Problem 6 - 21: Prepare & Reconcile Variable Costing Statements Given: Linden Company manufactures and sells a single

product. Cost data for the product follow: Variable costs per unit: Direct materials Direct labor Variable factory overhead Variable selling & administrative Total variable costs per unit Fixed costs per month: Fixed manufacturing overhead Fixed selling & administrative Total fixed cost per month

$6.00 12.00 4.00 3.00 $25.00

$240,000 180,000 $420,000

The product sells for $40 per unit. Production and sales data for May and June, the first two months of operations, are as follows; $40.00 Units Produced 30,000 30,000 Units Sold 26,000 34,000

May June

Income statements prepared by the Accounting department, using absorption costing, are presented below: May June Sales $1,040,000 $1,360,000 Cost of goods sold Beginning inventory $0 $120,000 $120,000 Add cost of goods manufactured 900,000 900,000 $900,000 Goods available for sale $900,000 $1,020,000 Less ending inventory 120,000 0 $120,000 Cost of goods sold $780,000 $1,020,000 Gross margin $260,000 $340,000 Selling & administrative expenses 258,000 282,000 $258,000 $282,000 Operating income $2,000 $58,000 Required: 1. Determine the unit product cost under: a. Absorption costing b. Variable costing Absorption Costing $6.00 12.00 4.00 8.00 $30.00 Variable Costing $6.00 12.00 4.00 $22.00

Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($240,000/30,000)

2. Prepare variable costing income statements for May and June using the contribution approach. Linden Company Variable Costing Income Statements For the Months of May and June Sales (26,000 X $40; 34,000 X $40) Variable expenses: Variable cost of goods sold Variable selling & administrative Total variable expenses Contribution margin Fixed expenses: Fixed manufacturing overhead Fixed selling & administrative Total fixed expenses Operating income (loss) May $1,040,000 $572,000 78,000 $650,000 $390,000 $240,000 180,000 $420,000 ($30,000) June $1,360,000 $748,000 102,000 $850,000 $510,000 $240,000 180,000 $420,000 $90,000

3. Reconcile the variable costing and absorption costing net operating income figures May June Operating variable costing income (loss) ($30,000) $90,000 Adjustment for Change in inventory during May Production 30,000 Sales 26,000 Increase in inventory 4,000 Fixed MOH rate $8.00 Fixed $ deferred in inventory $32,000 32,000 Operating absorption costing income (loss) $2,000 Adjustment for Change in inventory during June Production 30,000 Sales 34,000 Decrease in inventory (4,000) Fixed MOH rate $8.00 Fixed $ released from inventory ($32,000) (32,000) Operating absorption costing income (loss) $58,000 4. The company's Accounting Department has determined the break-even point to be 28,000 units per month, computed as follows: Fixed cost per month/Unit contribution margin = $420,000/$15 per unit = 28,000 units Upon receiving this figure, the president commented, "There's something peculiar here. The controller says that the break-even point is 28,000 per month. Yet we sold only 26,000 units in May, and the income statement we received showed a $2,000 profit. Which figure do we believe?" Prepare a brief explanation of what happened on the May income statement. The break-even analysis above assumes that all of Linden Company's $420,000 of monthly fixed costs will be recognized as expenses each month in its monthly income statements. If Linden Company uses a variable costing approach to measuring operating income, then this assumption

will hold true. However, if the absorption costing approach is used to measure operating income, this assumption will hold true only when production is equal to sales. In May, production was greater than sales by 4,000 units. Therefore, $32,000 (4,000 X $8) of fixed MOH costs was deferred in ending inventory to future periods. This $32,000 of deferred fixed MOH costs will be recognized in future periods as expense items when the inventory units to which these costs are assigned are sold. Fewer units need to be sold to B/E since recognized fixed costs are $32,000 less. Current sales B/E = ($420,000 - $32,000)/$15 = Sales greater than B/E CM per unit sold Operating income -- 26,000 sales 26,000.00 25,866.67 133.33 $15.00 $2,000.00

Thus, both are correct depending on underlying assumptions. Normal B/E analysis assumes production = sales. This assumption equates operating income measured under variable costing with operating income measured under absorption costing. Since production is greater than sales during May, operating income is greater when measured using an absorption costing approach than when using a variable costing approach.

Problem 6 - 25: Prepare and Interpret Statements; Changes in both Sales and Production; Lean Production Given: Memotec, Inc. manufactures and sells a unique electronic part. Operating results for the first three years of activity were as follows (absorption costing basis): Absorption Costing Sales Cost of goods sold Beginning inventory Add: Cost of goods manufactured Cost of goods available for sale Less: Ending Inventories Cost of goods sold Gross margin Selling and administrative expenses Net operating income (Loss) Year 1 $1,000,000 $0 800,000 $800,000 0 $800,000 $200,000 170,000 $30,000 Year 2 $800,000 $0 840,000 $840,000 280,000 $560,000 $240,000 150,000 $90,000 Year 3 $1,000,000 $280,000 760,000 $1,040,000 190,000 $850,000 $150,000 170,000 ($20,000)

Sales dropped by 20% during Year 2 due to the entry of several foreign competitors into the market. Memotec had expected sales to remain constant at 50,000 units for the year; production was set at 60,000 units in order to build a buffer of protection against unexpected spurts in demand. By the start of Year 3, management could see that spurts in demand were unlikely and that the inventory was excessive. To work off the excessive inventories, Memotec cut back production during Year 3, as shown below: Total Year 1 Year 2 Year 3 Production in units 150,000 50,000 60,000 40,000 Sales in units 140,000 50,000 40,000 50,000 P>S P=S P>S P<S Additional information about the company follows: a. The company's plant is highly automated. Variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead) total only $4 per unit, and FMOH costs total $600,000 per year. b. FMOH costs are applied to units of product on the basis of each year's production. (That is, a new FMOH rate is computed each year). c. Variable selling and administrative expenses are $2 per unit sold. Fixed selling & administrative expenses total $70,000 d. The company uses a FIFO inventory flow assumption Memotec's management can't understand why profits tripled during Year 2 when sales dropped by 20%, and why a loss was incurred during Year 3 when sales recovered to previous levels. Required: 1. Prepare a contribution format income statement for each year using variable costing.
Unit Sales 50,000 40,000 50,000

Variable Costing Sales Variable expenses:

$20

Year 1 $1,000,000

Year 2 $800,000

Year 3 $1,000,000

Cost of goods sold ($4 per unit sold) Selling & administrative ($2/unit sold) Total variable expenses Contribution margin Fixed expenses: Manufacturing overhead Selling and administrative expenses Total fixed expenses Net operating income (Loss)

$4 $2 $14

$200,000 100,000 $300,000 $700,000 $600,000 70,000 $670,000 $30,000

$160,000 80,000 $240,000 $560,000 $600,000 70,000 $670,000 ($110,000)

$200,000 100,000 $300,000 $700,000 $600,000 70,000 $670,000 $30,000

2. Refer to the absorption costing income statements above. a. Compute the unit product cost in each year under absorption costing. Calculation of unit product costs Variable cost of goods sold Fixed manufacturing costs Unit product costs Year 1 $4 12 $16 Year 2 $4 10 $14 Year 3 $4 15 $19

b. Reconcile the variable costing and absorption costing NOI figure for each year. P=S P>S P<S Year 1 Year 2 Year 3 NOI -- Variable Costing $30,000 ($110,000) $30,000 Change in inventory Year 2 Production 60,000 Sales 40,000 Inventory increase 20,000 FMOH rate Year 2 $10 Deferred FMOH Costs $200,000 200,000 Change in inventory Year 3 Fifo Cost Flow Released from EI Y2 FMOH rate Year 2 BI Y3 Units Production Sales EI Y3 Units FMOH Rate Year 3 Deferred FMOH Year 3 NOI -- Absorption Costing NOI -- Absorption Costing

20,000 $10 20,000 40,000 (50,000) 10,000 $15 $150,000 $30,000 $30,000 OK $90,000 $90,000 OK

(200,000)

150,000 ($20,000) ($20,000) OK

3. Refer again to the absorption costing income statements. Explain why NOI was higher in Year 2 than it was in Year 1 under the absorption approach, in light of the fact that fewer units were sold in Year 2 than in Year 1. Decrease in CM in Year 2 (real change) FMOH costs deferred in inventory (accounting change) ($140,000) 200,000 ($140,000)

Increase in NOI

$60,000

4. Refer again to the absorption costing income statements. Explain why the company suffered a loss in Year 3 but reported a profit in Year 1, although the same number of units were sold in each year. Based on a FIFO inventory flow assumption: FMOH costs from Year 2 released from Year 3 BI to COGM (20,000 X $10) FMOH costs from Year 3 deferred in EI of Year 3 (10,000 X $15) Differences in NOI (Year 1 compared with Year 3)

$200,000 150,000 $50,000

5. a. Explain how operations would have differed in Year 2 and Year 3 if the company had been using Lean Production with the result that ending inventory was zero. With Lean Production, production would have been geared to sales in each year so that little or no inventory of finished goods would have been built up in either Year 2 or Year 3. b. If Lean Production had been in use during Year 2 and Year 3, what would the company's net operating income (or loss) have been in each year under absorption ?? costing? Explain the reason for any differences between these income figures and the figures reported by the company in the statements above. If Lean Production had been in use, the NOI under absorption costing would have been the same as under variable costing in all three years. With production geared to sales, there would have been no ending inventory on hand, and therefore there would have been no FMOH costs deferred in inventory to other years. Assuming that the company expected to sell 50,000 units in each year and that unit product costs were set on the basis of that level of expected activity, the income statements under absorption costing would have been Year 1 50,000 50,000 Year 1 $1,000,000 $0 200,000 600,000 $800,000 0 $800,000 $200,000 170,000 $30,000 $30,000 Year 2 40,000 40,000 Year 2 $800,000 $0 160,000 480,000 120,000 $760,000 0 $760,000 $40,000 150,000 ($110,000) ($110,000) Year 3 50,000 50,000 Year 3 $1,000,000 $0 200,000 600,000 $800,000 0 $800,000 $200,000 170,000 $30,000 $30,000

Sales in units Production (matched to sales) Absorption Costing Sales Cost of goods sold Beginning inventory New mfg. costs added: Variable manufacturing costs ($4) Fixed mfg. costs applied ($12) Underapplied overhead Cost of goods available for sale Ending Inventories Cost of goods sold Gross margin Selling and administrative expenses Net operating income (Loss) Note: Same as Variable Costing Variable Costing NOI

Problem 7 - 16: Variable Costing Income Statements; Sales Constant; Production Varies Given: "Can someone explain to me what's wrong with these statements?" asked Cheri Reynolds, president of Milex Corporation. "They just don't make sense. We sold the same number of units this year as we did last year, yet our profits have tripled! Who messed up the calculations?" The absorption costing income statements to which Ms. Reynolds was referring are shown below: Units Units Sales 40,000 40,000 Production 40,000 50,000 Var. mfg. $/unit $6 $6 Var. S&A $/unit $2 $2 FMOH $ $600,000 $600,000 FMOH $/unit $15 $12 Year 1 Year 2 Sales (40,000 units each year) $31.25 $1,250,000 $1,250,000 $31.25 Cost of goods sold $840,000 840,000 720,000 $720,000 Gross margin $410,000 $530,000 Selling & administrative expense $80,000 350,000 350,000 $80,000 Net operating income $60,000 $180,000 Milex Corporation applies FMOH costs to its only product on the basis of each year's production. Required: 1. Compute the unit product cost for each year under: a. Absorption costing b. Variable costing Year 1 Year 2 Year 1 Absorption Absorption Variable Costing Costing Costing Variable mfg. $6.00 $6.00 $6.00 Fixed MOH 15.00 12.00 N/A $21.00 $18.00 $6.00

$270,000

Year 2 Variable Costing $6.00 N/A $6.00

2. Prepare a contribution format income statement for each year using variable costing Milex Corporation Variable Costing Contribution Format Income Statement For Year 1 and Year 2 Sales Variable expenses: Cost of goods sold Selling & Administrative Total variable expenses Contribution margin Fixed expenses: Fixed manufacturing overhead $1,250,000 $240,000 80,000 $320,000 $930,000 $600,000 $1,250,000 $240,000 80,000 $320,000 $930,000 $600,000

Fixed selling & administrative Total fixed expenses Net operating income

270,000 $870,000 $60,000

270,000 $870,000 $60,000

3. Reconcile the variable costing and absorption costing net operating income figures for each year. Year 1 $60,000 40,000 40,000 0 $15.00 $0 50,000 40,000 10,000 $12.00 $120,000 Year 2 $60,000

Operating variable costing income Adjustment for Change in inventory during Year Production Sales Increase in inventory Fixed MOH rate Fixed $ deferred in inventory Operating absorption costing income

0 $60,000

120,000 $180,000

4. Explain to the president why the net operating income for Year 2 was higher than for Year 1 under absorption costing, although the same number of units was sold in each year. Year 2 production was greater than Year 2 sales (P>S). The excess production resulted in inventory increasing by 10,000 units. Each of these inventory units has FMOH costs of $12 assigned to them under absorption costing. Thus $120,000 (10,000 X $12) of FMOH incurred in Year 2 was capitalized as inventory costs. These deferred costs will not be expensed until these units are sold. In Year 1, production was equal to sales (P=S). No inventory increase resulted to defer some of the FMOH costs incurred in Year 1 to future years. Thus, all $600,000 of FMOH costs incurred in Year 1 are expensed in Year 1. In Year 2, FMOH costs incurred also totaled $600,000. But, only $480,000 of these costs are expensed in Year 2. The remaining $120,000 are deferred in inventory to future time periods. This strange result occurs because under the traditional absorption costing approach, NOI is a function of both production and sales. Managers may manipulate NOI by adjusting production up (higher NOI) or down (lower NOI) A variable costing approach to income determination results in all FMOH costs being expensed in the year of occurrence; net operating income is a function of sales and can not be manipulated by merely increasing or decreasing production. Hence, managers prefer absorption costing for external reporting. 5. a. Explain how operations would have differed in Year 2 if the company had been using Lean Production and inventories had been "eliminated." Production must equal sales for there to be no inventory increases or decreases. When P = S, direct costing and absorption costing result in identical measures of NOI. If production is geared to sales estimates and sales estimates are correct, then inventories are minimal. Thus, Lean Production strategy would eliminate major inventories, and differences between NOI calculated using absorption costing and variable costing would be minimal. In addition, costs associated with carrying inventories would be minimal resulting in more efficient operations.

However, the risk of stock outs must not be overlooked. 5. b. If Lean Production had been in use during Year 2 and ending inventories were zero, what would the company's NOI have been under absorption costing? NOI would have been $60,000, the same as Year 1. There would have been no inventory build up and therefore no deferral of FMOH cost to a later time period. NOI reported would be $60,000 in both years under both costing methods (absorption costing, variable costing).

Problem 6-24: Incentives Created by Absorption Costing; Ethics and the Manager Given: Aristotle Constantinos, the manager of DuraProducts' Australian Division, is trying to set the production schedule for the last quarter of the year. The Australian Division had planned to sell 100,000 units during the year, but current projections indicate sales will be only 78,000 units in total. By September 30 the following activity had been reported: Units Inventory, January 1 0 Production 72,000 Sales 60,000 Inventory, September 30 12,000 Demand has been soft, and the sales forecast for the last quarter is only 18,000 units. The division can rent warehouse space to store up to 30,000 units. The division should maintain a minimum inventory level of at least 1,500 units. Mr. Constantinos is aware that production must be at least 6,000 units per quarter in order to retain a nucleus of key employees. Maximum production capacity is 45,000 units per quarter. Due to the nature of the division's operations, fixed manufacturing overhead is a major element of product cost. Required: 1. Assume that the division is using variable costing. How many units should be scheduled for production during the last quarter of the year? (The basic formula for computing the required production for a period in a company is: Expected sales + Desired ending inventory - Beginning inventory = Required production.) Show computations and explain your answer. Will the number of units scheduled for production affect the division's reported profit for the year? Explain. Expected sales for the last quarter of the year Desired minimum inventory Total units needed for sales and desired EI Less: Current inventory on hand -- September 30 Desired production for the 4th quarter 18,000 1,500 19,500 ** 12,000 7,500 ***

** Inventory should be drawn down to save inventory carrying costs such as storage (rent, insurance), interest, and obsolescence. *** Production exceeds 6,000 units needed to "retain a nucleus of key employees" The number of units scheduled for production will not affect the reported operating income or loss for the year if variable costing is in use. All fixed MOH costs will be treated as an expense of the period regardless of the number of units produced. Thus, no fixed MOH cost will be shifted between periods through the inventory account, and income will be a function of the number of units sold, rather than a function of the number of units produced and sold. 2. Assume that the division is using absorption costing and that the divisional manager is given an annual bonus based on the division's net operating income. If Mr. Constantinos wants to maximize his division's net operating income for the year, how many units should be scheduled for production during the last quarter? Explain.

Expected sales for the last quarter of the year Maximum inventory storage facilities available Total units needed for sales and desired EI Less: Current inventory on hand -- September 30 Desired production for the 4th quarter ** Storage capacity for 30,000 units can be rented. *** Does not exceed the 45,000 quarterly production capacity

18,000 30,000 ** 48,000 12,000 36,000 ***

By building inventory to maximum levels, Mr. Constantinos will be able to defer a portion of the year's fixed MOH to future years through the inventory account, rather than having all of these costs appear as charges on the current year's income statement. Thus, by producing enough units to build inventory to the maximum level that storage facilities will allow, Mr. Constantinos could relieve the current year of FMOH cost and thereby maximize the current year's net operating income (and his bonus). 3. Identify the ethical issues involved in the decision Mr. Constantinos must make about the level of production for the last quarter of the year Production options: 1. Production schedule designed to draw down inventory 2. Production schedule designed to maximize divisional manager's annual bonus

7,500 36,000

By setting a production schedule that will maximize his division's net operating income -- and maximize his own bonus -- Mr. Constantinos will be acting against the best interests of the company as a whole. The extra units aren't needed and will be expensive to carry in inventory. Moreover, there is no indication that demand will be any better next year than it has been in the current year, so the company may be required to carry the extra units in inventory a long time before they are ultimately sold. The company's bonus plan undoubtedly is intended to increase the company's profits by increasing sales and controlling expenses. If Mr. Constantinos sets a production schedule as shown in part (2) above, he will obtain his bonus as a result of sales and production rather than as a result of sales. Moreover, he will obtain it by creating greater expenses --rather than fewer expenses -- for the company as a whole. Producing as much as possible so as to maximize the division's net operating income and the manager's bonus would be unethical because it subverts the goals of the overall organization.

Exercise 6-14: Working with a Segmented Income Statement Given: Marple Associates is a consulting firm that specializes in information systems for construction and landscaping companies. The firm has two offices -- one in Houston and one in Dallas. The firm classifies the direct costs of consulting jobs as variable costs. A segmented contribution format income statement for the company's most recent year is given below: Office Total Company Houston Dallas $750,000 100.00% $150,000 100.00% $600,000 100.00% 405,000 54.00% 45,000 30.00% 360,000 60.00% $345,000 46.00% $105,000 70.00% $240,000 40.00% 168,000 22.40% 78,000 52.00% 90,000 15.00% $177,000 23.60% $27,000 18.00% $150,000 25.00% 120,000 $57,000 16.00% 7.60%

Sales Variable expenses Contribution margin Traceable fixed expenses Market segment margin Common fixed expenses (not traceable to offices) Net operating income

Required: 1. By how much would the company's net operating income increase if Dallas increased its sales by $75,000 per year? Assume no change in cost behavior patterns. Increase in Dallas sale Contribution margin ratio Increase in Company's NOI $75,000 40.00% $30,000

2. Refer to the original data. Assume that sales in Houston increased by $50,000 next year and that sales in Dallas remain unchanged. Assume no change in fixed costs. a. Prepare a new segmented income statement for the company using the above format. Show both amounts and percentages.
Office Total Company Sales Variable expenses Contribution margin Traceable fixed expenses Market segment margin Common fixed expenses (not traceable to offices) Net operating income 120,000 $92,000 15.00% 11.50% $800,000 420,000 $380,000 168,000 $212,000 100.00% 52.50% 47.50% 21.00% 26.50% Houston $200,000 60,000 $140,000 78,000 $62,000 100.00% 30.00% 70.00% 39.00% 31.00% Dallas $600,000 360,000 $240,000 90,000 $150,000 100.00% 60.00% 40.00% 15.00% 25.00%

b. Observe from the income statement you have prepared that the CM ratio for Houston has remained unchanged at 70% (the same as in the above data) but that the segment margin ratio has changed. How do you explain the change in the segment margin ratio? The traceable fixed expenses are spread over a larger base as sales increase.

Therefore, the segment margin ratio increase from 18% to 31%. The contribution margin ratio remains stable at 70% because there is no information to suggest that the selling price per unit or the variable cost per unit have changed. Exercise 6-15: Working with a Segmented Income Statement Given: Refer to the data in Exercise 12-11. Assume that Dallas' sales by major market are as follows: Dallas: Market Clients Dallas Office Construction Landscaping Sales $600,000 100.00% $400,000 100.00% $200,000 100.00% Variable expenses 360,000 60.00% 260,000 65.00% 100,000 50.00% Contribution margin $240,000 40.00% $140,000 35.00% $100,000 50.00% Traceable fixed expenses 72,000 12.00% 20,000 5.00% 52,000 26.00% Market segment margin $168,000 28.00% $120,000 30.00% $48,000 24.00% Common fixed expenses (not traceable to markets) 18,000 3.00% Net operating income $150,000 25.00% The company would like to initiate an intensive advertising campaign in one of the two markets during the next month. The campaign would cost $8,000. Marketing studies indicate that such a campaign would increase sales in the construction market by $70,000 or increase sales in the landscaping market by $60,000. Required: 1. In which of the markets would you recommend that the company focus its advertising campaign? The company should focus its campaign on Landscaping Clients.
Construction Clients Increased sales from campaign CM ratio for market client Increase in contribution margin Less cost of the campaign Increased segment margin & NOI $70,000 35.00% $24,500 8,000 $16,500 Landscaping Clients $60,000 50.00% $30,000 8,000 $22,000

2. In Exercise 6-14, Dallas shows $90,000 in traceable fixed expenses. What happened to the $90,000 in this exercise?
The $90,000 of traceable fixed cost to Dallas has been accounted for as follows: Construction Dallas Traceable fixed costs Common fixed expenses (not traceable to markets) Total 18,000 $90,000 $72,000 Clients $20,000 Landscaping Clients $52,000