accounting

Question #1

Consider the following information:

	Q1	Q2	Q3
Beginning inventory (units)	0	2,000	1,000
Budgeted units to be produced	300,000	300,000	300,000
Actual units produced	296,000	301,000	302,000
Units sold	294,000	302,000	302,000
Variable manufacturing costs per unit produced	$40	$40	$40
Variable selling costs per unit sold	$10	$10	$10
Fixed manufacturing costs	$3,000,000	$3,000,000	$3,000,000
Fixed selling costs	$1,000,000	$1,000,000	$1,000,000
Selling price per unit	$70	$70	$70

There are no price, efficiency, or spending variances, and any production-volume variance is directly written off to cost of goods in the quarter in which it occurs.

a) Prepare income statements for Q1, Q2, and Q3 using variable costing and absorption costing.

Variable costing	Q1	Q2	Q3
Revenue	$20,580,000	$21,140,000	$21,140,000
Variable cost of goods sold	$11,760,000	$12,080,000	$12,080,000
Variable selling costs	$2,940,000	$3,020,000	$3,020,000
Contribution margin	$5,880,000	$6,040,000	$6,040,000
Fixed manufacturing costs	$3,000,000	$3,000,000	$3,000,000
Fixed selling costs	$1,000,000	$1,000,000	$1,000,000
Operating Income	$1,880,000	$2,040,000	$2,040,000
Beginning inventory	$0	$80,000	$40,000
Variable manufacturing costs	$11,840,000	$12,040,000	$12,080,000
Variable cost of goods available for sale	$11,840,000	$12,120,000	$12,120,000
Ending inventory	$80,000	$40,000	$40,000
Variable cost of goods sold	$11,760,000	$12,080,000	$12,080,000

Absorption costing	Q1	Q2	Q3
Revenue	$20,580,000	$21,140,000	$21,140,000
Cost of goods sold	$14,740,000	$15,090,000	$15,080,000
Gross margin	$5,840,000	$6,050,000	$6,060,000
Variable selling costs	$2,940,000	$3,020,000	$3,020,000
Fixed selling costs	$1,000,000	$1,000,000	$1,000,000
Operating Income	$1,900,000	$2,030,000	$2,040,000
Beginning inventory	$0	$100,000	$50,000
Variable manufacturing costs	$11,840,000	$12,040,000	$12,080,000
Allocated fixed manufacturing costs	$2,960,000	$3,010,000	$3,020,000
Cost of goods available for sale	$14,800,000	$15,150,000	$15,150,000
Ending inventory	$100,000	$50,000	$50,000
Initial COGS	$14,700,000	$15,100,000	$15,100,000
Adjustment for PVV	$40,000	-$10,000	-$20,000
Final COGS	$14,740,000	$15,090,000	$15,080,000
Allocated fixed manufacturing costs	$2,960,000	$3,010,000	$3,020,000
PVV positive (negative) = unfav (fav)	$40,000	($10,000)	($20,000)

b) Explain the differences in operating income between the two costing systems for each quarter. Be specific!

	Q1	Q2	Q3
Absorption operating income	$1,900,000	$2,030,000	$2,040,000
Variable operating income	$1,880,000	$2,040,000	$2,040,000
Difference	$20,000	($10,000)	$0
Change in Inventory, Absorption	$100,000	($50,000)	$0
Change in Inventory, Variable	$80,000	($40,000)	$0
Difference	$20,000	($10,000)	$0
Units in ending inventory	2,000	1,000	1,000
Units in beginning inventory	0	2,000	1,000
Difference	2,000	-1,000	0
Fixed manufacturing in EI	$20,000	$10,000	$10,000
Fixed manufacturing in BI	$0	$20,000	$10,000
Difference	$20,000	($10,000)	$0

In Q1, absorption income is $20,000 higher. We can explain this in two different ways. First, since inventory increased by $20,000 more under absorption costing, income will be $20,000 higher. Another way is to focus on the change in the amount of fixed manufacturing costs in inventory under absorption costing during a period (it is always $0 under variable costing). This is the same as the change in total inventory, since the variable costs in inventory are the same under both methods. In Q1, it increased by $20,000. We know this because inventory increased by 2,000 units, and fixed manufacturing costs are $10 per unit ($3,000,000 / 300,000). We apply similar logic for Q2, except variable income is higher since inventory decreased. There is no difference in income in Q3 since inventory stayed the same.

Question #2

a) Under which inventory costing method would managers have an incentive to build excess inventory? What is it about that method that provides the incentive? Be sure to justify your answer.

Under full absorption costing, managers have an incentive to build excess inventory as more fixed manufacturing costs are absorbed into the balance sheet when production increases. This means less of these costs are expensed on the income statement. There is no incentive for this under variable costing because all fixed manufacturing costs are expensed under this method.

b) What steps can a manager take to reduce the incentive to build excess inventory? Be specific!

One thing a manager can do is use variable costing for internal purposes. A manager can also use additional performance metrics such as days to sell inventory, inventory turnover, inventory levels, and inventory as a % of sales or as a % of assets to discourage excess inventory. A manager can also impose a “charge back” for inventory levels.

Question #3

a) How does the choice of the denominator level capacity impact income reported under variable costing? Be sure to justify your answer.

It plays no role as the choice of capacity impacts the allocation of fixed manufacturing overhead. Under variable costing, there is no allocation as it is all expensed as incurred.

b) How does the choice of the denominator level capacity impact income reported under full absorption costing? Be sure to justify your answer.

The choice of capacity level impacts the rate used to allocate inventory. The higher the capacity used, the lower the allocation rate. With a lower rate, less fixed manufacturing overhead is allocated to actual output, resulting in a larger unfavorable production volume variance. If this variance is written off to COGS, then results using full absorption costing approach results under variable costing. This may be desirable for tax purposes where the goal is generally to reduce taxable income.