantity	15,000	20,000
Break-even sales quantity	16000	16000
Difference in quantity (Actual - Breakeven)	(1,000)	4,000
Contribution per unit	$ 35	$ 35
Total contribution of difference quantity	$ (35,000)	$ 140,000

Total contribution is equal to Net operating Income under variable costing.

Explanation of Solution

Given:

Break-even point is given as 16,000 units

Profit under absorption costing is given as $ 10,000

Calculation:

Net operating income, sales quantity has been taken from computation in previous solutions.

$\text{Contribution on difference quantity for July = (1,000) units X \$ 35 = \$ (35,000)}$

$\text{Contribution on difference quantity for August = 4,000 units X \$ 35 = \$ 140,000}$

Conclusion

Hence, the break-even point of 16,000 units is correct and is applicable under Variable Costing.

Also, the profit of $ 10,000 is correct under absorption costing.