For release on 30 Jan.

2018

CHAPTER 7
Tutorial Questions

Discussion:
1. Explain how fixed manufacturing overhead costs are shifted from one period
to another under absorption costing.
Suggestion solution:
1. Under absorption costing, as a company manufactures units of product, the
fixed manufacturing overhead costs of the period are added to the units, along with
direct materials, direct labor, and variable manufacturing overhead. If some of these
units are not sold by the end of the period, then they are carried into the next period
as inventory. The fixed manufacturing overhead cost attached to the units in ending
inventory follow the units into the next period as part of their inventory cost. When
the units carried over as inventory are finally sold, the fixed manufacturing overhead
cost that has been carried over with the units is included as part of that period’s cost
of goods sold.

2. What arguments can be advanced in favor of treating fixed manufacturing

overhead costs as product costs?
Suggested solution:
2. Many accountants and managers believe absorption costing does a better job
of matching costs with revenues than variable costing. They argue that all
manufacturing costs must be assigned to products to properly match the costs of
producing units of product with the revenues from the units when they are sold. They
believe that the fixed costs of depreciation, taxes, insurance, supervisory salaries,
and so on, are just as essential to manufacturing products as are the variable costs.

3. What arguments can be advanced in favor of treating fixed manufacturing

overhead costs as period costs?
Suggested solution:
3. Advocates of variable costing argue that fixed manufacturing costs are not
really the cost of any particular unit of product. If a unit is made or not, the total
fixed manufacturing costs will be exactly the same. Therefore, how can one say that
these costs are part of the costs of the products? These costs are incurred to have the
capacity to make products during a particular period and should be charged against
that period as period costs according to the matching principle.

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4. If production exceeds sales, which method would you expect to show higher
net operating income, variable or absorption costing? Why?
Suggested solution:
4. If production exceeds sales, absorption costing will show higher net operating
income than variable costing. The reason is that inventories will increase and
therefore part of the fixed manufacturing overhead cost of the current period will be
deferred in inventory to the next period under absorption costing. By contrast, all of
the fixed manufacturing overhead cost of the current period will be charged
immediately against revenues as a period cost under variable costing.

Computation:
5. A company has £8.00 per unit in variable production cost and £3.00 per unit
in variable selling and administrative cost. The annual fixed production cost
is £300,000. The annual fixed selling and administrative cost is £50,000.
a. Complete the table below for the number of units and dollar value of
ending inventory for each year. Assume a FIFO flow.

2004 2005 2006 2007

Units Produced 120,000 150,000 100,000 100,000
Units Sold 110,000 120,000 140,000 100,000
Units in ending
inventory
Ending inventory
using variable
costing
Ending inventory
using full costing

b. Assume that the selling price and cost structure stayed the same over
the 4-year period. How would the total income compare over the
period between variable and full costing?

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5. Suggested Solution:
a.
2004 2005 2006 2007
Units Produced 120,000 150,000 100,000 100,000
Units Sold 110,000 120,000 140,000 100,000
Units in ending 10,000 40,000 0 0
inventory
Ending inventory £80,000 £320,000 0 0
using variable
costing
Ending inventory £105,000 £400,000 0 0
using full costing

b. Since sales equals production for the 4-year period, income would be the
same.

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6. The Dean Company produces and sells a single product--a microwave oven.
The following data refer to the year just completed:

£
Beginning inventory ................... 0
Units produced ......................... 20,000
Units sold ............................. 19,000
Sales price per unit ................... 350
Selling and administrative expenses:
Variable per unit .................... 10
Fixed (total) ........................ 225,000
Manufacturing costs:
Direct materials cost per unit ...... 190
Direct labor cost per unit .......... 40
Variable overhead cost per unit 25
Fixed overhead (total) ............... 250,000

Assume that direct labor is a variable cost.

Required:

a. Compute the cost of a single unit of product under both the absorption costing
and variable costing approaches.
b. Prepare an income statement for the year using absorption costing.
c. Prepare an income statement for the year using variable costing.
d. Reconcile the absorption costing and variable costing net income figures in (b)
and (c) above.

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Suggested Solution:

6a. Cost per unit under absorption costing:

£
Direct materials.................... 190.00
Direct labor........................ 40.00
Variable overhead.................. 25.00
Fixed overhead (£250,000 ÷ 20,000) 12.50
Total cost per unit................. £267.50

Cost per unit under variable costing:

£
Direct materials.................... 190.00
Direct labor........................ 40.00
Variable overhead................... 25.00
Total cost per unit................. £255.00

6b. Absorption costing income statement:

£
Sales................................. 6,650,000
Cost of goods sold:
Beginning inventory................... £ 0
Cost of goods manufactured
(20,000 @ £267.50) ................. 5,350,000
Cost of goods available............... 5,350,000
Less ending inventory
(1,000 units @ £267.50) ............ 267,500 5,082,500
Gross profit.......................... 1,567,500
Less selling and administrative expenses:
[(£10 x 19,000) + £225,000]......... 415,000
Net income............................ £1,152,500

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6c. Variable costing income statement:

£
Sales................................. 6,650,000
Cost of goods sold:
Beginning inventory................... £ 0
Cost of goods manufactured
(20,000 @ £255) .................... 5,100,000
Cost of goods available............. 5,100,000
Less ending inventory
(1,000 units @ £255) ............... 255,000
Variable cost of goods sold........... 4,845,000
Variable selling and administrative
expenses: (19,000 x £10)............ 190,000 5,035,000
Contribution margin................... 1,615,000
Less fixed expenses:
Manufacturing overhead............. £ 250,000
Selling and administrative............ 225,000 475,000
Net income............................ £1,140,000

6d.
£
Net income under variable costing..... 1,140,000
Add fixed manufacturing overhead costs
deferred in inventory under absorption
costing (1,000 units X £12.50) ......... 12,500
Net income under absorption costing... £1,152,500

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2007 (resit) examination question

Question 7 (17 Marks)

A company has a variable manufacturing cost of £3.00 per unit, a variable selling cost of £1.00 per unit; a
fixed manufacturing cost of £100,000 per year; and a fixed selling and administrative cost of £60,000 per
year. The selling price is £9.00 per unit. During the year, 50,000 units are produced and 42,000 units are
sold.

Required:
a. Prepare an income statement using variable costing. (5 marks)
b. Prepare an income statement using absorption costing. (5 marks)
c. Can a company continue to increase income indefinitely by using absorption costing?
(3 marks)
d. Explain how fixed manufacturing overhead costs are shifted from one period to another under
absorption costing. (4 marks)

Suggested solution to Question 1 (17 Marks)

7a. Sales (42,000 * 9) £378,000
Variable Mfg cost (42000 * 3) 126,000
Variable Selling cost (42000 * 1) 42,000 168,000
Contribution Margin £210,000
Fixed Costs: Production 100,000
S&A 60,000 £160,000
Income £ 50,000
(5 marks)

7b. Sales (42,000 * 9) £378,000

Cost of Goods sold (42,000 * 5) 210,000
Gross Profit £168,000
Selling and Admin (60,000 + 1*42,000) 102,000
Income £ 66,000
(5 marks)

7c. It is possible that a growing company can do this. The only way to do this is to produce more than
is sold in each year. This will result in a continuous buildup of inventory. For most companies,
that would not be a good strategy as it would lead to expensive cash outflow for buildups of
inventories along with all the associated carrying costs.
(3 marks)
7d. Under absorption costing, as a company manufactures units of product, the fixed manufacturing
overhead costs of the period are added to the units, along with direct materials, direct labor, and
variable manufacturing overhead. If some of these units are not sold by the end of the period, then
they are carried into the next period as inventory. The fixed manufacturing overhead cost attached
to the units in ending inventory follow the units into the next period as part of their inventory cost.
When the units carried over as inventory are finally sold, the fixed manufacturing overhead cost
that has been carried over with the units is included as part of that period’s cost of goods sold.
(4 marks)