Practice Question CVP / Absorption and Variable Costing Dec 2016

Q1. Dexter Corporation produces and sells a single product, a wooden hand loom for weaving small items such
as scarves. Selected cost and operating data relating to the product for two years are given below:

Selling price per unit ...................................... $50

Manufacturing costs:

Variable per unit produced:

Direct materials ...................................... $11
Direct labor ............................................. $6
Variable overhead ................................... $3

Fixed per year ............................................ $120,000

Selling and administrative costs:

Variable per unit sold .................................. $4
Fixed per year ............................................ $70,000

Year 1 Year 2
Units in beginning inventory ........................... 0 2,000
Units produced during the year ..................... 10,000 6,000
Units sold during the year .............................. 8,000 8,000
Units in ending inventory ............................... 2,000 0

Required:

1. Assume the company uses absorption costing.

a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.

2. Assume the company uses variable costing.

a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.

3. Reconcile the variable costing and absorption costing net operating incomes.

Q2. Chuck Wagon Grills, Inc., makes a single producta handmade specialty barbecue grill that it sells for
$210. Data for last years operations follow:

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Required:
1. Assume that the company uses variable costing. Compute the unit product cost for one barbecue grill.
2. Assume that the company uses variable costing. Prepare a contribution format income statement for the year.
3. What is the companys break-even point in terms of the number of barbecue grills sold?

Q3. High Country, Inc., produces and sells many recreational products. The company has just opened a new
plant to produce a folding camp cot that will be marketed throughout the United States. The following cost and
revenue data relate to May, the first month of the plants operation:

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Management is anxious to see how profitable the new camp cot will be and has asked that an income statement
be prepared for May.
Required:
1. Assume that the company uses absorption costing.
a. Determine the unit product cost.
b. Prepare an income statement for May.

2. Assume that the company uses variable costing.

a. Determine the unit product cost.
b. Prepare a contribution format income statement for May.

3. Explain the reason for any difference in the ending inventory balances under the two costing methods and the
impact of this difference on reported net operating income.

Q4.

Menlo Company distributes a single product. The companys sales and expenses for last month follow:

Required:
1. What is the monthly break-even point in units sold and in sales dollars?
2. Without resorting to computations, what is the total contribution margin at the break-even point?
3. How many units would have to be sold each month to earn a target profit of $90,000? Use the formula
method. Verify your answer by preparing a contribution format income statement at the target sales level.
4. Refer to the original data. Compute the companys margin of safety in both dollar and percentage terms.
5. What is the companys CM ratio? If sales increase by $50,000 per month and there is no change in fixed
expenses, by how much would you expect monthly net operating income to increase?

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Q2.

1. Under variable costing, only the variable manufacturing costs are included in product costs.
Direct materials............................................. $50
Direct labor.................................................... 80
Variable manufacturing overhead.................. 20
Variable costing unit product cost................. $150
Note that selling and administrative expenses are not treated as product costs; that is, they are not included
in the costs that are inventoried. These expenses are always treated as period costs.

2. The variable costing income statement appears below:

Sales....................................................................................... $3,990,000
Variable expenses:
Variable cost of goods sold (19,000 units $150 per
unit)................................................................................ $2,850,000
Variable selling and administrative expenses (19,000
units $10 per unit)....................................................... 190,000 3,040,000
Contribution margin.............................................................. 950,000
Fixed expenses:
Fixed manufacturing overhead.......................................... 700,000
Fixed selling and administrative expenses......................... 285,000 985,000
Net operating loss.................................................................. $ (35,000)

3. The break-even point in units sold can be computed using the contribution margin per unit as follows:
Selling price per unit............................. $210
Variable cost per unit............................. 160
Contribution margin per unit................. $50

Fixed expenses
Unit sales to break even =
Unit contribution margin
$985,000
= = 19,700 units
$50 per unit

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Q3.

1. a. The unit product cost under absorption costing is:

Direct materials................................................................................................ $20
Direct labor....................................................................................................... 8
Variable manufacturing overhead..................................................................... 2
Fixed manufacturing overhead ($100,000 10,000 units).............................. 10
Absorption costing unit product cost............................................................... $40

b. The absorption costing income statement is:

Sales (8,000 units $75 per unit)...................................................... $600,000
Cost of goods sold (8,000 units $40 per unit)................................ 320,000
Gross margin...................................................................................... 280,000
Selling and administrative expenses
[$200,000 + (8,000 units $6 per unit)]........................................ 248,000
Net operating income......................................................................... $32,000

2. a. The unit product cost under variable costing is:

Direct materials............................................... $20
Direct labor..................................................... 8
Variable manufacturing overhead................... 2
Variable costing unit product cost................... $30

b. The variable costing income statement is:

Sales (8,000 units $75 per unit)........................................... $600,000
Variable expenses:
Variable cost of goods sold
(8,000 units $30 per unit)............................................. $240,000
Variable selling expenses
(8,000 units $6 per unit)............................................... 48,000 288,000
Contribution margin................................................................ 312,000
Fixed expenses:
Fixed manufacturing overhead............................................ 100,000
Fixed selling and administrative expenses.......................... 200,000 300,000
Net operating income.............................................................. $ 12,000

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3. The difference in the ending inventory relates to a difference in the handling of fixed manufacturing
overhead costs. Under variable costing, these costs have been expensed in full as period costs. Under
absorption costing, these costs have been added to units of product at the rate of $10 per unit ($100,000
10,000 units produced = $10 per unit). Thus, under absorption costing a portion of the $100,000 fixed
manufacturing overhead cost for the month has been added to the inventory account rather than expensed on
the income statement:
Added to the ending inventory
(2,000 units $10 per unit)..................................................................... $20,000
Expensed as part of cost of goods sold
(8,000 units $10 per unit)..................................................................... 80,000
Total fixed manufacturing overhead cost for the month............................. $100,000
Because $20,000 of fixed manufacturing overhead cost has been deferred in inventory under absorption
costing, the net operating income reported under that costing method is $20,000 higher than the net
operating income under variable costing, as shown in parts (1) and (2) above.

Q4

1. Profit = Unit CM Q Fixed expenses

$0 = ($30 $12) Q $216,000
$0 = ($18) Q $216,000
$18Q = $216,000
Q = $216,000 $18
Q = 12,000 units, or at $30 per unit, $360,000

Alternative solution:

Unit sales = Fixed expenses

to break even Unit contribution margin

$216,000
=
= 12,000 units
$18
or at $30 per unit, $360,000

2. The contribution margin is $216,000 because the contribution margin is equal to the fixed expenses at the
break-even point.

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3. Units sold to attain= Target profit + Fixed expenses
target profit Unit contribution margin
$90,000 + $216,000
= = 17,000 units
$18

Total Unit
Sales (17,000 units $30 per unit)............................ $510,000 $30
Variable expenses
(17,000 units $12 per unit).................................. 204,000 12
Contribution margin.................................................. 306,000 $18
Fixed expenses........................................................... 216,000
Net operating income................................................ $90,000

4. Margin of safety in dollar terms:

Margin of safety = Total sales - Break-even sales
in dollars

= $450,000 - $360,000 = $90,000

Margin of safety in percentage terms:

Margin of safety=Margin of safety in dollars

percentage Total sales
$90,000
= = 20%
$450,000

5. The CM ratio is 60%.

Expected total contribution margin: ($500,000 60%)............................. $300,000

Present total contribution margin: ($450,000 60%)................................ 270,000
Increased contribution margin.................................................................... $ 30,000

Alternative solution:
$50,000 incremental sales 60% CM ratio = $30,000
Given that the companys fixed expenses will not change, monthly net operating income will also increase
by $30,000.