Chapter 7, Problem 3PA

During the first month of operations ended May 31, Big Sky Creations Company produced 40,000 designer cowboy boots, of which 36,000 were sold. Operating data for the month are summarized as follows:

During June, Big Sky Creations produced 32,000 designer cowboy boots and sold 36,000 cowboy boots. Operating data for June are summarized as follows:

Instructions

1. Using the absorption costing concept, prepare income statements for (a) May and (b) June.

2. Using the variable costing concept, prepare income statements for (a) May and (b) June.

3. a. Explain the reason for the differences in operating income in (1) and (2) for May.

b. Explain the reason for the differences in operating income in (1) and (2) for June.

4. Based on your answers to (1) and (2), did Big Sky Creations Company operate more profitably in May or in June? Explain.

To determine

Prepare an income statement according to the absorption costing concept for (a) May and (b) June.

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 are included as part of factory overhead.

(a)

Prepare an income statement according to the absorption costing concept for May.

Company BSC
Absorption costing income statement
For the month ending May, 31
Particulars	Amount ($)	Amount ($)
Sales		4,500,000
Less: Cost of goods sold
Cost of goods manufactured	3,600,000
Inventory on May, 31 (1)	(360,000)
Total cost of goods sold		(3,240,000)
Gross profit		1,260,000
Less: Selling and administrative expenses		(152,000)
Operating income		1,108,000

Table (1)

Working note (1):

Calculate the value of ending inventory, May 31.

$\begin{array}{c}\text{Ending inventory =}\frac{\text{Cost of good manufactured}}{\text{Units manufactured}}\times \text{units in ending inventory}\\ =\frac{\$3,600,000}{40,000\text{ Units}}\times 4,000\text{ units}\\ =\$360,000\end{array}$

(b)

Prepare an income statement according to the absorption costing concept for June.

Company BSC
Absorption costing income statement
For the month ending June, 30
Particulars	Amount ($)	Amount ($)
Sales		4,500,000
Less: Cost of goods sold
Cost of goods manufactured	2,904,000
Inventory on May, 31  (1)	360,000
Total cost of goods sold		3,264,000
Gross profit		1,236,000
Less: Selling and administrative expenses		152,000
Operating income		1,084,000

Table (2)

To determine

Prepare an income statement according to the variable costing concept for (a) May and (b) June.

Explanation of Solution

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 is treated as period (fixed) expense.

(a)

Prepare an income statement according to the variable costing concept for May.

Company BSC
Variable costing income statement
For the month ending May, 31
Particulars	Amount ($)	Amount ($)
Sales		4,500,000
Less: Variable cost of goods sold
Variable cost of goods manufactured	3,480,000
Inventory, May 31 (2)	(348,000)
Total variable cost of goods sold		(3,132,000)
Manufacturing margin		1,368,000
Less: Variable selling and administrative expenses		(72,000)
Contribution margin		1,296,000
Less: Fixed costs
Fixed manufacturing costs	120,000
Fixed selling and administrative expenses	80,000
Total fixed cost		(200,000)
Operating income		1,096,000

Table (3)

Working note (2):

Calculate the value of ending inventory, May 31.

$\begin{array}{c}\text{Ending inventory =}\frac{\text{Cost of good manufactured}}{\text{Units manufactured}}\times \text{Units in ending inventory}\\ =\frac{\$3,480,000}{40,000\text{ Units}}\times 4,000\text{units}\\ =\$348,000\end{array}$

(b)

Prepare an income statement according to the variable costing concept for June.

Company BSC
Variable costing income statement
For the month ending June, 30
Particulars	Amount ($)	Amount ($)
Sales		4,500,000
Less: Variable cost of goods sold
Variable cost of goods manufactured	2,784,000
Inventory on June 1 (1)	348,000
Total variable cost of goods sold		3,132,000
Manufacturing margin		1,368,000
Less: Variable selling and administrative expenses		(72,000)
Contribution margin		1,296,000
Less: Fixed costs
Fixed manufacturing costs	120,000
Fixed selling and administrative expenses	80,000
Total fixed cost		(200,000)
Operating income		1,096,000

Table (4)

To determine

Identify the reason for the difference between the amount of operating income reported in (1) and (2) for the month of May.

Explanation of Solution

The difference between the absorption and variable costing operating income of $12,000 $\left(\$1,108,000–\$1,096,000\right)$ is explained below:

Increase in inventory = 4,000 units $\left(40,000\text{ Units}-36,000\text{ Units}\right)$

Fixed factory overhead per unit = $3$\left(\frac{\$120,000}{40,000\text{ Units}}\right)$

$\begin{array}{c}\begin{array}{l}\text{Difference in income}\\ \text{ from operations}\end{array})\text{=}\left(\begin{array}{l}\text{Increase in inventory}\times \text{Fixed }\\ \text{factory overhead per unit}\end{array}\right)\\ \text{=}4,0\text{00}\text{units }\times \text{\$3}\text{per unit}\\ \text{=}\text{\$12,000}\end{array}$

The operating income reported for the month of May under absorption costing exceeds the variable costing by $12,000. This difference exists under absorption costing, because $12,000 of fixed manufacturing costs is included in ending inventory of May under absorption costing, while entire fixed manufacturing costs is expensed in the month of May itself under variable costing.

To determine

Identify the reason for the difference between the amount of operating income reported in (1) and (2) for the month of June.

Explanation of Solution

The difference between the absorption and variable costing income from operations of $12,000 $\left(\$1,096,000–\$1,084,000\right)$ is explained below:

The operating income reported for the month of June under absorption costing is less than variable costing by $12,000. This difference exists under absorption costing, because $12,000 of fixed manufacturing costs is included in beginning inventory of June under absorption costing, while entire fixed manufacturing costs is expensed in the month of May itself under variable costing.

To determine

Identify the month in which Company BSC operates more profitability, based on findings from (1) and (2).

Explanation of Solution

Based on variable costing concept, Company BSC was equally profitable in May and June. Sales and variable cost per unit were the same for both the month and under both concept. Only difference is allocation of $12,000 of fixed manufacturing cost to May 31 ending inventory under absorption costing.