Solutions for Problems in Chapter 14
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Chapter 15 Measuring and Assigning Costs for Income Statements LEARNING OBJECTIVES Chapter 15 addresses the following objectives: LO1 Prepare absorption and variable costing income statements and reconcile the resulting net incomes. LO2 Discuss the factors that affect the choice of production volume measures for allocating fixed overhead. LO3 Prepare absorption and variable costing income statements considering beginning inventory balances, and evaluate the impact of inventory on income. LO4 Prepare throughput costing income statement and evaluate absorption, variable, and throughput costing income. These learning objectives (LO1 through LO4) are cross-referenced in the textbook to individual exercises and problems.
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QUESTIONS 15.1
The three methods are similar because they assign some costs to inventory as product costs, and expense other costs as period costs. The three methods differ in the categories that are used for product and period costs. Details of these categorizations follow. Absorption costing allocates all production costs, both fixed and variable, to units as product costs so cost of goods sold and inventory on the balance sheet include fixed manufacturing costs. Cost of goods sold is subtracted from revenue to arrive at gross margin, and then other nonmanufacturing expenses are subtracted to arrive at operating income. Variable costing assigns direct costs (direct labour and direct materials) and variable overhead costs to inventory and variable cost of goods sold. Variable cost of goods sold and all other non-manufacturing variable costs are subtracted from revenue to arrive at contribution margin. All fixed costs, both manufacturing and non-manufacturing, are then subtracted from contribution margin to arrive at operating income. Throughput costing assigns only direct materials costs to inventory and throughput cost of goods sold. Throughput cost of goods sold is subtracted from revenue to arrive at throughput margin. All other costs are considered period costs and deducted from throughput margin to arrive at operating income. Uses of the three methods are different, also. Absorption costing income statements meet GAAP and are used by shareholders and other external stakeholders. Variable costing income statements generally do not meet GAAP and are only available for internal reporting. Information from these reports is used in decision-making. Throughput accounting income statements provide information for very short-term decisions and are especially helpful when capacity constraints exist.
15.2
The allocated fixed manufacturing overhead that is added (if production is greater than sales) or subtracted (if production is less than sales) from finished goods is the reconciliation amount between variable versus absorption costing.
15.3
The volume variance arises because of differences between actual volumes and budgeted volumes used to allocate fixed manufacturing overhead. Under variable costing all fixed manufacturing overhead is treated as a period expense; there are no allocations of fixed manufacturing overhead to inventory or variable cost of goods sold. Hence, there will be no volume variances.
15.4
Under variable costing, all fixed manufacturing overhead is treated as an expense of the period, regardless of how many units were produced or sold; income will vary only with the number of units sold, the level of production has no effect. Under absorption costing, fixed manufacturing overhead is first assigned to product; the amount of fixed overhead that appears on the income statement depends on unit sales. Income depends upon both the level of production and the level of sales.
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15.5
Eventually all of the units are sold under either method, so eventually all of the fixed manufacturing cost will be expensed under either method. Under variable costing, it is expensed during the period it is incurred, whereas under absorption costing, a portion of fixed manufacturing cost is inventoried and expensed when the inventory is sold rather than during the period it was incurred.
15.6
A variable cost increases proportionately with volume. Variable costing is a method of calculating income.
15.7
Unless the organization is not-for-profit, none. For most on-going, profit-seeking firms, denominator volume should exceed breakeven volume because the firm plans to be operating at volumes greater than breakeven.
15.8
The fixed manufacturing overhead of the current period will be shown in its entirety as an expense if variable costing is used. If absorption costing is used, some of it will be assigned to the units added to inventory, so that the fixed manufacturing overhead included in cost of goods sold will be less than the total fixed manufacturing overhead that is expensed on the variable costing income statement.
15.9
Both IFRS and GAAP require absorption costing to match production-related expenses to revenues.
15.10 This can be accomplished through the use of an adjusting journal entry at the end of the period. The objective is to distribute or allocate the fixed manufacturing overhead of the period between inventories on hand (WIP and FG) and cost of goods sold. 15.11 A joint cost may be either fixed or variable and a separable cost may be either fixed or variable. Both variable and absorption costing can be applied to joint product situations. Under variable costing, the joint costs are first categorized as fixed or variable and then listed on the income statement under the headings of variable or fixed production costs. Under absorption costing, the common and separable costs are considered product costs and assigned to inventory. 15.12 Under absorption costing, managers could manipulate earnings during a period by producing more inventory than is sold. As inventory on the balance sheet increases, the amount of fixed overhead expense allocated to the units in inventory also increases, while expense for cost of goods sold decreases because the fixed overhead is spread across and increasingly large number of units, some of which are not sold. 15.13 Supply-based capacity levels measure the amount of capacity that is available for production. Theoretical capacity and practical capacity are supply based. Demand-based capacity levels measure the amount of capacity needed to meet sales volumes. Normal capacity and budgeted capacity are demand based. 15.14 Theoretical capacity is the maximum number of units that would be produced under continuous, uninterrupted production over 365 days per year. Practical capacity is the upper capacity limit taking into account regularly scheduled times for production and © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management planned downtimes for holidays, maintenance, and any other scheduled interruptions in production. Normal capacity is an average use of capacity across time under normal circumstances. Budgeted or expected capacity is the planned use of capacity in the next period. Theoretical capacity and practical capacity are supply-based capacity levels that depend on the amount of capacity available for production. Normal capacity and budgeted or expected capacity are demand-based capacity levels that measure the amount of capacity needed to meet sales volumes.
15.15 In the financial statements, volume variances that are immaterial are allocated to cost of goods sold. When the volume variance is large and favorable, the variance is prorated among cost of goods sold and ending inventory. If production is below normal capacity, the volume variance is closed to cost of goods sold to avoid increasing the amount of fixed cost in inventory on the balance sheet.
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MULTIPLE-CHOICE QUESTIONS The following information pertains to Questions 15.16 and 15.17: Vintage Co. made 4,000 units of a product during its first year of operations and sold 3,000 units for $600,000. There was no ending work-in-process inventory. Total costs were $600,000: Direct materials and direct labour $250,000 Manufacturing overhead (50% fixed) $200,000 Marketing and administrative costs (100% variable) $150,000 15.16 The cost of the 1,000 units of finished goods ending inventory under variable costing is: a) $150,000 b) $125,000 c) $112,500 d) $87,500 e) $62,500 Ans: D ( $250,000 + ($200,000 *50%) )/4000 * 1000 = $87,500 15.17 The cost of the 1,000 units of finished goods ending inventory under absorption costing is: a) $150,000 b) $125,000 c) $112,500 d) $62,500 e) $25,000 Ans: C ( $250,000 + $200,000 )/4000 * 1000 = $112,500 15.18 In Company LL, the fixed factory overhead per unit is $5, and the fixed selling administration charges are $11. This year, the company produced and sold 100,000 units of product. The company uses the LIFO method of accounting for its inventory. What would be the difference in income reported by the company if it used variable costing instead of absorption costing? a) $ 0 b) $ 500,000 c) $1,100,000 d) $1,600,000 Ans: A Since there is no ending inventory all fixed costs are reported on the income statement under both methods.
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15.19 How does the accounting treatment of selling and administration costs differ between absorption and variable costing if more units are produced than are sold? a) The variable portion is added to the cost of ending inventory based on a pro rata portion of units produced to those sold. b) The fixed portion is added to the costs of ending inventory based on a pro rata portion of units produced to those sold. c) There is no difference in the treatment. d) Both fixed and variable portions are added to the cost of ending inventory based on a prorata portion of units produced to those sold. Ans: C 15.20 Which of the following statements is true about the variable cost method? a) It is always inappropriate for performing a profitability analysis. b) It is useful for determining the price of a product for a special order. c) It is always useful when fixing the price for a long period. d) It is helpful for performing target costing. Ans: B
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EXERCISES 15.21 Absorption and Variable Income - Famous Desk Company A and B. First list all pertinent information: Revenue = 220 desks * $300 = $66,000 Variable production costs = 220 desks * $80 = $17,600 Variable selling and administrative costs = 220 desks * $30 = $6,600 Fixed selling and administrative = $6,000 Fixed overhead absorbed into inventory under normal production Beginning Inventory 100 units with variable cost of $80 per desk and absorption cost of $146.67 per desk $146.67 - $80 = $66.67 fixed costs per desk Fixed overhead volume variance = $10,000 – (200 desks x $66.67) = $3,334 overapplied, which is closed to COGS Variable Costing Revenue Variable costs: Production Selling Contribution Margin Fixed costs: Production Admin and Sales Operating income
$66,000 (17,600) (6,600) 41,800 (10,000) (6,000) $25,800
Absorption Costing Revenue $66,000 Cost of goods sold 220 desks x ($80 + $66.67) (32,267) Volume variance 3,334 Gross Margin 37,067 Selling and administrative ($6,600 + $6,000) Operating income
(12,600) $24,467
Double-check calculations: Difference in operating income = 20 units x $66.67 = $1,333 (fixed overhead brought into income statement under absorption costing from units produced in prior periods) Difference in operating income = $25,800 - $24,467 = $1,333.
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15.22 Absorption and Variable Income, Reconcile Incomes - Rock Crusher Corp. A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. Variable costing income statement VARIABLE COSTING Variable cost per unit produced A100 A300 Revenue Variable costs: Production: A100 A300 Selling Contribution margin Fixed costs: Production: Selling and administrative Operating income
$5.00 $2.50 $240,000
$15,000 10,000
(25,000) (35,000) 180,000 (100,000) (60,000) $20,000
Computation details for variable production cost per unit: A100: $20,000/4,000 tons = $5 per ton A300: $15,000/6,000 tons = $2.50 per ton B. Absorption costing income statement: ABSORPTION COSTING Fixed production cost per ton Total production cost per ton: A100 A300
Revenue Cost of goods sold: A100 A300 Gross margin Selling and administrative: Variable Fixed Operating income
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$10.00 $15.00 $12.50
$240,000 $45,000 50,000
$35,000 60,000
(95,000) 145,000
(95,000) $50,000
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Calculation details for cost of goods sold: Fixed production cost per ton = $100,000/10,000 tons = $10 per ton Variable production cost per ton was calculated in Part A Cost of goods sold: A100 [($10+$5) x 3,000] $45,000 A300 [($10+$2.50) x 4,000] 50,000 Total $95,000 C. The difference in income resides in inventory. There was no beginning inventory, but there were 3,000 tons (10,000 tons produced – 7,000 tons sold) with $10 of fixed production cost per ton absorbed into inventory on the balance sheet under absorption costing. The difference in income = $50,000 - $20,000 = $30,000, and the fixed production cost in inventory is 3,000 x $10 = $30,000. 15.23 Absorption and Variable Inventory and Income, Reconciliation - Start-Up Firm A and B. Units in ending inventory: Units beginning inventory Units produced Units sold Units ending inventory
0 1,000 (850) 150
Variable Costing Revenue (850 units × $89) $75,650 Variable costs: Production (850 units × $40) (34,000) Selling (850 units × $9) (7,650) Contribution Margin 34,000
Absorption Costing Revenue (850 units × $89) $75,650 Cost of goods sold 850 units × ($40 + $10) (42,500)
Fixed costs: Production Selling and administrative Operating Income (Loss)
Selling and administrative ($25,000 + $9 × 850 units)
(32,650)
Operating Income
$
Ending inventory ($40 × 150 units)
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(10,000) (25,000) $(1,000)
Gross Margin
33,150
500
Ending inventory $6,000
[$40+($10,000/1,000)]×150 units
$7,500
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Cost Management C. With no beginning inventory, the reconciliation of variable costing to absorption costing income is affected by only ending inventory: Variable costing operating income (loss) Fixed manufacturing overhead added to ending inventory under absorption costing [(150 units × ($10,000/1,000 units)] Absorption costing operating income
$(1,000) 1,500 $ 500
15.24 Absorption and Variable Inventory and Income, Reconciliation Calculations for both costing methods: Selling price: $200,000 revenue last year / 5,000 units sold last year = $40 per unit Variable manufacturing cost: $40,000/5,000 units produced = $8 per unit Units in ending inventory = 5,000 units produced – 4,500 units sold = 500 units Variable selling and administration cost: $30,000/5,000 units sold last year = $6 per unit A. Variable costing (1) Ending inventory: $8 variable manufacturing cost per unit * 500 units = $4,000 (2) Variable costing income statement Revenue ($40 *4,500 units) Variable costs: Manufacturing costs ($8 * 4,500 units) Selling and administration($6 * 4,500 units) Contribution margin Fixed costs: Manufacturing costs Selling and administration Operating Income
$180,000 36,000 27,000 117,000 60,000 50,000 $ 7,000
B. Absorption costing Fixed production cost allocation rate: $60,000/5,000 units = $12 per unit Absorption cost per unit = $8 variable manufacturing cost per unit + $12 fixed manufacturing cost per unit = $20 per unit Note: No information is provided about any capacity levels other than actual production volume, so these calculations assume that actual costing is used. (1) Ending inventory: $20 absorption cost per unit × 500 units = $10,000 (2) Absorption Costing Income Statement Revenue ($40 *4,500 units) Cost of goods sold ($20 * 4,500 units) Gross margin Selling and administration[$50,000 + ($6 * 4,500 units)] Operating Income © 2012 John Wiley and Sons Canada, Ltd.
$180,000 90,000 90,000 77,000 $ 13,000
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C. With no beginning inventory, the reconciliation of variable costing to absorption costing income is affected by only ending inventory: Variable costing operating income Fixed manufacturing overhead added to ending inventory under absorption costing ($12 × 500 units) Absorption costing operating income
$ 7,000 6,000 $13,000
15.25 Absorption and Variable Income – Vintage Co. A. Total variable manufacturing costs = $250,000 + $190,000(.55) = $354,500 Variable manufacturing cost per unit = $354,500/4,000 = $88.625 Cost of ending finished goods inventory = 1,000 × $88.625 = $88,625 B. Under absorption costing, fixed manufacturing overhead would be included in ending finished goods inventory, but it would not be included under variable costing. Therefore, net profit would increase by the following amount: Variable manufacturing overhead / total units produced * ending inventory =($190,000 * 45%)/4,000 * 1,000 = $21,375 decrease in COGS under absorption costing = $21,375 increase in operating income Alternative calculation: Net profit under absorption costing: Revenue – [Total production costs / units produced * units sold] – selling and administrative = $600,000 - [($250,000 + $190,000) /4,000 * 3,000] - $150,000 = $600,000 - $330,000 - $150,000 = $120,000 Net profit under variable costing: Revenue – [Variable production costs/units produced * units sold – fixed production costs – selling and administrative = $600,000 - [($250,000+($190,000*55%)]/4,000*3,000] - ($190,000*45%) - $150,000 = $600,000 - $265,875 - $85,500 - $150,000 = $98,625 Difference = $120,000 - $98,625 = $21,375 increase
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15.26 Absorption and Variable Income – The Wye Co. Ltd. A. Which income statement was prepared using actual absorption costing? Under actual absorption costing, cost of goods sold is calculated as the actual rate * actual inputs used for both direct and indirect costs. Therefore, no variances would be calculated and the income statement is E. B. Which income statement was prepared using standard variable costing? Under standard variable costing, cost of goods sold is calculated as the standard variable cost * the standard inputs allowed for actual outputs. Therefore, there may be variable cost variances but no fixed cost variances and the income statement is B. C. How many units of product RGW were actually produced during the year? Operating income statement D includes all variance therefore it is standard absorption costing. COGS $378,000 / $42 = 9,000 units Operating income statement B (i.e. standard variable costing) $514,000 Operating income statement D (i.e. standard absorption costing) 508,000 Fixed overhead in ending inventory $6,000 $6,000 / $6 standard fixed overhead per unit = 1,000 ending inventory units Number of units sold 9,000 Number of units produced 10,000 15.27 Absorption and Variable Costing Income – Hamilton Limited A. Variable costs = $9 + $12 + $15 + $6 = $42 Profit/loss = 70,000 units* ($72 - $42) - $1,800,000 - $600,000 = $2,100,000 - $2,400,000 = $300,000 loss B. 100,000 units sold - 70,000 units produced = 30,000 units in inventory Inventory under absorption costing includes a portion of fixed manufacturing costs, whereas no fixed manufacturing costs are inventoried under variable costing. Therefore, income would be 30,000 * $18 = $540,000 higher under absorption costing than under variable costing. ($300,000) + $540,000 = $240,000
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15.28 Throughput Inventory and Income, Reconciliation Continuation of 15.24 A. Throughput costing Direct cost per unit: $25,000/5,000 units produced = $5 per unit Other variable manufacturing costs per unit: ($40,000 – $25,000) /5,000 units produced = $3 per unit (1) Ending inventory: $5 direct cost per unit × 500 units = $2,500 (2) Throughput Costing Income Statement Revenue ($40 × 4,500 units) Direct material costs ($5 × 4,500 units) Throughput contribution Other costs: Manufacturing costs [$60,000 + ($3 *5,000 units)] Selling and administration[$50,000 + ($6 * 4,500 units)] Operating Income
$180,000 22,500 157,500 75,000 77,000 $ 5,500
B. With no beginning inventory, the reconciliation of throughput costing to variable costing is affected by only ending inventory: Throughput costing operating income Non-material variable manufacturing costs added to ending inventory under variable costing ($3 × 500 units) Absorption costing operating income
$5,500 1,500 $7,000
15.29 Absorption and Variable Inventory and Income - Plains Irrigation A. The value of inventory is higher when absorption costing is used because some fixed manufacturing overhead is allocated to inventory to match revenue with expense at the time of sale. If there is fixed manufacturing overhead, the value of inventory under absorption costing will always be higher than under variable costing. B. To identify the costing method that would result in higher income, first calculate the change in inventory during October under both methods: October inventory added under absorption costing ($2,598-$1,346) October inventory added under variable costing ($1,647-854) Difference
$1,252 793 $ 459
Because $459 more cost was assigned to inventory under absorption costing, operating income during October would be higher by $459 under absorption than under variable costing. © 2012 John Wiley and Sons Canada, Ltd.
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15.30 Absorption, Variable, and Throughput Inventory and Income - Asian Iron A. 1. Under variable costing: Total variable production cost = (NT$2,300 + 3,300 + 2,800) = NT$8,400 Variable cost per unit = NT$8,400/10,500 = NT$0.80 per unit Units in ending inventory = 10,500 – 9,400 = 1,100 units Ending inventory = NT$0.80 x 1,100 units = NT$880 2. Under absorption costing: Fixed manufacturing overhead = NT$8,250/10,500 units = NT$0.7857 per unit Total cost per unit = NT$0.80 + NT$0.7857 = NT$1.5857 Ending inventory = NT$1.5857 x 1,100 units = NT$1,744 3. Under throughput costing: Total direct materials cost per unit = NT$2,300/10,500 units = NT$0.21905 Ending inventory = NT$0.21905 x 1,100 units = NT$241 C. 1, 2, 3 Variable Costing
Absorption Costing
Throughput Costing
Revenue NT$32,900 Variable costs: Production (NT$0.80 x 9,400) (7,520) Selling (940) Contribution margin 24,440 Fixed costs: Production (8,250) Selling and admin. (14,560) Operating income NT$ 1,630
Revenue NT$32,900 Cost of goods sold (NT$1.5857 x 9,400) (14,906) Gross margin 17,994 Selling and admin. (NT$940 + 14,560) (15,500) Operating income NT$ 2,494
Revenue NT$32,900 Direct materials (NT$0.21905 x 9,400) (2,059) Throughput margin 30,841 Operating expenses (a) (29,850) Operating income NT$ 991
(a) NT$(3,300 + 2,800 + 940 + 8,250 + 14,560) = NT$29,850 Double-check computations for absorption versus variable costing: There were no beginning inventories. Therefore, the change in inventory is equal to the ending inventory (calculated in Part A). Inventory under absorption costing NT$1,744 Inventory under variable costing 880 Difference in inventory NT$ 864 Difference in operating income - NT$2,494 - NT$1,630
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NT$ 864
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Double-check computations for absorption versus throughput costing: Inventory under absorption costing NT$1,744 Inventory under throughput costing 241 Difference in inventory NT$1,503 Difference in operating income - NT$2,494 - NT$991
NT$1,503
C. It is first necessary to calculate the revenue and variable costs per unit: Revenue per unit = NT$32,900/9,400 = NT$3.50 Variable production cost per unit = NT$0.80 Variable selling cost per unit = NT$940/9,400 = NT$0.10 Revenue (12,110 x $3.50) Variable costs: Production (12,110 x NT$0.80) Selling (12,110 x NT$0.10) Contribution margin Fixed costs: Production Selling and administrative Operating income
NT$42,385 (9,688) (1,211) 31,486 (8,250) (14,560) NT$ 8,676
15.31 Calculations Using Balance Sheet Data – A Manufacturing Firm A. Balance Sheet 2 has higher unit costs in inventory, so it must be an absorption costing statement. B. Assuming that costs per unit did not decrease, the decrease in total cost of inventory from January 1 to January 31 indicates that more units were sold than produced. C. Difference between variable costing income and absorption costing income: Fixed costs in beginning absorption inventory ($38,000 – $17,000) $21,000 Fixed costs in ending absorption inventory ($19,000 – $8,000) 11,000 Variable costing income higher than absorption costing income $10,000 15.32 Calculations Using Income Statement Data A. Absorption costing will have the larger cost per unit for cost of goods sold, so Income Statement 2 must be the absorption costing statement and Income Statement 1 must be the variable costing statement. B. Absorption costing income is higher than variable costing income, so the quantity of units in inventory must have increased during the period. Thus, production exceeded sales. © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management C. The difference between the two income statements is the treatment of fixed manufacturing overhead costs. Under absorption costing, manufacturing overhead cost per unit is included in cost of goods sold. Under variable costing, the total amount of manufacturing overhead costs incurred during the current period is included in other expenses. Thus, the total amount of fixed overhead can be calculated from the difference in other expenses shown on the two income statements: $4,180 – $3,100 = $1,080 Note that fixed overhead cannot be derived by comparing cost of goods sold because some of the fixed overhead will be deferred into ending inventory under absorption costing. The amount deferred this period is: $1,080 – ($4,032 – 3,000) = $48
15.33 Absorption, Variable, and Throughput Income, Reconcile Incomes - Happy Bikers Motorcycle Company A, B, C. Variable Costing Revenue (a) Variable costs: Production (b) Selling (c) Contribution margin Fixed costs: Production Selling and admin. Operating income
$150,000 (45,000) (3,750) 101,250
Absorption Costing Revenue (a) Cost of goods sold (d) Volume variance (e) Gross margin Selling and admin. (f) Operating income
$150,000 (105,000) 26,667 71,667 (43,750) $ 27,917
Throughput Costing Revenue (a) Raw materials (g) Throughput margin Operating expenses (h) Operating income
$150,000 (30,000) 120,000 (101,750) $ 18,250
(40,000) (40,000) $ 21,250
Calculation details: (a) Revenue = 15 motorcycles * $10,000 = $150,000 (b) Variable production costs = 15 motorcycles * ($2,000 + $1,000) = $45,000 (c) Variable selling and administrative costs = 15 motorcycles * $250 = $3,750 (d) Absorption cost of goods sold: Normal capacity = 10 motorcycles per month Estimated fixed overhead per motorcycle = $40,000/10 = $4,000 Total fixed and variable production cost per unit = $4,000 + $2,000 + $1,000 = $7,000 Cost of goods sold = 15 motorcycles* $7,000 = $105,000 (e) Volume variance: Fixed production overhead $ 40,000 Allocated overhead (18 motorcycles * $4,000) 72,000 Overapplied overhead $(32,000) Because the volume variance is material relative to actual production costs, it will be prorated between cost of goods sold and ending inventory. The portion allocated to cost of goods sold is: $32,000 * (15/18 motorcycles) $(26,667) (f) Total selling and administrative expense = $40,000 + 15 motorcycles * $250 = $43,750 © 2012 John Wiley and Sons Canada, Ltd.
Chapter 15: Measuring and Assigning Costs for Income Statements (g) Total raw materials = 15 motorcycles * $2,000 = $30,000 (h) Total operating expenses: Direct labour and variable overhead (18 motorcycles * $1,000) Fixed production costs Variable selling and administrative (15 motorcycles * $250) Fixed selling and administrative Total
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$ 18,000 40,000 3,750 40,000 $101,750
D. Here is a schedule to reconcile the three income statements. Recall that inventory increased during the month by 3 units (18 motorcycles manufactured – 15 motorcycles sold). Throughput costing operating income $18,250 Direct labour and variable overhead costs added to ending variable costing inventory (3 motorcycles * $1,000) 3,000 Variable costing operating income 21,250 Fixed overhead costs allocated to ending absorption costing income (after the volume variance adjustment, this is equal to actual fixed overhead cost per unit) [3 motorcycles x ($40,000/18)] 6,667 Absorption costing operating income $27,917 15.34 Variable and Absorption Costing, Multiyear Analysis – LeFiell Manufacturing A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. and B. Below are the income statements produced using the spreadsheet. 2010 2011 2012 Units Sold 14,000 15,000 16,000 Units Produced 15,000 15,000 15,000 $500,00 Fixed Production Costs 0 $500,000 $500,000 7 Variable production costs per unit 75 75 5 20 Selling price per unit 200 200 0 Fixed selling and administrative expenses 100,000 100,000 100,000 Absorption Costing Revenue (a) Cost of Goods Sold (b) Gross Margin © 2012 John Wiley and Sons Canada, Ltd.
2010 $2,800,0 00 1,516,66 7 $1,283,3
2011 $3,000,0 00 1,625,00 0 $1,375,0
2012 $3,200,0 00 1,733,33 3 $1,466,6
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Selling and Administrative Operating Income
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33 100,000 $1,183,3 33
00 100,000 $1,275,0 00
67 100,000 $1,366,6 67
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Variable Costing Revenue (a) Variable Production Costs (c) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income
2010 $2,800,0 00 1,050,00 0 $1,750,0 00
2011 $3,000,0 00 1,125,00 0 $1,875,0 00
2012 $3,200,0 00 1,200,00 0 $2,000,0 00
500,000 100,000 $1,150,0 00
500,000 100,000 $1,275,0 00
500,000 100,000 $1,400,0 00
Calculations Details: (a) Revenue = units sold x $200 (b) Absorption Cost of Goods Sold: * Fixed Production Cost per unit = $500,000 / 15,000 units= Total Production Cost per unit = $75 + $33.33333 = Absorption cost of Goods Sold = $108.33 x units sold (c ) Variable Production Costs = $75 x units sold
$33.333 33 $108.33333
*Since fixed overhead costs and production were constant each month the fixed overhead production cost per unit was calculated using the 15,000 units produced each month. Ending Inventory Value: Absorption Costing $108.3333 x units remaining in inventory 2010 = 1,000 units
2010
C. © 2012 John Wiley and Sons Canada, Ltd.
2012
$108,333 .33 $108,333 .33
2011 = 1,000 units 2012 = 0 units Variable Costing $75 x units remaining in inventory
2011
$0
$75,000. 00
$75,000. 00
$0
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Difference in Operating Income Absorption Costing Income Variable Costing Income Difference in Operating Income Difference in Change in Inventory Absorption costing: Ending Inventory Beginning Inventory Increase (decrease)
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2010 $1,183,3 33 1,150,00 0 33,333
$108,333 .33 0 108,333. 33
2011 2012 $1,275,0 $1,366,66 00 7 1,275,00 0 1,400,000 0
(33,333)
$108,333 $ .33 0 108,333. 108,333.3 33 3 (108,333. 0 33)
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Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference
$75,000. 00 0 75,000.0 0 33,333.3 3
$75,000. $ 00 0 75,000.0 0 75,000.00 (75,000.0 0 0) (33,333.3 0 3)
The net income under the absorption costing method is higher in 2010 because a portion of the fixed production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under absorption costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2011 the net incomes were the same because production and sales were equal and the higher inventory costs carried over to the balance sheet again. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $ 3,825,000 under both methods. 15.35 Throughput Costing, Multiyear Approach – LeFiell Manufacturing (Continued) A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A and B: Below is the income statement produced using the spreadsheet. 2010 2011 2012 14,0 15,0 16,0 Units Sold 00 00 00 15,0 15,0 15,0 Units Produced 00 00 00 Fixed Production Costs $500,000 $500,000 $500,000 Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Direct materials per unit Throughput Costing Revenue (a) © 2012 John Wiley and Sons Canada, Ltd.
75 2 00 100,0 00 50
$2,800,00
75 2 00 100,0 00 50
75 2 00 100,0 00 50
$3,000,00 $3,200,00
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Direct material costs (b) Throughput contribution Other costs: Other production costs (c) Selling and administrative expenses (d) Operating Income
© 2012 John Wiley and Sons Canada, Ltd.
0 700,0 00 $2,100,00 0
0 0 750,0 800,0 00 00 $2,250,00 $2,400,00 0 0
875,0 00 100,0 00 $1,125,00 0
875,0 875,0 00 00 100,0 100,0 00 00 $1,275,00 $1,425,00 0 0
Chapter 15: Measuring and Assigning Costs for Income Statements
Calculations Details (a) Revenue = units sold x $200 (b) Direct material costs = units sold x $50 (c ) Other Production Costs = [($75 - 50) x units produced] + $500,000 (d) Selling and administrative expenses = $100,000 Ending Inventory Value: Throughput Costing Direct materials per unit x units remaining in inventory $50,000.0 2010 = 1,000 units 0 $50,000. 00
2011 = 1,000 units 2012 = 0 units
Difference in Operating Income Throughput Costing Income Variable Costing Income (15.34) Difference in Operating Income Difference in Change in Inventory Throughput costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference © 2012 John Wiley and Sons Canada, Ltd.
-
2010 $1,125,00 0 1,150,0 00 (25,0 00)
2011 $1,275,0 00 1,275,0 00
50,000. 00
50,000. 00 50,000. 00
50,000. 00 75,000. 00 75,000. 00 (25,000.
-
75,000. 00 75,000. 00 -
2012 $1,425,0 00 1,400,0 00 25,0 00
50,000. 00 (50,000. 00) 75,000. 00 (75,000. 00) 25,000.
139
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Cost Management 00)
-
00
The net income under the variablecosting method is higher in 2010 because a portion of the variable production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under variable costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2011 the net incomes were the same because production and sales were equal and the higher inventory costs carried over to the balance sheet again. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $ 3,825,000 under both methods. 15.36 Variable and Absorption Costing, Multi-year Approach – MacHine Company A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. and B. 2010 Units Sold
5,000
Units Produced
5,500
Fixed Production Costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Absorption Costing Revenue (a) Cost of Goods Sold (b) Gross Margin Selling and Administrative Operating Income © 2012 John Wiley and Sons Canada, Ltd.
$200,000 55 175 50,000 2010 $875,000 .00 456,818. 18 $418,181 .82 50,000.0 0 $368,181 .82
2011 5, 500 6, 000 $200, 000
2012 6, 000 5, 000 $200,00 0
55
55
175 50, 000
175 50, 000
2011 $962,500. 00 487,348.4 8 $475,151. 52
2012 $1,050,000 .00
50,000.00 $425,151. 52
563,333.33 $486,666.6 7 50,000. 00 $436,666.6 7
Chapter 15: Measuring and Assigning Costs for Income Statements
Variable Costing Revenue (a) Variable Production Costs (c) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income
2010 $875,000 .00 275,000. 00 $600,000 .00
2011 $962,500. 00 302,500.0 0 $660,000. 00
200,000. 00 50,000.0 0 $350,000 .00
200,000.0 0
200,000.00
50,000.00 $410,000. 00
50,000.00 $470,000.0 0
Calculations Details: 2010 2011 (a) Revenue = units sold x $175 (b) Absorption Cost of Goods Sold: *Fixed Production Cost per unit (allocated based on actual production) = $200,000 / actual production 36.3636 each year 4 33.33333 Total Production Cost per unit 91.3636 = $55 + fixed prod cost per unit 4 88.33333 **Absorption cost of Goods Sold 2010 = units sold x Total prod cost/unit 2011 = 500 u (end inv in 2007) x $91.36364 + 5,000 u x $88.33333 2012 = 1,000 u (end inv in 2008) x $88.33333 + 5,000 u x $95 (c) Variable Production Costs = $55 x units sold
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2012 $1,050,000 .00 330,000.00 $720,000. 00
2012
40.00000 95.00000 456,818.1 8 487,348.4 8 563,333.3 3
*Since fixed overhead costs and production were not constant each month the fixed overhead production cost per unit was calculated using the actual units produced each month. Alternatively the average could have been calculated based on a normal capacity but this information was not given in the question. **Since the production costs are not the same each year, the cost of goods sold must take into account that the ending inventory from the prior year has a different cost than the current year production. Since the company uses a FIFO costing system the assumption was © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management made that the beginning inventories were sold first at last year’s cost and then the remaining units sold were from current year’s production.
Ending Inventory Value: 2010 2011 Absorption Costing = total production cost / unit x units remaining in inventory $45,681.8 2010 = 500 units x $91.36364 2 $88,333.3 2011 = 1,000 units x $88.33333 3 2012 = 0 units Variable Costing $55 x units remaining in inventory C. Difference in Operating Income Absorption Costing Income Variable Costing Income Difference in Operating Income Difference in Change in Inventory Absorption costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory
$27,500.0 0
$55,000.0 0
2010 $368,181. 82 350,000.0 0
2011 $425,151. 52 410,000.0 0
18,181.82
$45,681.8 2 0
15,151.52
$88,333.3 3 45,681.82
45,681.82
42,651.52
27,500.00
55,000.00
0
27,500.00
Increase (decrease)
27,500.00
27,500.00
Difference
18,181.82
15,151.52
© 2012 John Wiley and Sons Canada, Ltd.
2012
$0
$0
2012 $436,666. 67 470,000.0 0 (33,333.3 3)
$ 0 88,333.33 (88,333.3 3) 0 55,000.00 (55,000.0 0) (33,333.3 3)
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The net income under the absorption costing method is higher in 2010 and 2011 because a portion of the fixed production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under absorption costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2012 the net income was lower using absorption costing by an amount equal to the two previous years when the net income was higher using absorption costing. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $1,230,000 under both methods. 15.37 Throughput Costing, Multiyear Approach – MacHine Company (Continued) A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. and B. Units Sold Units Produced Fixed Production Costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Direct materials per unit
2010 5,0 00 5,5 00 $200,0 00
2011 5,5 00 6,0 00 $200,0 00
2012 6,0 00 5,0 00 $200,0 00
55 1 75 50,0 00
55 1 75 50,0 00
55 1 75 50,0 00
20
20
20
Throughput Costing Revenue (a) Cost of Materials (b) Throughput Margin Other Production Costs (c) Selling and Administrative Operating Income © 2012 John Wiley and Sons Canada, Ltd.
$875,000. 00 100,000. 00 $775,000. 00 392,500. 00 50,000. 00 $332,50
$962,500. $1,050,000 00 .00 110,000. 120,000. 00 00 $852,500. $930,000. 00 00 410,000. 375,000. 00 00 50,000. 50,000. 00 00 $392,50 $505,000
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Cost Management 0.00
0.00
.00
Variable Costing (15.36) Revenue (a) Variable Production Costs (d) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income
$875,000. 00 275,000. 00 $600,000. 00
$962,500. 00 302,500. 00 $660,000. 00
$1,050,000 .00 330,000. 00 $720,000.0 0
200,000. 00 50,000. 00 $350,00 0.00
200,000. 00 50,000. 00 $410,000 .00
200,000. 00 50,000. 00 $470,000. 00
Calculations Details (a) Revenue = units sold x selling price per unit (b) Throughput Cost of Materials = $20 x units sold (c) Throughput Other Production Costs Fixed Production Cost + (Variable cost per unit - direct materials per unit) x units produced (d ) Variable Production Costs = $55 x units sold Ending Inventory Value: Throughput Costing = materials cost per unit x units remaining in inventory $10,000. 2010 = 500 units x $20 00 $20,000. 2011 = 1,000 units x $20 00 2012 = 0 units
-
Variable Costing $55 x units remaining in inventory
$27,500.0 0
$55,000. 00
-
Difference in Operating Income Throughput Costing Income
2010 $332,500.
2011 $392,500.
2012 $505,000.0
© 2012 John Wiley and Sons Canada, Ltd.
Chapter 15: Measuring and Assigning Costs for Income Statements
Variable Costing Income Difference in Operating Income Difference in Change in Inventory Throughput costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference
00 350,000. 00 (17,500. 00)
00 410,000. 00 (17,500. 00)
0 470,000. 00 35,000. 00
10,000. 00
20,000. 00 10,000. 00 10,000. 00
20,000. 00 (20,000.0 0)
55,000. 00 27,500. 00 27,500. 00 (17,500. 00)
55,000. 00 (55,000.0 0) 35,000. 00
10,000. 00 27,500. 00 27,500. 00 (17,500. 00)
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The net income under the variable costing method is higher in 2010 and 2011 because a portion of the direct materials production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under variable costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2012 the net income was lower using variable costing by an amount equal to the two previous years when the net income was higher using variable costing. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $1,230,000 under both methods.
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PROBLEMS 15.38 Absorption and Variable Costing Income Statements, Reconciliation of Net Incomes – Okanagan Company It is useful to set out the given information in the following format prior to addressing the requirements (there are no WIP inventories). Absorption Costing Sales $900,000 COGS Beginning FG + COGM − Ending FG − COGS Gross margin SG&A (all fixed) Operating profit $186,000
Variable Costing $900,000
Sales
? ? ? ? $162,000 42,000 $120,000
Variable costs Manufacturing + SG&A = Total variable costs Contribution margin Fixed costs manufacturing Fixed costs SG&A Operating profit
? 0 ? 360,000 132,000 42,000
A. 1) From the information given in the variable costing income statement, total variable cost of goods sold = Sales – CM = $900,000 – 360,000 = $540,000. There are no variable SG&A expenses. Given that unit variable manufacturing cost is $6, total units sold are: $540,000 / 6 = 90,000. 2) From the absorption costing income statement: COGS = Sales – Gross margin = $900,000 − $162,000 = $738,000. Since 90,000 units were sold, the product cost per unit is $738,000 / 90,0000 = $8.20 3) Unit fixed costs are $8.20 − $6 = $2.20. Since total fixed costs are $132,000 in 2009, production must be $132,000 / 2.2 = 60,000 units. B. and C. Production and sales quantities are provided for this part. The product cost of manufacturing can thus be determined and the income statements constructed. (b) Absorption Costing Sales
(c) Variable Costing $900,000
Sales
$900,000 COGS Beginning FG (A1) + COGM
2
246,000
492,0001
© 2012 John Wiley and Sons Canada, Ltd.
Variable costs Manufacturing + SG&A
540,000 0
Chapter 15: Measuring and Assigning Costs for Income Statements 03 738,000 (A2) $162,000 42,000 $120,000
− Ending FG − COGS Gross margin SG&A (all fixed) Operating profit
= Total variable costs Contribution margin Fixed costs manufacturing Fixed costs SG&A Operating profit
147
540,000 360,000 132,000 42,000
$186,000 Notes: 1 COGM = 60,000 * $8.20 = $492,000. See A3 and A2 above 2 Beginning FG = COGS – COGM = $738,000 − $492,000 = $246,000 represents the difference between beginning FG and ending FG. Thus Units in beginning inventory – Units in ending inventory = $246,000 / $8.2 = 30,000 units 3 Ending FG = 30,000 beginning inventory units + 60,000 units produced – 90,000 units sold = 0 units D. Reconciliation Absorption costing operating profit $120,000 + FC released from beginning inventory (30,000 * $2.20) 66,000 − FC held back in ending inventory (0 * $2.20 0 = Variable costing operating profit $186,000 15.39 Absorption and Variable Costing Income Statements, Reconciliation of Net Incomes – Hermione Corporation A. Absorption costing income statement HERMIONE CORPORTATION Pro-forma Income Statement — Absorption Costing Basis Year Ended December 31, 2012 Sales (96,000 * $12.00) Costs of goods sold Beginning inventory (4,000 * $5.00) Variable manufacturing cost (100,000 * $7.50) $750,000 Fixed overhead, manufacturing 80,000 Cost of goods manufactured Cost of goods available for sale Ending inventory [8,000 * ($7.50+($80,000/100,000)] Cost of goods sold Gross margin Variable selling and administrative (96,000 * $1.00) Fixed selling and administrative Total selling and administrative Net income © 2012 John Wiley and Sons Canada, Ltd.
$1,152,000 $ 20,000 830,000 $850,000 (66,400) 783,600 368,400 $ 96,000 55,000 151,000 $ 217,400
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Variable costing income statement HERMIONE CORPORTATION Pro-forma Income Statement — Variable Costing Basis Year ended December 31, 2012 Sales $1,152,000 Costs of goods sold Beginning inventory $ 20,000 Variable manufacturing cost 750,000 Variable manufacturing cost of goods available for sale 770,000 Variable cost of manufacturing in ending inventory (60,000) Variable cost of goods sold $710,000 Variable selling and administrative 96,000 Total variable cost 806,000 Contribution margin $ 346,000 Fixed overhead, manufacturing $80,000 Fixed selling and administrative 55,000 Total fixed costs 135,000 Net income $ 211,000 Calculations Ending inventory 4,000 purchased units + 100,000 manufactured units – 96,000 sold units 8,000 units Reconciliation Absorption costing net income (NI) – Variable costing NI = Fixed cost in ending inventory – Fixed cost in beginning inventory $217,400 - $211,000 = $6,400 8,000 units x 0.80 = $6,400 Note: Fixed manufacturing costs per unit = $80,000/100,000 = $0.80 There are no fixed costs in beginning inventory since it was purchased from an outside supplier. Those units were not manufactured.
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15.40 Absorption and Variable Costing Income Statements – KopyKat Company A. The following calculations will be used in the solution. i) Units in beginning and ending inventory Beginning inventory Production Good available for sale Sales Ending inventory
October
November
10,000 units 25,000 35,000 15,000 20,000
20,000 units ---20,000 20,000 0
ii) Product cost per unit Variable manufacturing Fixed manufacturing
September
October
November
$ 18 $ 101 $ 28
$ 18 $ 122 $ 30
$ 18 N/A3 $ 18
1
Total product of beginning inventory is given in the question: $280,000 / 10,000 units = $28 per unit total product cost. $28 - $18 variable costs = $10 fixed costs allocated to beginning inventory. 2
Total fixed manufacturing cost/production =
$300,000 = $12 25,000
3
Since there is no production in November, fixed costs for the period cannot be unitized. Absorption Format Income Statement October Sales1 Cost of goods sold Beginning inventory2 Costs of goods manufactured3 Ending inventory4 Cost of goods sold Gross margin Selling and administration costs Variable5 Fixed Total selling and administrative costs Net income © 2012 John Wiley and Sons Canada, Ltd.
November
$ 750,000
$1,000,000
280,000 750,000 (600,000) $430,000 $ 320,000
600,000 300,000 ( 0) $ 900,000 $ 100,000
45,000 260,000 $ 305,000 $ 15,000
60,000 260,000 $ 320,000 $ (220,000)
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Cost Management
1
October: 15,000 * $50 November: 20,000 * $50
2
October: Given November: Same as October ending inventory
3
October: 25,000 * $30 November: This is the fixed manufacturing cost; no production occurred, thus no variable costs were incurred. 4
October: 20,000 * $30 November: 0
5
October: 15,000 * $3 November: 20,000 * $3
B. Absorption costing net income Plus fixed cost in beginning inventory1 Minus fixed cost in ending inventory2 Equals variable costing net income
October
November
$ 15,000 $ 100,000 $ 240,000 $(125,000)
$ (220,000) $ 240,000 0 $ 20,000
1
October: Unit fixed cost * Units in inventory = $10 * 10,000 = $100,000 November: Unit fixed cost * Units in inventory = $12 * 20,000 = $240,000
2
October: Unit fixed cost * Units in inventory = $12 * 20,000 = $240,000 November: Unit fixed cost * Units in inventory = $12 * 0 = $0
C. The CEO’s confusion stems from the fact that in November the sales were filled entirely from inventory, and thus the costs in inventory that were deferred in October flow to the income statement as a cost in November. Additionally, since there is no production in November, the company must still cover the fixed manufacturing costs from the sales. Thus the cost of goods sold is $900,000. With no excess production in November to absorb the fixed costs, all of this cost is expensed and net income is affected negatively.
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15.41 Absorption and Variable Inventory and Income, Reconcile Incomes - Wild Bird Feeders A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A and B. Absorption and variable costing ending inventory The problem states the 2012 actual costs for direct materials, direct labour, and variable manufacturing overhead are the same as the planned costs (i.e., $3,120,000/130,000 units = $24.00 for direct materials, $2,340,000/130,000 units = $18.00 for direct labour, and $520,000/130,000=$4.00 for variable manufacturing overhead). The problem also states that all over- or underapplied overhead is assigned directly to cost of goods sold. Therefore, the 2012 overhead costs assigned to inventory are the same as the planned costs. Thus, the prior year inventory costs are the same as the current year inventory costs, and it does not matter which cost flow assumption the company uses. COST OF ENDING INVENTORY Production cost per unit: Direct materials (actual) Direct labour (actual) Variable manufacturing overhead (allocated=actual) Fixed manufacturing overhead (allocated) Total Units: Beginning inventory Production Sales Ending inventory
2011 Absorption Variable Costing Costing $24.00 $24.00 18.00 18.00 4.00 4.00 5.00 $51.00 $46.00
2012 Absorption Variable Costing Costing $24.00 $24.00 18.00 18.00 4.00 4.00 5.00 $51.00 $46.00
30,000 130,000 (125,000)
5,000 35,000
Cost of ending inventory
$1,785,000
$1,610,000
C. Manufacturing and total contribution margin VARIABLE COSTING Revenue Variable production costs Manufacturing contribution margin Other variable costs: Variable selling Variable administrative Total contribution margin Fixed costs: Manufacturing overhead Selling Administrative Operating income
$12,375,000 (5,750,000) 6,625,000 $1,750,000 125,000
$710,000 980,000 850,000
(1,875,000) 4,750,000
(2,540,000) $2,210,000
D. This question asks for the total fixed costs on the income statement and then proceeds to develop that cost in steps as follows. 1. Fixed selling and administration = ($980,000 + $850,000) = $1,830,000 © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management 2. Fixed manufacturing overhead allocated to COGS: Fixed overhead at given allocation rate (125,000 x $5)
$625,000
3. As noted in the answer to Parts A and B, the cost per unit during 2011 was the same as the cost per unit assigned to inventory during 2012. Therefore, the cost per unit assigned to cost of goods sold and to inventory is not affected by whether the company’s inventory levels increased or decreased during 2012. In other words, sales of units that were produced last year do not need to be considered. 4. Calculation of overapplied (underapplied) overhead: Overhead allocated to production Actual overhead (Underapplied) overhead
$625,000 710,000 $ (85,000)
5. Total fixed costs on income statement = $1,830,000 + $625,000 + $85,000 (because the underapplied overhead is closed to COGS) = $2,540,000. E. Variable costs on variable costing income statement (see the solution to Part C): $5,750,000 + $1,875,000 = $7,625,000. F. Absorption income would be higher than variable income because the company produced more units that it sold, and the units remaining in ending inventories include an allocation of fixed manufacturing overhead cost under absorption costing. Therefore, total overhead expense on the income statement is less under absorption than under variable costing, where the total fixed cost for the period is expensed. G. There are two ways to answer this question. The first method is to calculate the amount of fixed overhead added to inventory under absorption costing. The fixed overhead allocation rate is $5 per unit, and 5,000 units were added to inventory. Therefore, absorption costing income should be $25,000 higher than variable costing income. The second method is to prepare the two income statements and compare the results. The difference in income is (income statements are available on the sample spreadsheet for this problem): Absorption costing operating income $2,235,000 Variable costing operating income 2,210,000 Difference $ 25,000 15.42 Differences in Income, Choice of Absorption and Variable Costing – Nova Scotia Lobsters Company A. Absorption income statements assign all direct production costs and allocate all indirect production costs to inventory. At the time of sale, per unit revenue is matched with per unit expense on the income statement. Variable income statements categorize costs into fixed and variable, and production related and non-production related costs. © 2012 John Wiley and Sons Canada, Ltd.
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B. If the company has no shareholders, the company may have no need for GAAP-based income statements. The variable income statement would be more useful for internal management use. C. If the company wishes to apply for external funds, such as a bank loan, the company may be required to prepare GAAP-basis financial statements. D. It is easy to prepare both types of statements. However, for decision-making purposes the variable statements are better. E. If Nova Scotia Lobsters wants other family members to know how the business is doing, GAAP statements would be prepared in a manner that would allow comparison with other businesses. 15.43 Absorption, Variable, and Throughput Income; Normal Capacity; Choice of Denominator - Giant Jets A. Production and sales data: Year Production Sales
2010 10 10
2011 6 4
2012 8 10
2010 €10,000,000
2011 €4,000,000
2012 €10,000,000
Variable costing income statements: Revenues (jets sold x €1,000,000) Variable costs: Production [jets sold *( €200,000 + €150,000 + €50,000)] Selling (jets sold * €100,000) Contribution margin Fixed costs: Production Administrative and selling Operating income
© 2012 John Wiley and Sons Canada, Ltd.
(4,000,000) (1,000,000) 5,000,000 (600,000) (100,000) € 4,300,000
(1,600,000) (400,000) 2,000,000
(4,000,000) (1,000,000) 5,000,000
(600,000) (600,000) (100,000) (100,000) €1,300,000 € 4,300,000
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Cost Management B. Throughput costing income statements: Revenues (jets sold * €1,000,000) Direct materials (jets sold * €200,000) Throughput margin Operating expenses: Direct labour(jetsproduced * €150,000) Variable production overhead (jets produced * €50,000) Variable selling (jets sold * €100,000) Fixed production overhead Fixed administrative and selling Operating income
2010 €10,000,000 (2,000,000) 8,000,000 (1,500,000) (500,000) (1,000,000) (600,000) (100,000) € 4,300,000
2011 2012 €4,000,000 €10,000,000 (800,000) (2,000,000) 3,200,000 8,000,000 (900,000)
(1,200,000)
(300,000) (400,000) (400,000) (1,000,000) (600,000) (600,000) (100,000) (100,000) € 900,000 € 4,700,000
C. Cost per jet under absorption costing: 2010 €200,000 150,000 50,000
2011 €200,000 150,000 50,000
2012 €200,000 150,000 50,000
100,000 €500,000
75,000 €475,000
10 10
4 6
10 8
€4,600,000 0 €4,600,000
€2,000,000 0 €2,000,000
€3,800,000 1,000,000 €4,800,000
Direct materials Direct labour Variable production overhead Fixed production overhead per unit: €600,000/units produced 60,000 Total cost per jet €460,000 Jets sold Jets produced Cost of goods sold: Units produced this year Units produced last year Total Absorption costing income statements: Revenues (jets sold * €1,000,000) Cost of goods sold Gross margin Administrative and selling [€100,000 + (jets sold * €100,000)] Operating income
2010 €10,000,000 (4,600,000) 5,400,000
2011 2012 €4,000,000 €10,000,000 (2,000,000) (4,800,000) 2,000,000 5,200,000
(1,100,000) € 4,300,000
(500,000) (1,100,000) €1,500,000 € 4,100,000
D. Normal capacity is an average capacity over time. It represents the volume of production that is expected to occur in a typical year. E. There are likely to be differences of opinion on the normal volume. One way to estimate the normal volume is to calculate the average over the three years presented, or 8 jets per year. The following income statement is calculated using 8 jets as the normal volume. © 2012 John Wiley and Sons Canada, Ltd.
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Cost per jet under absorption costing: Direct materials €200,000 Direct labour 150,000 Variable production overhead 50,000 Fixed production overhead per unit: €600,000/8 jets 75,000 Total cost per jet €475,000 Volume variance: Jets produced Fixed production overhead allocated Actual fixed production overhead Over (under)applied overhead
2010 10 €750,000 600,000 €150,000
2011 6 € 450,000 600,000 €(150,000)
2012 8 €600,000 600,000 € 0
The volume variance does not appear to be material relative to total production costs in 2010 and 2011. Therefore, all of it is allocated to cost of goods sold. Absorption costing income statements: Revenues (jets sold x €1,000,000) Cost of goods sold (jets sold * €475,000) Volume variance adjustment Throughput margin Administrative and selling [€100,000 + (jets sold * €100,000)] Operating income
2010 €10,000,000 (4,750,000) 150,000 5,400,000
2011 2012 €4,000,000 €10,000,000 (1,900,000) (4,750,000) (150,000) 0 1,950,000 5,250,000
(1,100,000) € 4,300,000
(500,000) (1,100,000) €1,450,000 € 4,150,000
F. The textbook is not clear about which absorption costing income (the one in Part C or the one in Part E) to use in the reconciliation. Therefore, reconciliations are shown for both income statements. 2010 2011 2012 Jets produced 10 6 8 Jets sold 10 4 10 Increase (decrease) in inventory of jets 0 2 (2) Throughput costing income (Part B) Direct labour and variable production overhead added to (subtracted from) ending variable costing inventory [Change in inventory * (€150,000+€50,000)]
€4,300,000
€ 900,000
0 4,300,000
400,000 1,300,000
(400,000) 4,300,000
200,000 €1,500,000
(200,000) € 4,100,000
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€4,700,000
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€1,300,000
€4,300,000
150,000 €1,450,000
(150,000) € 4,150,000
(a) Because the volume variance was allocated 100% to cost of goods sold, it can be ignored in this reconciliation. 15.44 Absorption, Variable, and Throughput Income and Inventory; Method for Manager Bonus - Fighting Kites A, B, and C. Product costs: Direct materials Other variable production costs Fixed production costs (a) Total product costs
Variable $ 40,000 60,000
Throughput $40,000
$100,000
$40,000
Absorption $ 40,000 60,000 80,000 $180,000
(a) Absorption costing fixed production rate: $100,000/25,000 denominator level = $4 per kit Fixed production cost allocated to kits produced: $4 * 20,000 kits = $80,000 Cost per kit (20,000 produced)
$5
Cost for 2,000 kits from beginning inventory Cost for 16,000 kits produced and sold Cost of Goods Sold Cost for 4,000 kits added to inventory 4,000 kits * $5 4,000 kits * $2 4,000 kits * $9 + volume variance $4,000
$10,000 80,000 $90,000
$2 $ 4,000* 32,000 $36,000
$9 $15,000 144,000 $159,000
$20,000 $8,000 $ 40,000
*The value of the beginning inventory assumes the same proportion of direct materials and other variable production costs as this year. Variable Costing Revenue (a) Variable costs: Production (above) Selling Contribution margin Fixed costs: Production Selling and admin. Operating income
$540,000 (90,000) (18,000) 432,000
Throughput Costing Revenue (a) Raw materials (above) Throughput margin Operating expenses (b) Operating income
(100,000) (100,000) $232,000
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$540,000 (36,000) 504,000 (278,000) $226,000
Absorption Costing Revenue (a) $540,000 Cost of goods sold (above)(159,000) Volume variance (c) (16,000) Gross margin 365,000 Selling and admin. (d) (118,000) Operating income $247,000
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Calculation details: (a) Revenue = 18,000 kits x $30 = $540,000 (b) Throughput costing operating expenses: Other variable production costs Fixed production costs Variable selling costs Fixed selling and administrative costs Total (c) Volume variance: Fixed production cost allocated ($4 x 20,000 kits) Actual fixed production cost (Underallocated) fixed production costs
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$ 60,000 100,000 18,000 100,000 $278,000 $ 80,000 100,000 $ (20,000)
Because the volume variance is material, it is prorated between cost of goods sold and ending inventory: Cost of goods sold ($20,000 *16,000/20,000 kits) $(16,000) Ending inventory ($20,000 *4,000/20,000 kits) (4,000) Total volume variance adjustment $(20,000) (d) Selling and administrative: Variable selling costs $ 18,000 Fixed selling and administrative costs 100,000 Total $118,000 Although the problem does not ask for a reconciliation of income across the three methods, it is useful to prepare a reconciliation to double-check the preceding computations: Throughput costing operating income Direct labour and variable overhead costs added to ending variable costing inventory ($60,000 x 4,000/20,000 kits) Direct labour and variable overhead costs resulting from beginning inventory sold this year (assuming same ratio as this year) Variable costing operating income Difference in fixed overhead costs assumed this year resulting from beginning inventory sold this year (10,000 – 15,000) Fixed overhead costs allocated to ending absorption costing inventory (after the volume variance adjustment, this is equal to actual fixed overhead cost per unit) $100,000 x 4,000/20,000 kits Absorption costing operating income
$226,000 12,000 (6,000) 232,000 (5,000)
20,000 $247,000
D. Student answers to this question should demonstrate that they have considered how the managers might use the absorption costing information, and they should also clarify their assumptions. If the managers’ primary goal in using absorption costing is to assign actual costs to inventory as accurately as possible, then next year’s expected production volume should be used as the denominator value. If demand and production volumes are © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management expected to remain at 20,000, then a volume of 20,000 would be appropriate. If production volumes are not stable, then next year’s volume could be estimated using sales forecasts for next year and/or production volumes over several past years. On the other hand, the managers may wish to monitor use of capacity, particularly if production volumes vary. In that case, a volume such as practical capacity might be best. E. Student responses will vary. Following is an example of a good response. I recommend that Fighting Kites use variable income or throughput income because both of these methods provide less incentive to build up inventories and more incentive to control fixed and overhead costs. In addition, these statements provide information about current period costs to those individuals charged with evaluating managers’ performance. The variable income statement displays fixed and variable, production and nonproduction costs in such a manner that they are easily compared across time for meaningful performance evaluation. For example, if manufacturing fixed costs are considerably higher or lower in one period than in the prior periods, this information would be easy to identify and managers could be rewarded or encouraged to control costs better. In addition, the information from both variable and throughput costing income statements is broken down into categories that are useful for decision-making. When Fighting Kites needs to make a short or long term production decision, the variable costing income statement provides ample relevant information. When capacity constraints exist, throughput costing information may be better. If Fighting Kites guarantees its direct labour employees a 40-hour work week, then throughput costing information provides the best information for decision-making.
15.45 Absorption and Variable Income and Uses, Reconcile Incomes - Security Vehicles A. Variable costing income statement for January: Revenue (3 vehicles * $100,000) Variable costs: Production (3 vehicles * $60,000) Administrative and selling (3 vehicles * $5,000) Contribution margin Fixed costs: Production Administrative and selling Operating income B. Absorption costing income statement for January: Revenue (3 vehicles * $100,000) Cost of goods sold (a) Gross margin Operating expenses: Administrative and selling [$20,000 + ($5,000 * 3 vehicles)] Operating income © 2012 John Wiley and Sons Canada, Ltd.
$300,000 (180,000) (15,000) 105,000 (60,000) (20,000) $ 25,000 $300,000 (225,000) 75,000 (35,000) $ 40,000
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(a) Absorption cost per unit (assuming that fixed costs are allocated based on actual costs and actual production volume): Variable production costs $60,000 Fixed production costs ($60,000/4 vehicles) 15,000 Total absorption cost per unit $75,000 Cost of goods sold (3 vehicles * $75,000)
$225,000
C. This question calls for a reconciliation of February incomes under variable and absorption costing. First calculate February income under these two methods: Variable Costing Revenue (6 * $100,000) $600,000 Variable costs: Production (6 * $60,000) (360,000) Selling (6 * $5,000) (30,000) Contribution margin 210,000 Fixed costs: Production (60,000) Administrative and selling (20,000) Operating income $130,000
Absorption Costing Revenue (6 * $100,000) $600,000 Cost of goods sold (a) (435,000) Gross margin 165,000 Administrative and selling ($20,000 + $5,000 * 6 vehicles) (50,000) Operating income $115,000
Computation details: (a) Absorption cost per unit (assuming that fixed costs are allocated based on actual costs and actual production volume): Variable production costs $60,000 Fixed production costs ($60,000/5 vehicles) 12,000 Total absorption cost per unit during February $72,000 Cost of goods sold: Vehicles produced during February (5 vehicles * $72,000) Vehicle produced during January (1 vehicle * $75,000) Total
$360,000 75,000 $435,000
In February, under absorption cost income, one vehicle was sold from January’s production. In January, overhead allocated to production was $15,000, so February’s income under absorption costing is $15,000 less than variable costing. D. An organization could produce absorption cost income statements for external users such as shareholders, creditors, and suppliers. For internal decision-making information, variable cost income statements could be produced.
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15.46 Throughput Costing, Reconciling Income – Security Vehicles (Continued) A. Throughput costing income statement for January: Revenue (3 vehicles * $100,000) Materialcosts (3 vehicles * $50,000) Contribution margin Other costs: Other Variable Production (4vehicles * $10,000) Fixed Production Variable Administrative and selling (3 vehicles * $5,000) Fixed Administrative and selling Operating income
$300,000 (150,000) 150,000 (40,000) (60,000) (15,000) (20,000) $ 15,000
B. This question calls for a reconciliation of February incomes under variable and throughput costing. First calculate February income under these two methods: Variable Costing Revenue (6 * $100,000) $600,000 Variable costs: Production (6 * $60,000) (360,000) Selling (6 * $5,000) (30,000) Contribution margin 210,000 Fixed costs: Production (60,000) Administrative and selling (20,000) Operating income $130,000
Throughput Costing Revenue (6 * $100,000) $600,000 Cost of materials (a) (300,000) Throughput margin 300,000 Other costs: Other production (110,000) Administrative and selling (50,000) Operating income $140,000
Computation details: (a) Throughput cost of materials ($50,000*6 vehicles) (b) Other Costs: Production Vehicles produced during February (5 vehicles * $10,000) Fixed production costs Total Administration and Selling: Variable administration and selling costs (6 vehicles * $5,000) Fixed administration and selling costs Total In February one vehicle from January inventory was sold.
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$300,000
$50,000 60,000 $110,000 $30,000 20,000 $50,000
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$140,000 ($60,000) 50,000 130,000
15.47 Overapplied/Underapplied Overhead, Units Versus Machine Hours as Allocation Base - Northcoast Manufacturing Company [Note: Parts B and C require students to use and evaluate overhead allocation methods introduced in Chapters 5 and 11.] A. Among the 3 budgeted levels of activity presented in the problem, the one closest to the actual production of 500,000 units is for 540,000 units of production. Based on this budgeted level of activity, the amount of over/underapplied overhead is calculated as follows: Overhead can be allocated based on labour hours or labour costs and the question does not indicate which base to use so both will be shown here. The over or under applied overhead is the same for either base. Based on labour dollars: Estimated overhead allocation rate = Total budgeted overhead/budgeted direct labour cost = $961,200/(36,000 * $15) = 178% of direct labour cost Allocated overhead [(35,000 * $15) * 178%] Actual incurred overhead Overapplied (Underapplied) Overhead
$ 934,500 1,130,000 $ (195,500)
This amount is material because it is over 11% of COGS ($195,500/$1,720,960) Based on labour hours: Estimated overhead allocation rate = Total budgeted overhead/budgeted direct labour hours = $961,200/36,000 = $26.70 per labour hour Allocated overhead (35,000 * $26.70) Actual incurred overhead Overapplied (Underapplied) Overhead
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$ 934,500 1,130,000 $ (195,500)
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Cost Management B. If machine hours were used, the amount of over/underapplied overhead would have been: Overhead allocation rate $961,200/108,000 machine hours = $8.90 per machine hour Allocated overhead ($8.90 * 130,000 machine hours) Actual incurred overhead Overapplied (Underapplied) Overhead
$1,157,000 1,130,000 $ 27,000
C. Machine hours would be a more appropriate allocation base for Northcoast Manufacturing’s fixed manufacturing overhead because the company appears to have a capital-intensive manufacturing process where each direct labourer operates two to four machines simultaneously. In this type of setting, the use of machines drives a large portion of overhead costs, such as depreciation, maintenance, and utilities. Consequently, using machine hours as the allocation base results in more reliable cost information and better decisions. D. If units are used as the denominator volume, managers can shift costs from the income statement to the balance sheet by producing more inventory than is sold. Each unit of inventory carries with it a portion of fixed cost that is booked as an asset (inventory) on the balance sheet and so fixed overhead cost is not completely expensed for the accounting period. 15.48 Recommend Income Format - GameZ A. Three choices are available for income statement formats, absorption costing, variable costing, and throughput costing. Absorption costing meets GAAP standards and is used for income statements required by banks and creditors. Variable and throughput costing income statements produce detailed information that can be used in decision-making. B. Absorption costing matches revenues with expenses under accrual accounting. Because this is required for GAAP, these statements are appropriate for external reports to creditors and shareholders. Variable costing separates costs into fixed and variable categories and expenses all fixed costs as period costs. Income levels are not affected by changes in inventory levels so managers have no incentive to manipulate inventory when income is reported using variable costing. The same advantages and disadvantages apply to absorption costing. C. As mentioned above, the bank and other creditors will want the absorption income statement, but the brother will want information produced by either the variable cost or throughput income statements. Variable cost statements provide more detail than throughput costing so variable income statements would likely be preferred for developing information for decision-making. For compensation purposes, variable or © 2012 John Wiley and Sons Canada, Ltd.
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throughput income statements are best because income is less subject to manipulation through inventory level adjustments. 15.49 Cumulative Exercise (Chapter 3): Breakeven, Absorption and Variable Income, Volume Alternatives - Schatzberg Company [Note: This exercise requires application of knowledge from Chapter 3.] A. To determine the breakeven point, set profit to 0 and solve for the quantity Q: Revenue – Variable costs – Fixed costs = 0 $25Q – ($10 + $5)Q – ($150,000 + $200,000) = 0 $10Q = $350,000 Q = 35,000 units at the breakeven point B. Absorption costing income statement with volume variance closed to COGS Fixed overhead rate = $150,000/50,000 = $3 per unit Ending inventory = ($3 per unit fixed + $10 per unit variable) = $13 per unit Ending inventory = 40,000 units produced – 35,000 units sold = 5,000 units Revenue ($25 * 35,000 units) Cost of goods sold ($13 * 35,000) Volume variance [(50,000 – 40,000) * $3] Gross Margin Selling and administrative [$200,000 + ($5 * 35,000)] Operating income
$875,000 (455,000) (30,000) 390,000 (375,000) $ 15,000
C. Absorption costing income statement with volume variance prorated Revenue ($25 * 35,000) Cost of goods sold ($13 * 35,000) Volume variance [$30,000 * (35,000/40,000)] Gross Margin Selling and administrative [$200,000 + ($5 * 35,000)] Operating income Reconciliation of volume variance: Included in cost of goods sold (above) Added to inventory [$30,000 * (5,000/40,000)] Total volume variance (in Part B)
$875,000 (455,000) (26,250) 393,750 (375,000) $ 18,750
$26,250 3,750 $30,000
D. Under U.S. GAAP (and IFRS), when volumes are abnormally lower than normal capacity, the volume variance should be closed to COGS. In this exercise, volume is lower than normal by 20% (10,000/50,000), which would probably be considered abnormal (i.e., it would be outside of the normal range for production). Thus, the volume variance should be closed to COGS. E. Variable costing income statement © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management Revenue ($25 * 35,000) Variable costs: Production ($10 * 35,000) Selling and administration ($5 * 35,000) Contribution margin Fixed costs: Manufacturing Selling and administration Operating income
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$875,000 350,000 175,000 350,000 150,000 200,000 $ 0
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MINI-CASES 15.50 Bonuses and Production Decisions, Profit Variances, Income Statement Format Pine Producers A. Grand Forks plant manager’s bonus Third quarter = 5% of $2,338 = $116.90 Fourth quarter = 5% of $12,646 = $632.30 Singapore plant manager’s bonus Third quarter = 5% of $3,190 = $159.50 Fourth quarter = 5% of $5,791 = $289.55 Each plant manager would prefer higher income to receive higher bonus amounts. This may encourage them to produce in excess and build up inventories. The fixed costs would then be spread out over all units and a portion of the fixed costs would be allocated to the balance sheet causing larger incomes. B. For the Grand Forks plant, sales increased but cost of goods sold decreased. Either cost reductions were instituted or there was a build-up of inventory over the period, which would reduce the amount of fixed overhead in cost of goods sold. C. If variable costs are immaterial, the difference in inventory amounts between the last two quarters is assumed to be expense that is on the balance sheet instead of on the income statement. Grand Forks Plant Singapore Plant Fourth quarter income $12,646 $5,791 Change in inventory (18,100) (2,508) Variable costing income (loss) $ (5,454) $3,283 D I would conclude that the Grand Forks plant manager’s performance was poor during the last quarter of the year, and certainly not as good as the performance of the Singapore plant manager. E. There is no one answer to this part. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).
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15.51 Communication of Information The answers below provide suggestions for improved communication. Additional ideas can be found in the following article: Jim Cole, “Speak English Please! How to Communicate Financial Information to Non-Accountants,” SmartPros, October 2004, available at http://accounting.smartpros.com/x44566.xml. A. Here are a few ideas for improving the conciseness and clarity of written and spoken communications; students may think of others. •
• • •
•
Practice eliminating unnecessary words. Re-read what you have written and remove words or phrases that do not add meaning. Think of ways to say the same thing with fewer words. Reflect on phrases or sentences you have spoken and identify ways to simplify them. Avoid using jargon and overly-technical language. Adopt words that will convey your professionalism and also communicate effectively. Read any written communication out loud to detect wordy passages or sentences with unclear meaning. If you stumble over a phrase, it should be rewritten to reflect simple, yet concise language. Learn from your listeners’ reactions. Requests to repeat what you have said might suggest that you mumble or speak too softly. Watch for nonverbal cues, such as frowns or puzzled faces, which indicate your audience does not understand. Avoid speaking too quickly, particularly when leaving telephone messages. Speak slowly and distinctly when providing information such as your name and telephone number. Also slow down when you are trying to make a point.
B. 1. Audience members vary in terms of their expectations, prior experience with the subject matter, learning styles, and so on. It is not possible to fully anticipate the needs of everyone in an audience. 2. Group brainstorming is an excellent way to learn about other peoples’ perceptions. Try this activity and see what you learn! 3. There will be many different types of answers to this question. The purpose is to help students recognize that communication styles should vary from setting to setting. 4. There are two major differences in communication among the three methods introduced in this chapter. First, each costing method assigns a different proportion of production costs to the cost of goods manufactured. All production costs are assigned to products under absorption costing, whereas only variable production costs are assigned to products under variable costing, and only direct materials costs are assigned under throughput costing. Under all three methods, costs not assigned to products are treated as period costs when calculating operating income. Second, each method presents a subtotal on the operating statement that has a unique meaning. © 2012 John Wiley and Sons Canada, Ltd.
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Under absorption costing, the gross margin is the excess of revenues over the product cost of goods sold. Under variable costing, the contribution margin is the excess of revenues over both production and nonproduction variable costs. Under throughput costing, the throughput margin in the excess of revenues over direct material costs of goods sold. C. 1. Indirect messages are any part of communication that is not explicit but that may convey meaning. Examples include posture, facial and other body expressions, tone of voice, connotation of words used, eye contact, personal appearance, quality of penmanship, and physical materials used for written communications. 2. Indirect messages can help communication by conveying information, emphasizing what is said, and improving interactions. Indirect messages can also hinder communication because they may be misinterpreted, particularly between people from different backgrounds who may fail to understand their intended meaning. 3. Effective communication over time involves engaging in continuous improvement in both communicating and understanding others’ communications and ensuring that interactions do not break down. Students’ examples for this question are likely to vary widely. The purpose is to help students use what they have learned from past communication experiences to actively promote more effective future communication. 4. Again, student responses will vary.
15.52 Integrating Across the Curriculum: Financial Accounting and Auditing – Channel stuffing, uncertainties, error versus fraud, fraud incentives and costs A. Channel stuffing is the practice of coercing customers to take delivery of excess merchandise for the purpose of improving the seller’s reported financial results. B. Sales volumes are uncertain for most companies because they are subject to a variety of economic factors that cannot be fully anticipated, such as shifts in customer tastes, changes in competition, introduction of substitute products, changes in customer perceptions about product quality, consumer spending habits, fluctuations in the economy, variations in the sales effort of product distributors, and so on. Uncertainties about sales quantities make it more difficult for companies to plan production volumes, particularly when they cannot be rapidly increased or decreased. C. In the case of McAfee and Harley-Davidson, customers were dealers or distributors with whom they had developed long-term relationships. Accordingly, these customers were willing to accept excess inventories because they were afraid that sufficient future inventories could be in doubt if they failed to cooperate. Sometimes the threat is explicit. For example, in the Bausch & Lomb case discussed in chapter 1, the distributors were © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management told that they would lose their distributorships if they refused to take additional shipments at the end of 1993. D. Here is a possible paragraph, written from the perspective of a Coca-Cola manager: The demand for our products has not slowed down. We have been investing in our company, products and our communities. Following is a list of our achievements in 20071: • Launched more than 150 low- and no-calorie drinks in 2007, increasing our portfolio of low- and no-calorie beverages to more than 700 beverage products. • Spent $366 million with diverse suppliers (first- and second-tier minority- and women-owned businesses) in 2007, a 23-percent increase over 2006. • Invested $40 million to build the world’s largest PET bottle-to-bottle recycling plant. Expected to be operational in 2009 in Spartanburg, South Carolina, the plant will produce approximately 100 million pounds of PET plastic for reuse each year (the equivalent of 2 billion 20-ounce PET bottles). • Achieved a 2 percent improvement in water use efficiency. Coca-Cola plants used an average of 2.47 litres of water to make one litre of beverage. Since 2002, the Coca-Cola system has improved water use efficiency by more than 20-percent, saving more than 160 billion litres of water. • Announced plans to purchase and put into service 100,000 coolers that use CO2 as a refrigerant gas by the end of 2010 – the largest deployment of this new technology by anyone in the industry to date. • Created more than 7,500 jobs in East Africa through the Company’s Manual Distribution Centres program, which has helped start more than 1,800 small distribution businesses and generated more than $500 million in revenue. • Made $99 million in charitable contributions from The Coca-Cola Company and The Coca-Cola Foundation, funding programs in the areas of community and economic development, education, health and wellness, environment, arts and culture, disaster relief, and HIV/AIDS. • Ranked No. 2 on DiversityInc magazine's "Top 50 Companies for Diversity" in 2008, up from the Company's No. 4 ranking in 2007. • Increased its supplier audits by 28-percent for a total of 1,313 audits in 2007, over its 1,029 facility audits in 2006. For several years, we have steadily increased our production to better meet customer demand. Our goal is to keep our customers happy, which includes reducing delivery time. In the past, we have lost sales to competitors because we could not deliver products fast enough. Now we are in a better position to compete, and we expect even stronger sales over the next few years. E. The first step is to examine the CICA’s accounting standards. Then the SEC’s accounting guidelines will be examined. There are two major pronouncements by the CICA with implications for revenue recognition in cases of channel stuffing. The first deals with Revenue recognition which can be found in the accounting standards
1
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handbook section 3400. The appropriate sections have been included here for discussion purposes:2 3400.07 In a transaction involving the sale of goods, performance should be regarded as having been achieved when the following conditions have been fulfilled: (a) the seller of the goods has transferred to the buyer the significant risks and rewards of ownership, in that all significant acts have been completed and the seller retains no continuing managerial involvement in, or effective control of, the goods transferred to a degree usually associated with ownership; and (b) reasonable assurance exists regarding the measurement of the consideration that will be derived from the sale of goods, and the extent to which goods may be returned. [OCT. 1986] 3400.10 Revenue from a transaction involving the sale of goods would be recognized when the seller has transferred to the buyer the significant risks and rewards of ownership of the goods sold. When the seller retains significant risks of ownership, it is normally inappropriate to recognize the transaction as a sale. Examples of a significant risk of ownership being retained by a seller are: when there is a liability for unsatisfactory performance not covered by normal warranty provisions; when the purchaser has the right to rescind the transaction; when the goods are shipped on consignment. 3400.18 Uncertainties relating to the measurement of revenue may result from one or both of the following issues: (a) Consideration When consideration is not determinable within reasonable limits, for example, when payment relating to goods sold depends on the resale of the goods by the buyer, revenue would not be recognized. (b) Returns Revenue would not be recognized when an enterprise is subject to significant and unpredictable amounts of goods being returned, for example, when the market for a returnable good is untested. If an enterprise is exposed to significant and predictable amounts of goods being returned, it may be sufficient to provide therefore. This is relevant in the situation of McAfee because they were accepting returns from their distributors through Net Tools Inc., a company that was a wholly owned subsidiary of McAfee.These returns were not being declared in the books of McAfee and this was a true intentional misrepresentation of their revenue earned. The second indication that revenue should not have been recognized is brought forth by the Emerging Issues Committee Abstract of Issues Discussed EIC-1413. Following are excerpts from the Abstract that are relevant to channel stuffing: 2
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3. Fixed or determinable sales price Paragraph 3400.07(b) requires that the reasonable assurance exists regarding the measurement of the consideration (price) for the sale of goods, and the extent to which goods may be returned. Paragraph 3400.18 then provides brief guidance on uncertainties relating to measurement of the revenue. (b) Right of return arrangements In some sales transactions, a product may be returned, whether as a matter of contract or as a matter of existing practice, either by the ultimate customer or by a party who resells the product to others. The product may be returned for a refund of the purchase price, for a credit applied to amounts owed or to be owed for other purchases, or in exchange for other products. The purchase price or credit may include amounts related to incidental services, such as installation. The existence of a right of return raises significant concerns as to whether the enterprise has reasonable assurance with respect to whether the consideration that will be derived from the sale of the goods is fixed or determinable. Reasonable estimate of future returns (item 3(b)(vi)) The Committee noted that the ability to make a reasonable estimate of the amount of future returns, as required by item (vi), depends on many factors and circumstances that will vary from one case to the next. However, the following factors may impair the ability to make a reasonable estimate: (i)
the susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand;
The existence of one or more of the above factors, in light of the significance of other factors, may not be sufficient to prevent making a reasonable estimate; likewise, other factors, such as the following, may preclude a reasonable estimate: (i)
significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as "channel stuffing");
(ii) lack of "visibility" into or the inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users; (c) Price protections and/or inventory credit arrangements Under some sales arrangements, when an enterprise reduces its published price list for products, it provides cash refunds ("price protection") or credit on future purchases ("inventory credit") to customers (resellers) for products held in their inventories. In many instances, price protection and inventory credit arrangements are offered in lieu of 3
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or in addition to a right of return (i.e., the seller reduces the price that the customer paid for the goods in inventory to the price on the revised price list, rather than have the customer return the goods and then re-order the same goods at the new price). The existence of price protection and inventory credit arrangements raise similar concerns to right of return provisions as to whether the enterprise has reasonable assurance with respect to whether the consideration that will be derived from the sale of the goods is fixed or determinable. The Committee reached a consensus that an enterprise should recognize revenue on sales for which it offers, or reasonably expects to offer, price protection or inventory credit arrangements, only if the amount of price protection or inventory credit adjustments can be reasonably estimated, taking into consideration the above discussion of the factors relating to the ability to reasonably estimate product returns. This is relevant here because McAfee offered “distributors a number of incentives, including deep price discounts, cash payments, and rebates, to continue to hold excess inventory.”4 The discounts and rebates along with the returns made to Net Tools Inc., discussed above, indicate that the SEC could claim that McAfee had improperly recognized revenue and channel stuffing violates GAAP. Because channel stuffing involves selling customers more merchandise than they need, a risk exists that the customers might later return the excess merchandise. In recent years, the SEC has investigated numerous instances of channel stuffing, and its staff has expanded its revenue recognition guidelines to address this problem. The SEC’s accounting standards for revenues refer to FASB Concepts Statement No. 5 and FAS 48.5 The standards also contain a series of questions and answers about whether revenue should be recognize in various situations. Two of these issues may apply to channel stuffing and are discussed below. Question 9 Facts: Paragraph 8 of SFAS No. 48 lists a number of factors that may impair the ability to make a reasonable estimate of product returns in sales transactions when a right of return exists. The paragraph concludes by stating "other factors may preclude a reasonable estimate." Question: What "other factors," in addition to those listed in paragraph 8 of SFAS No. 48, has the staff identified that may preclude a registrant from making a reasonable and reliable estimate of product returns? Interpretive Response: The staff believes that the following additional factors, among others, may affect or preclude the ability to make reasonable and reliable estimates of product returns: (1) significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as "channel stuffing"), (2) lack of "visibility" into or the 4
Cost Management textbook, Focus on Ethical Decision Making – Channel Stuffing at McAfee Inc, page 618 SEC Staff Accounting Bulletin, Codification of Staff Accounting Bulletins, Staff Accounting Bulletin 101: Revenue Recognition in Financial Statements, Revised as of December 2003, available at http://www.sec.gov/interps/account/sab101.htm. © 2012 John Wiley and Sons Canada, Ltd. 5
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Cost Management inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users, (3) expected introductions of new products that may result in the technological obsolescence of and larger than expected returns of current products, (4) the significance of a particular distributor to the registrant's (or a reporting segment's) business, sales and marketing, (5) the newness of a product, (6) the introduction of competitors' products with superior technology or greater expected market acceptance, and other factors that affect market demand and changing trends in that demand for the registrant's products. Registrants and their auditors should carefully analyze all factors, including trends in historical data, that may affect registrants' ability to make reasonable and reliable estimates of product returns. Persuasive evidence that an arrangement exists. The SEC states that companies should not recognize revenue unless they have reached a clear understanding with their customer about the nature and terms of the transaction. When channel stuffing occurs, the seller often requires the buyer to sign a purchase agreement. On the surface revenue recognition appears to be appropriate; however, the substance of the transaction may be different than its legal form. If the seller did not voluntarily agree to the terms, then it could be argued that no agreement exists and that revenue should not be recognized. Inability to reasonably estimate product returns. The SEC staff expanded the list of conditions for FAS 48 to include additional factors that might prevent a company from making a reasonable estimate of its product returns and, therefore, from recognizing revenue. These factors include: •
Significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as “channel stuffing”).
•
The inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users.
The SEC guidelines provide a more stringent test for evaluating whether revenue can be recognized in cases where channel stuffing might have occurred. These guidelines require managers and auditors to evaluate the trends in inventory levels not only at the company but also in its distribution channels. If customer inventory levels have increased significantly, then the revenue probably cannot be recognized. F. As stated in the problem, an error is defined as an unintentional mistake, while fraud is intentional. Thus, the auditor must evaluate whether McAfee’s misstatement was intentional or unintentional. This is a difficult question, because one cannot read the minds of the managers. Were they simply aggressive in meeting sales goals? Or did they intentionally force customers to take inventories that they knew might later be returned? The auditing standards provide some guidance in this area. According to CICA General Assurance and Auditing section, the auditor should maintain an attitude of professional scepticism as shown below. Thus, an auditor is likely to conclude that the McAfee misstatement constituted fraud. © 2012 John Wiley and Sons Canada, Ltd.
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5135.024 ¨The auditor should maintain an attitude of professional scepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding the auditor's past experience with the entity about the honesty and integrity of management and those charged with governance. [JAN. 2006]6 G. Managers have many incentives to continue reporting sales and earnings growth. These incentives include performance-based bonuses, the value of the manager’s stock or stock options, manager reputation, and job security. H. Behaviour such as channel stuffing imposes both direct and indirect costs on the company. Direct costs include higher income taxes, foregone opportunities to reduce production costs, and possible increases in customer bad debts. Indirect costs include loss of reputation, which in turn increases the company’s cost of capital, weakens its relationships with customers, and encourages higher employee turnover. In addition to the company’s own effects, the stockholders often experience a large decline in the value of their investment. This type of fraud can also lead to greater financial trouble for the company, which often increases employee layoffs and can cause financial distress for the company’s suppliers and customers.
6
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Chapter 15 Measuring and Assigning Costs for Income Statements LEARNING OBJECTIVES Chapter 15 addresses the following objectives: LO1 Prepare absorption and variable costing income statements and reconcile the resulting net incomes. LO2 Discuss the factors that affect the choice of production volume measures for allocating fixed overhead. LO3 Prepare absorption and variable costing income statements considering beginning inventory balances, and evaluate the impact of inventory on income. LO4 Prepare throughput costing income statement and evaluate absorption, variable, and throughput costing income. These learning objectives (LO1 through LO4) are cross-referenced in the textbook to individual exercises and problems.
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QUESTIONS 15.1
The three methods are similar because they assign some costs to inventory as product costs, and expense other costs as period costs. The three methods differ in the categories that are used for product and period costs. Details of these categorizations follow. Absorption costing allocates all production costs, both fixed and variable, to units as product costs so cost of goods sold and inventory on the balance sheet include fixed manufacturing costs. Cost of goods sold is subtracted from revenue to arrive at gross margin, and then other nonmanufacturing expenses are subtracted to arrive at operating income. Variable costing assigns direct costs (direct labour and direct materials) and variable overhead costs to inventory and variable cost of goods sold. Variable cost of goods sold and all other non-manufacturing variable costs are subtracted from revenue to arrive at contribution margin. All fixed costs, both manufacturing and non-manufacturing, are then subtracted from contribution margin to arrive at operating income. Throughput costing assigns only direct materials costs to inventory and throughput cost of goods sold. Throughput cost of goods sold is subtracted from revenue to arrive at throughput margin. All other costs are considered period costs and deducted from throughput margin to arrive at operating income. Uses of the three methods are different, also. Absorption costing income statements meet GAAP and are used by shareholders and other external stakeholders. Variable costing income statements generally do not meet GAAP and are only available for internal reporting. Information from these reports is used in decision-making. Throughput accounting income statements provide information for very short-term decisions and are especially helpful when capacity constraints exist.
15.2
The allocated fixed manufacturing overhead that is added (if production is greater than sales) or subtracted (if production is less than sales) from finished goods is the reconciliation amount between variable versus absorption costing.
15.3
The volume variance arises because of differences between actual volumes and budgeted volumes used to allocate fixed manufacturing overhead. Under variable costing all fixed manufacturing overhead is treated as a period expense; there are no allocations of fixed manufacturing overhead to inventory or variable cost of goods sold. Hence, there will be no volume variances.
15.4
Under variable costing, all fixed manufacturing overhead is treated as an expense of the period, regardless of how many units were produced or sold; income will vary only with the number of units sold, the level of production has no effect. Under absorption costing, fixed manufacturing overhead is first assigned to product; the amount of fixed overhead that appears on the income statement depends on unit sales. Income depends upon both the level of production and the level of sales.
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15.5
Eventually all of the units are sold under either method, so eventually all of the fixed manufacturing cost will be expensed under either method. Under variable costing, it is expensed during the period it is incurred, whereas under absorption costing, a portion of fixed manufacturing cost is inventoried and expensed when the inventory is sold rather than during the period it was incurred.
15.6
A variable cost increases proportionately with volume. Variable costing is a method of calculating income.
15.7
Unless the organization is not-for-profit, none. For most on-going, profit-seeking firms, denominator volume should exceed breakeven volume because the firm plans to be operating at volumes greater than breakeven.
15.8
The fixed manufacturing overhead of the current period will be shown in its entirety as an expense if variable costing is used. If absorption costing is used, some of it will be assigned to the units added to inventory, so that the fixed manufacturing overhead included in cost of goods sold will be less than the total fixed manufacturing overhead that is expensed on the variable costing income statement.
15.9
Both IFRS and GAAP require absorption costing to match production-related expenses to revenues.
15.10 This can be accomplished through the use of an adjusting journal entry at the end of the period. The objective is to distribute or allocate the fixed manufacturing overhead of the period between inventories on hand (WIP and FG) and cost of goods sold. 15.11 A joint cost may be either fixed or variable and a separable cost may be either fixed or variable. Both variable and absorption costing can be applied to joint product situations. Under variable costing, the joint costs are first categorized as fixed or variable and then listed on the income statement under the headings of variable or fixed production costs. Under absorption costing, the common and separable costs are considered product costs and assigned to inventory. 15.12 Under absorption costing, managers could manipulate earnings during a period by producing more inventory than is sold. As inventory on the balance sheet increases, the amount of fixed overhead expense allocated to the units in inventory also increases, while expense for cost of goods sold decreases because the fixed overhead is spread across and increasingly large number of units, some of which are not sold. 15.13 Supply-based capacity levels measure the amount of capacity that is available for production. Theoretical capacity and practical capacity are supply based. Demand-based capacity levels measure the amount of capacity needed to meet sales volumes. Normal capacity and budgeted capacity are demand based. 15.14 Theoretical capacity is the maximum number of units that would be produced under continuous, uninterrupted production over 365 days per year. Practical capacity is the upper capacity limit taking into account regularly scheduled times for production and © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management planned downtimes for holidays, maintenance, and any other scheduled interruptions in production. Normal capacity is an average use of capacity across time under normal circumstances. Budgeted or expected capacity is the planned use of capacity in the next period. Theoretical capacity and practical capacity are supply-based capacity levels that depend on the amount of capacity available for production. Normal capacity and budgeted or expected capacity are demand-based capacity levels that measure the amount of capacity needed to meet sales volumes.
15.15 In the financial statements, volume variances that are immaterial are allocated to cost of goods sold. When the volume variance is large and favorable, the variance is prorated among cost of goods sold and ending inventory. If production is below normal capacity, the volume variance is closed to cost of goods sold to avoid increasing the amount of fixed cost in inventory on the balance sheet.
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MULTIPLE-CHOICE QUESTIONS The following information pertains to Questions 15.16 and 15.17: Vintage Co. made 4,000 units of a product during its first year of operations and sold 3,000 units for $600,000. There was no ending work-in-process inventory. Total costs were $600,000: Direct materials and direct labour $250,000 Manufacturing overhead (50% fixed) $200,000 Marketing and administrative costs (100% variable) $150,000 15.16 The cost of the 1,000 units of finished goods ending inventory under variable costing is: a) $150,000 b) $125,000 c) $112,500 d) $87,500 e) $62,500 Ans: D ( $250,000 + ($200,000 *50%) )/4000 * 1000 = $87,500 15.17 The cost of the 1,000 units of finished goods ending inventory under absorption costing is: a) $150,000 b) $125,000 c) $112,500 d) $62,500 e) $25,000 Ans: C ( $250,000 + $200,000 )/4000 * 1000 = $112,500 15.18 In Company LL, the fixed factory overhead per unit is $5, and the fixed selling administration charges are $11. This year, the company produced and sold 100,000 units of product. The company uses the LIFO method of accounting for its inventory. What would be the difference in income reported by the company if it used variable costing instead of absorption costing? a) $ 0 b) $ 500,000 c) $1,100,000 d) $1,600,000 Ans: A Since there is no ending inventory all fixed costs are reported on the income statement under both methods.
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15.19 How does the accounting treatment of selling and administration costs differ between absorption and variable costing if more units are produced than are sold? a) The variable portion is added to the cost of ending inventory based on a pro rata portion of units produced to those sold. b) The fixed portion is added to the costs of ending inventory based on a pro rata portion of units produced to those sold. c) There is no difference in the treatment. d) Both fixed and variable portions are added to the cost of ending inventory based on a prorata portion of units produced to those sold. Ans: C 15.20 Which of the following statements is true about the variable cost method? a) It is always inappropriate for performing a profitability analysis. b) It is useful for determining the price of a product for a special order. c) It is always useful when fixing the price for a long period. d) It is helpful for performing target costing. Ans: B
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EXERCISES 15.21 Absorption and Variable Income - Famous Desk Company A and B. First list all pertinent information: Revenue = 220 desks * $300 = $66,000 Variable production costs = 220 desks * $80 = $17,600 Variable selling and administrative costs = 220 desks * $30 = $6,600 Fixed selling and administrative = $6,000 Fixed overhead absorbed into inventory under normal production Beginning Inventory 100 units with variable cost of $80 per desk and absorption cost of $146.67 per desk $146.67 - $80 = $66.67 fixed costs per desk Fixed overhead volume variance = $10,000 – (200 desks x $66.67) = $3,334 overapplied, which is closed to COGS Variable Costing Revenue Variable costs: Production Selling Contribution Margin Fixed costs: Production Admin and Sales Operating income
$66,000 (17,600) (6,600) 41,800 (10,000) (6,000) $25,800
Absorption Costing Revenue $66,000 Cost of goods sold 220 desks x ($80 + $66.67) (32,267) Volume variance 3,334 Gross Margin 37,067 Selling and administrative ($6,600 + $6,000) Operating income
(12,600) $24,467
Double-check calculations: Difference in operating income = 20 units x $66.67 = $1,333 (fixed overhead brought into income statement under absorption costing from units produced in prior periods) Difference in operating income = $25,800 - $24,467 = $1,333.
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15.22 Absorption and Variable Income, Reconcile Incomes - Rock Crusher Corp. A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. Variable costing income statement VARIABLE COSTING Variable cost per unit produced A100 A300 Revenue Variable costs: Production: A100 A300 Selling Contribution margin Fixed costs: Production: Selling and administrative Operating income
$5.00 $2.50 $240,000
$15,000 10,000
(25,000) (35,000) 180,000 (100,000) (60,000) $20,000
Computation details for variable production cost per unit: A100: $20,000/4,000 tons = $5 per ton A300: $15,000/6,000 tons = $2.50 per ton B. Absorption costing income statement: ABSORPTION COSTING Fixed production cost per ton Total production cost per ton: A100 A300
Revenue Cost of goods sold: A100 A300 Gross margin Selling and administrative: Variable Fixed Operating income
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$10.00 $15.00 $12.50
$240,000 $45,000 50,000
$35,000 60,000
(95,000) 145,000
(95,000) $50,000
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Calculation details for cost of goods sold: Fixed production cost per ton = $100,000/10,000 tons = $10 per ton Variable production cost per ton was calculated in Part A Cost of goods sold: A100 [($10+$5) x 3,000] $45,000 A300 [($10+$2.50) x 4,000] 50,000 Total $95,000 C. The difference in income resides in inventory. There was no beginning inventory, but there were 3,000 tons (10,000 tons produced – 7,000 tons sold) with $10 of fixed production cost per ton absorbed into inventory on the balance sheet under absorption costing. The difference in income = $50,000 - $20,000 = $30,000, and the fixed production cost in inventory is 3,000 x $10 = $30,000. 15.23 Absorption and Variable Inventory and Income, Reconciliation - Start-Up Firm A and B. Units in ending inventory: Units beginning inventory Units produced Units sold Units ending inventory
0 1,000 (850) 150
Variable Costing Revenue (850 units × $89) $75,650 Variable costs: Production (850 units × $40) (34,000) Selling (850 units × $9) (7,650) Contribution Margin 34,000
Absorption Costing Revenue (850 units × $89) $75,650 Cost of goods sold 850 units × ($40 + $10) (42,500)
Fixed costs: Production Selling and administrative Operating Income (Loss)
Selling and administrative ($25,000 + $9 × 850 units)
(32,650)
Operating Income
$
Ending inventory ($40 × 150 units)
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(10,000) (25,000) $(1,000)
Gross Margin
33,150
500
Ending inventory $6,000
[$40+($10,000/1,000)]×150 units
$7,500
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Cost Management C. With no beginning inventory, the reconciliation of variable costing to absorption costing income is affected by only ending inventory: Variable costing operating income (loss) Fixed manufacturing overhead added to ending inventory under absorption costing [(150 units × ($10,000/1,000 units)] Absorption costing operating income
$(1,000) 1,500 $ 500
15.24 Absorption and Variable Inventory and Income, Reconciliation Calculations for both costing methods: Selling price: $200,000 revenue last year / 5,000 units sold last year = $40 per unit Variable manufacturing cost: $40,000/5,000 units produced = $8 per unit Units in ending inventory = 5,000 units produced – 4,500 units sold = 500 units Variable selling and administration cost: $30,000/5,000 units sold last year = $6 per unit A. Variable costing (1) Ending inventory: $8 variable manufacturing cost per unit * 500 units = $4,000 (2) Variable costing income statement Revenue ($40 *4,500 units) Variable costs: Manufacturing costs ($8 * 4,500 units) Selling and administration($6 * 4,500 units) Contribution margin Fixed costs: Manufacturing costs Selling and administration Operating Income
$180,000 36,000 27,000 117,000 60,000 50,000 $ 7,000
B. Absorption costing Fixed production cost allocation rate: $60,000/5,000 units = $12 per unit Absorption cost per unit = $8 variable manufacturing cost per unit + $12 fixed manufacturing cost per unit = $20 per unit Note: No information is provided about any capacity levels other than actual production volume, so these calculations assume that actual costing is used. (1) Ending inventory: $20 absorption cost per unit × 500 units = $10,000 (2) Absorption Costing Income Statement Revenue ($40 *4,500 units) Cost of goods sold ($20 * 4,500 units) Gross margin Selling and administration[$50,000 + ($6 * 4,500 units)] Operating Income © 2012 John Wiley and Sons Canada, Ltd.
$180,000 90,000 90,000 77,000 $ 13,000
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C. With no beginning inventory, the reconciliation of variable costing to absorption costing income is affected by only ending inventory: Variable costing operating income Fixed manufacturing overhead added to ending inventory under absorption costing ($12 × 500 units) Absorption costing operating income
$ 7,000 6,000 $13,000
15.25 Absorption and Variable Income – Vintage Co. A. Total variable manufacturing costs = $250,000 + $190,000(.55) = $354,500 Variable manufacturing cost per unit = $354,500/4,000 = $88.625 Cost of ending finished goods inventory = 1,000 × $88.625 = $88,625 B. Under absorption costing, fixed manufacturing overhead would be included in ending finished goods inventory, but it would not be included under variable costing. Therefore, net profit would increase by the following amount: Variable manufacturing overhead / total units produced * ending inventory =($190,000 * 45%)/4,000 * 1,000 = $21,375 decrease in COGS under absorption costing = $21,375 increase in operating income Alternative calculation: Net profit under absorption costing: Revenue – [Total production costs / units produced * units sold] – selling and administrative = $600,000 - [($250,000 + $190,000) /4,000 * 3,000] - $150,000 = $600,000 - $330,000 - $150,000 = $120,000 Net profit under variable costing: Revenue – [Variable production costs/units produced * units sold – fixed production costs – selling and administrative = $600,000 - [($250,000+($190,000*55%)]/4,000*3,000] - ($190,000*45%) - $150,000 = $600,000 - $265,875 - $85,500 - $150,000 = $98,625 Difference = $120,000 - $98,625 = $21,375 increase
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15.26 Absorption and Variable Income – The Wye Co. Ltd. A. Which income statement was prepared using actual absorption costing? Under actual absorption costing, cost of goods sold is calculated as the actual rate * actual inputs used for both direct and indirect costs. Therefore, no variances would be calculated and the income statement is E. B. Which income statement was prepared using standard variable costing? Under standard variable costing, cost of goods sold is calculated as the standard variable cost * the standard inputs allowed for actual outputs. Therefore, there may be variable cost variances but no fixed cost variances and the income statement is B. C. How many units of product RGW were actually produced during the year? Operating income statement D includes all variance therefore it is standard absorption costing. COGS $378,000 / $42 = 9,000 units Operating income statement B (i.e. standard variable costing) $514,000 Operating income statement D (i.e. standard absorption costing) 508,000 Fixed overhead in ending inventory $6,000 $6,000 / $6 standard fixed overhead per unit = 1,000 ending inventory units Number of units sold 9,000 Number of units produced 10,000 15.27 Absorption and Variable Costing Income – Hamilton Limited A. Variable costs = $9 + $12 + $15 + $6 = $42 Profit/loss = 70,000 units* ($72 - $42) - $1,800,000 - $600,000 = $2,100,000 - $2,400,000 = $300,000 loss B. 100,000 units sold - 70,000 units produced = 30,000 units in inventory Inventory under absorption costing includes a portion of fixed manufacturing costs, whereas no fixed manufacturing costs are inventoried under variable costing. Therefore, income would be 30,000 * $18 = $540,000 higher under absorption costing than under variable costing. ($300,000) + $540,000 = $240,000
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15.28 Throughput Inventory and Income, Reconciliation Continuation of 15.24 A. Throughput costing Direct cost per unit: $25,000/5,000 units produced = $5 per unit Other variable manufacturing costs per unit: ($40,000 – $25,000) /5,000 units produced = $3 per unit (1) Ending inventory: $5 direct cost per unit × 500 units = $2,500 (2) Throughput Costing Income Statement Revenue ($40 × 4,500 units) Direct material costs ($5 × 4,500 units) Throughput contribution Other costs: Manufacturing costs [$60,000 + ($3 *5,000 units)] Selling and administration[$50,000 + ($6 * 4,500 units)] Operating Income
$180,000 22,500 157,500 75,000 77,000 $ 5,500
B. With no beginning inventory, the reconciliation of throughput costing to variable costing is affected by only ending inventory: Throughput costing operating income Non-material variable manufacturing costs added to ending inventory under variable costing ($3 × 500 units) Absorption costing operating income
$5,500 1,500 $7,000
15.29 Absorption and Variable Inventory and Income - Plains Irrigation A. The value of inventory is higher when absorption costing is used because some fixed manufacturing overhead is allocated to inventory to match revenue with expense at the time of sale. If there is fixed manufacturing overhead, the value of inventory under absorption costing will always be higher than under variable costing. B. To identify the costing method that would result in higher income, first calculate the change in inventory during October under both methods: October inventory added under absorption costing ($2,598-$1,346) October inventory added under variable costing ($1,647-854) Difference
$1,252 793 $ 459
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15.30 Absorption, Variable, and Throughput Inventory and Income - Asian Iron A. 1. Under variable costing: Total variable production cost = (NT$2,300 + 3,300 + 2,800) = NT$8,400 Variable cost per unit = NT$8,400/10,500 = NT$0.80 per unit Units in ending inventory = 10,500 – 9,400 = 1,100 units Ending inventory = NT$0.80 x 1,100 units = NT$880 2. Under absorption costing: Fixed manufacturing overhead = NT$8,250/10,500 units = NT$0.7857 per unit Total cost per unit = NT$0.80 + NT$0.7857 = NT$1.5857 Ending inventory = NT$1.5857 x 1,100 units = NT$1,744 3. Under throughput costing: Total direct materials cost per unit = NT$2,300/10,500 units = NT$0.21905 Ending inventory = NT$0.21905 x 1,100 units = NT$241 C. 1, 2, 3 Variable Costing
Absorption Costing
Throughput Costing
Revenue NT$32,900 Variable costs: Production (NT$0.80 x 9,400) (7,520) Selling (940) Contribution margin 24,440 Fixed costs: Production (8,250) Selling and admin. (14,560) Operating income NT$ 1,630
Revenue NT$32,900 Cost of goods sold (NT$1.5857 x 9,400) (14,906) Gross margin 17,994 Selling and admin. (NT$940 + 14,560) (15,500) Operating income NT$ 2,494
Revenue NT$32,900 Direct materials (NT$0.21905 x 9,400) (2,059) Throughput margin 30,841 Operating expenses (a) (29,850) Operating income NT$ 991
(a) NT$(3,300 + 2,800 + 940 + 8,250 + 14,560) = NT$29,850 Double-check computations for absorption versus variable costing: There were no beginning inventories. Therefore, the change in inventory is equal to the ending inventory (calculated in Part A). Inventory under absorption costing NT$1,744 Inventory under variable costing 880 Difference in inventory NT$ 864 Difference in operating income - NT$2,494 - NT$1,630
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NT$ 864
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Double-check computations for absorption versus throughput costing: Inventory under absorption costing NT$1,744 Inventory under throughput costing 241 Difference in inventory NT$1,503 Difference in operating income - NT$2,494 - NT$991
NT$1,503
C. It is first necessary to calculate the revenue and variable costs per unit: Revenue per unit = NT$32,900/9,400 = NT$3.50 Variable production cost per unit = NT$0.80 Variable selling cost per unit = NT$940/9,400 = NT$0.10 Revenue (12,110 x $3.50) Variable costs: Production (12,110 x NT$0.80) Selling (12,110 x NT$0.10) Contribution margin Fixed costs: Production Selling and administrative Operating income
NT$42,385 (9,688) (1,211) 31,486 (8,250) (14,560) NT$ 8,676
15.31 Calculations Using Balance Sheet Data – A Manufacturing Firm A. Balance Sheet 2 has higher unit costs in inventory, so it must be an absorption costing statement. B. Assuming that costs per unit did not decrease, the decrease in total cost of inventory from January 1 to January 31 indicates that more units were sold than produced. C. Difference between variable costing income and absorption costing income: Fixed costs in beginning absorption inventory ($38,000 – $17,000) $21,000 Fixed costs in ending absorption inventory ($19,000 – $8,000) 11,000 Variable costing income higher than absorption costing income $10,000 15.32 Calculations Using Income Statement Data A. Absorption costing will have the larger cost per unit for cost of goods sold, so Income Statement 2 must be the absorption costing statement and Income Statement 1 must be the variable costing statement. B. Absorption costing income is higher than variable costing income, so the quantity of units in inventory must have increased during the period. Thus, production exceeded sales. © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management C. The difference between the two income statements is the treatment of fixed manufacturing overhead costs. Under absorption costing, manufacturing overhead cost per unit is included in cost of goods sold. Under variable costing, the total amount of manufacturing overhead costs incurred during the current period is included in other expenses. Thus, the total amount of fixed overhead can be calculated from the difference in other expenses shown on the two income statements: $4,180 – $3,100 = $1,080 Note that fixed overhead cannot be derived by comparing cost of goods sold because some of the fixed overhead will be deferred into ending inventory under absorption costing. The amount deferred this period is: $1,080 – ($4,032 – 3,000) = $48
15.33 Absorption, Variable, and Throughput Income, Reconcile Incomes - Happy Bikers Motorcycle Company A, B, C. Variable Costing Revenue (a) Variable costs: Production (b) Selling (c) Contribution margin Fixed costs: Production Selling and admin. Operating income
$150,000 (45,000) (3,750) 101,250
Absorption Costing Revenue (a) Cost of goods sold (d) Volume variance (e) Gross margin Selling and admin. (f) Operating income
$150,000 (105,000) 26,667 71,667 (43,750) $ 27,917
Throughput Costing Revenue (a) Raw materials (g) Throughput margin Operating expenses (h) Operating income
$150,000 (30,000) 120,000 (101,750) $ 18,250
(40,000) (40,000) $ 21,250
Calculation details: (a) Revenue = 15 motorcycles * $10,000 = $150,000 (b) Variable production costs = 15 motorcycles * ($2,000 + $1,000) = $45,000 (c) Variable selling and administrative costs = 15 motorcycles * $250 = $3,750 (d) Absorption cost of goods sold: Normal capacity = 10 motorcycles per month Estimated fixed overhead per motorcycle = $40,000/10 = $4,000 Total fixed and variable production cost per unit = $4,000 + $2,000 + $1,000 = $7,000 Cost of goods sold = 15 motorcycles* $7,000 = $105,000 (e) Volume variance: Fixed production overhead $ 40,000 Allocated overhead (18 motorcycles * $4,000) 72,000 Overapplied overhead $(32,000) Because the volume variance is material relative to actual production costs, it will be prorated between cost of goods sold and ending inventory. The portion allocated to cost of goods sold is: $32,000 * (15/18 motorcycles) $(26,667) (f) Total selling and administrative expense = $40,000 + 15 motorcycles * $250 = $43,750 © 2012 John Wiley and Sons Canada, Ltd.
Chapter 15: Measuring and Assigning Costs for Income Statements (g) Total raw materials = 15 motorcycles * $2,000 = $30,000 (h) Total operating expenses: Direct labour and variable overhead (18 motorcycles * $1,000) Fixed production costs Variable selling and administrative (15 motorcycles * $250) Fixed selling and administrative Total
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$ 18,000 40,000 3,750 40,000 $101,750
D. Here is a schedule to reconcile the three income statements. Recall that inventory increased during the month by 3 units (18 motorcycles manufactured – 15 motorcycles sold). Throughput costing operating income $18,250 Direct labour and variable overhead costs added to ending variable costing inventory (3 motorcycles * $1,000) 3,000 Variable costing operating income 21,250 Fixed overhead costs allocated to ending absorption costing income (after the volume variance adjustment, this is equal to actual fixed overhead cost per unit) [3 motorcycles x ($40,000/18)] 6,667 Absorption costing operating income $27,917 15.34 Variable and Absorption Costing, Multiyear Analysis – LeFiell Manufacturing A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. and B. Below are the income statements produced using the spreadsheet. 2010 2011 2012 Units Sold 14,000 15,000 16,000 Units Produced 15,000 15,000 15,000 $500,00 Fixed Production Costs 0 $500,000 $500,000 7 Variable production costs per unit 75 75 5 20 Selling price per unit 200 200 0 Fixed selling and administrative expenses 100,000 100,000 100,000 Absorption Costing Revenue (a) Cost of Goods Sold (b) Gross Margin © 2012 John Wiley and Sons Canada, Ltd.
2010 $2,800,0 00 1,516,66 7 $1,283,3
2011 $3,000,0 00 1,625,00 0 $1,375,0
2012 $3,200,0 00 1,733,33 3 $1,466,6
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Selling and Administrative Operating Income
© 2012 John Wiley and Sons Canada, Ltd.
33 100,000 $1,183,3 33
00 100,000 $1,275,0 00
67 100,000 $1,366,6 67
Chapter 15: Measuring and Assigning Costs for Income Statements
Variable Costing Revenue (a) Variable Production Costs (c) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income
2010 $2,800,0 00 1,050,00 0 $1,750,0 00
2011 $3,000,0 00 1,125,00 0 $1,875,0 00
2012 $3,200,0 00 1,200,00 0 $2,000,0 00
500,000 100,000 $1,150,0 00
500,000 100,000 $1,275,0 00
500,000 100,000 $1,400,0 00
Calculations Details: (a) Revenue = units sold x $200 (b) Absorption Cost of Goods Sold: * Fixed Production Cost per unit = $500,000 / 15,000 units= Total Production Cost per unit = $75 + $33.33333 = Absorption cost of Goods Sold = $108.33 x units sold (c ) Variable Production Costs = $75 x units sold
$33.333 33 $108.33333
*Since fixed overhead costs and production were constant each month the fixed overhead production cost per unit was calculated using the 15,000 units produced each month. Ending Inventory Value: Absorption Costing $108.3333 x units remaining in inventory 2010 = 1,000 units
2010
C. © 2012 John Wiley and Sons Canada, Ltd.
2012
$108,333 .33 $108,333 .33
2011 = 1,000 units 2012 = 0 units Variable Costing $75 x units remaining in inventory
2011
$0
$75,000. 00
$75,000. 00
$0
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Difference in Operating Income Absorption Costing Income Variable Costing Income Difference in Operating Income Difference in Change in Inventory Absorption costing: Ending Inventory Beginning Inventory Increase (decrease)
© 2012 John Wiley and Sons Canada, Ltd.
2010 $1,183,3 33 1,150,00 0 33,333
$108,333 .33 0 108,333. 33
2011 2012 $1,275,0 $1,366,66 00 7 1,275,00 0 1,400,000 0
(33,333)
$108,333 $ .33 0 108,333. 108,333.3 33 3 (108,333. 0 33)
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Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference
$75,000. 00 0 75,000.0 0 33,333.3 3
$75,000. $ 00 0 75,000.0 0 75,000.00 (75,000.0 0 0) (33,333.3 0 3)
The net income under the absorption costing method is higher in 2010 because a portion of the fixed production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under absorption costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2011 the net incomes were the same because production and sales were equal and the higher inventory costs carried over to the balance sheet again. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $ 3,825,000 under both methods. 15.35 Throughput Costing, Multiyear Approach – LeFiell Manufacturing (Continued) A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A and B: Below is the income statement produced using the spreadsheet. 2010 2011 2012 14,0 15,0 16,0 Units Sold 00 00 00 15,0 15,0 15,0 Units Produced 00 00 00 Fixed Production Costs $500,000 $500,000 $500,000 Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Direct materials per unit Throughput Costing Revenue (a) © 2012 John Wiley and Sons Canada, Ltd.
75 2 00 100,0 00 50
$2,800,00
75 2 00 100,0 00 50
75 2 00 100,0 00 50
$3,000,00 $3,200,00
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Direct material costs (b) Throughput contribution Other costs: Other production costs (c) Selling and administrative expenses (d) Operating Income
© 2012 John Wiley and Sons Canada, Ltd.
0 700,0 00 $2,100,00 0
0 0 750,0 800,0 00 00 $2,250,00 $2,400,00 0 0
875,0 00 100,0 00 $1,125,00 0
875,0 875,0 00 00 100,0 100,0 00 00 $1,275,00 $1,425,00 0 0
Chapter 15: Measuring and Assigning Costs for Income Statements
Calculations Details (a) Revenue = units sold x $200 (b) Direct material costs = units sold x $50 (c ) Other Production Costs = [($75 - 50) x units produced] + $500,000 (d) Selling and administrative expenses = $100,000 Ending Inventory Value: Throughput Costing Direct materials per unit x units remaining in inventory $50,000.0 2010 = 1,000 units 0 $50,000. 00
2011 = 1,000 units 2012 = 0 units
Difference in Operating Income Throughput Costing Income Variable Costing Income (15.34) Difference in Operating Income Difference in Change in Inventory Throughput costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference © 2012 John Wiley and Sons Canada, Ltd.
-
2010 $1,125,00 0 1,150,0 00 (25,0 00)
2011 $1,275,0 00 1,275,0 00
50,000. 00
50,000. 00 50,000. 00
50,000. 00 75,000. 00 75,000. 00 (25,000.
-
75,000. 00 75,000. 00 -
2012 $1,425,0 00 1,400,0 00 25,0 00
50,000. 00 (50,000. 00) 75,000. 00 (75,000. 00) 25,000.
139
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Cost Management 00)
-
00
The net income under the variablecosting method is higher in 2010 because a portion of the variable production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under variable costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2011 the net incomes were the same because production and sales were equal and the higher inventory costs carried over to the balance sheet again. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $ 3,825,000 under both methods. 15.36 Variable and Absorption Costing, Multi-year Approach – MacHine Company A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. and B. 2010 Units Sold
5,000
Units Produced
5,500
Fixed Production Costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Absorption Costing Revenue (a) Cost of Goods Sold (b) Gross Margin Selling and Administrative Operating Income © 2012 John Wiley and Sons Canada, Ltd.
$200,000 55 175 50,000 2010 $875,000 .00 456,818. 18 $418,181 .82 50,000.0 0 $368,181 .82
2011 5, 500 6, 000 $200, 000
2012 6, 000 5, 000 $200,00 0
55
55
175 50, 000
175 50, 000
2011 $962,500. 00 487,348.4 8 $475,151. 52
2012 $1,050,000 .00
50,000.00 $425,151. 52
563,333.33 $486,666.6 7 50,000. 00 $436,666.6 7
Chapter 15: Measuring and Assigning Costs for Income Statements
Variable Costing Revenue (a) Variable Production Costs (c) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income
2010 $875,000 .00 275,000. 00 $600,000 .00
2011 $962,500. 00 302,500.0 0 $660,000. 00
200,000. 00 50,000.0 0 $350,000 .00
200,000.0 0
200,000.00
50,000.00 $410,000. 00
50,000.00 $470,000.0 0
Calculations Details: 2010 2011 (a) Revenue = units sold x $175 (b) Absorption Cost of Goods Sold: *Fixed Production Cost per unit (allocated based on actual production) = $200,000 / actual production 36.3636 each year 4 33.33333 Total Production Cost per unit 91.3636 = $55 + fixed prod cost per unit 4 88.33333 **Absorption cost of Goods Sold 2010 = units sold x Total prod cost/unit 2011 = 500 u (end inv in 2007) x $91.36364 + 5,000 u x $88.33333 2012 = 1,000 u (end inv in 2008) x $88.33333 + 5,000 u x $95 (c) Variable Production Costs = $55 x units sold
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2012 $1,050,000 .00 330,000.00 $720,000. 00
2012
40.00000 95.00000 456,818.1 8 487,348.4 8 563,333.3 3
*Since fixed overhead costs and production were not constant each month the fixed overhead production cost per unit was calculated using the actual units produced each month. Alternatively the average could have been calculated based on a normal capacity but this information was not given in the question. **Since the production costs are not the same each year, the cost of goods sold must take into account that the ending inventory from the prior year has a different cost than the current year production. Since the company uses a FIFO costing system the assumption was © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management made that the beginning inventories were sold first at last year’s cost and then the remaining units sold were from current year’s production.
Ending Inventory Value: 2010 2011 Absorption Costing = total production cost / unit x units remaining in inventory $45,681.8 2010 = 500 units x $91.36364 2 $88,333.3 2011 = 1,000 units x $88.33333 3 2012 = 0 units Variable Costing $55 x units remaining in inventory C. Difference in Operating Income Absorption Costing Income Variable Costing Income Difference in Operating Income Difference in Change in Inventory Absorption costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory
$27,500.0 0
$55,000.0 0
2010 $368,181. 82 350,000.0 0
2011 $425,151. 52 410,000.0 0
18,181.82
$45,681.8 2 0
15,151.52
$88,333.3 3 45,681.82
45,681.82
42,651.52
27,500.00
55,000.00
0
27,500.00
Increase (decrease)
27,500.00
27,500.00
Difference
18,181.82
15,151.52
© 2012 John Wiley and Sons Canada, Ltd.
2012
$0
$0
2012 $436,666. 67 470,000.0 0 (33,333.3 3)
$ 0 88,333.33 (88,333.3 3) 0 55,000.00 (55,000.0 0) (33,333.3 3)
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The net income under the absorption costing method is higher in 2010 and 2011 because a portion of the fixed production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under absorption costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2012 the net income was lower using absorption costing by an amount equal to the two previous years when the net income was higher using absorption costing. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $1,230,000 under both methods. 15.37 Throughput Costing, Multiyear Approach – MacHine Company (Continued) A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A. and B. Units Sold Units Produced Fixed Production Costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses Direct materials per unit
2010 5,0 00 5,5 00 $200,0 00
2011 5,5 00 6,0 00 $200,0 00
2012 6,0 00 5,0 00 $200,0 00
55 1 75 50,0 00
55 1 75 50,0 00
55 1 75 50,0 00
20
20
20
Throughput Costing Revenue (a) Cost of Materials (b) Throughput Margin Other Production Costs (c) Selling and Administrative Operating Income © 2012 John Wiley and Sons Canada, Ltd.
$875,000. 00 100,000. 00 $775,000. 00 392,500. 00 50,000. 00 $332,50
$962,500. $1,050,000 00 .00 110,000. 120,000. 00 00 $852,500. $930,000. 00 00 410,000. 375,000. 00 00 50,000. 50,000. 00 00 $392,50 $505,000
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0.00
.00
Variable Costing (15.36) Revenue (a) Variable Production Costs (d) Contribution Margin Fixed Costs: Production Selling and Administrative Operating Income
$875,000. 00 275,000. 00 $600,000. 00
$962,500. 00 302,500. 00 $660,000. 00
$1,050,000 .00 330,000. 00 $720,000.0 0
200,000. 00 50,000. 00 $350,00 0.00
200,000. 00 50,000. 00 $410,000 .00
200,000. 00 50,000. 00 $470,000. 00
Calculations Details (a) Revenue = units sold x selling price per unit (b) Throughput Cost of Materials = $20 x units sold (c) Throughput Other Production Costs Fixed Production Cost + (Variable cost per unit - direct materials per unit) x units produced (d ) Variable Production Costs = $55 x units sold Ending Inventory Value: Throughput Costing = materials cost per unit x units remaining in inventory $10,000. 2010 = 500 units x $20 00 $20,000. 2011 = 1,000 units x $20 00 2012 = 0 units
-
Variable Costing $55 x units remaining in inventory
$27,500.0 0
$55,000. 00
-
Difference in Operating Income Throughput Costing Income
2010 $332,500.
2011 $392,500.
2012 $505,000.0
© 2012 John Wiley and Sons Canada, Ltd.
Chapter 15: Measuring and Assigning Costs for Income Statements
Variable Costing Income Difference in Operating Income Difference in Change in Inventory Throughput costing: Ending Inventory Beginning Inventory Increase (decrease) Variable Costing: Ending Inventory Beginning Inventory Increase (decrease) Difference
00 350,000. 00 (17,500. 00)
00 410,000. 00 (17,500. 00)
0 470,000. 00 35,000. 00
10,000. 00
20,000. 00 10,000. 00 10,000. 00
20,000. 00 (20,000.0 0)
55,000. 00 27,500. 00 27,500. 00 (17,500. 00)
55,000. 00 (55,000.0 0) 35,000. 00
10,000. 00 27,500. 00 27,500. 00 (17,500. 00)
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The net income under the variable costing method is higher in 2010 and 2011 because a portion of the direct materials production costs were allocated to ending inventory and therefore showed on the balance sheet reducing costs on the income statement. In 2012 the net income was lower under variable costing because the costs that were previously allocated to inventory were now brought into cost of goods sold and absorbed in the income statement. In 2012 the net income was lower using variable costing by an amount equal to the two previous years when the net income was higher using variable costing. Once the entire inventory is sold the combined net incomes over the 3 years will be equal. The combined net income for the 3 year period was $1,230,000 under both methods.
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PROBLEMS 15.38 Absorption and Variable Costing Income Statements, Reconciliation of Net Incomes – Okanagan Company It is useful to set out the given information in the following format prior to addressing the requirements (there are no WIP inventories). Absorption Costing Sales $900,000 COGS Beginning FG + COGM − Ending FG − COGS Gross margin SG&A (all fixed) Operating profit $186,000
Variable Costing $900,000
Sales
? ? ? ? $162,000 42,000 $120,000
Variable costs Manufacturing + SG&A = Total variable costs Contribution margin Fixed costs manufacturing Fixed costs SG&A Operating profit
? 0 ? 360,000 132,000 42,000
A. 1) From the information given in the variable costing income statement, total variable cost of goods sold = Sales – CM = $900,000 – 360,000 = $540,000. There are no variable SG&A expenses. Given that unit variable manufacturing cost is $6, total units sold are: $540,000 / 6 = 90,000. 2) From the absorption costing income statement: COGS = Sales – Gross margin = $900,000 − $162,000 = $738,000. Since 90,000 units were sold, the product cost per unit is $738,000 / 90,0000 = $8.20 3) Unit fixed costs are $8.20 − $6 = $2.20. Since total fixed costs are $132,000 in 2009, production must be $132,000 / 2.2 = 60,000 units. B. and C. Production and sales quantities are provided for this part. The product cost of manufacturing can thus be determined and the income statements constructed. (b) Absorption Costing Sales
(c) Variable Costing $900,000
Sales
$900,000 COGS Beginning FG (A1) + COGM
2
246,000
492,0001
© 2012 John Wiley and Sons Canada, Ltd.
Variable costs Manufacturing + SG&A
540,000 0
Chapter 15: Measuring and Assigning Costs for Income Statements 03 738,000 (A2) $162,000 42,000 $120,000
− Ending FG − COGS Gross margin SG&A (all fixed) Operating profit
= Total variable costs Contribution margin Fixed costs manufacturing Fixed costs SG&A Operating profit
147
540,000 360,000 132,000 42,000
$186,000 Notes: 1 COGM = 60,000 * $8.20 = $492,000. See A3 and A2 above 2 Beginning FG = COGS – COGM = $738,000 − $492,000 = $246,000 represents the difference between beginning FG and ending FG. Thus Units in beginning inventory – Units in ending inventory = $246,000 / $8.2 = 30,000 units 3 Ending FG = 30,000 beginning inventory units + 60,000 units produced – 90,000 units sold = 0 units D. Reconciliation Absorption costing operating profit $120,000 + FC released from beginning inventory (30,000 * $2.20) 66,000 − FC held back in ending inventory (0 * $2.20 0 = Variable costing operating profit $186,000 15.39 Absorption and Variable Costing Income Statements, Reconciliation of Net Incomes – Hermione Corporation A. Absorption costing income statement HERMIONE CORPORTATION Pro-forma Income Statement — Absorption Costing Basis Year Ended December 31, 2012 Sales (96,000 * $12.00) Costs of goods sold Beginning inventory (4,000 * $5.00) Variable manufacturing cost (100,000 * $7.50) $750,000 Fixed overhead, manufacturing 80,000 Cost of goods manufactured Cost of goods available for sale Ending inventory [8,000 * ($7.50+($80,000/100,000)] Cost of goods sold Gross margin Variable selling and administrative (96,000 * $1.00) Fixed selling and administrative Total selling and administrative Net income © 2012 John Wiley and Sons Canada, Ltd.
$1,152,000 $ 20,000 830,000 $850,000 (66,400) 783,600 368,400 $ 96,000 55,000 151,000 $ 217,400
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Variable costing income statement HERMIONE CORPORTATION Pro-forma Income Statement — Variable Costing Basis Year ended December 31, 2012 Sales $1,152,000 Costs of goods sold Beginning inventory $ 20,000 Variable manufacturing cost 750,000 Variable manufacturing cost of goods available for sale 770,000 Variable cost of manufacturing in ending inventory (60,000) Variable cost of goods sold $710,000 Variable selling and administrative 96,000 Total variable cost 806,000 Contribution margin $ 346,000 Fixed overhead, manufacturing $80,000 Fixed selling and administrative 55,000 Total fixed costs 135,000 Net income $ 211,000 Calculations Ending inventory 4,000 purchased units + 100,000 manufactured units – 96,000 sold units 8,000 units Reconciliation Absorption costing net income (NI) – Variable costing NI = Fixed cost in ending inventory – Fixed cost in beginning inventory $217,400 - $211,000 = $6,400 8,000 units x 0.80 = $6,400 Note: Fixed manufacturing costs per unit = $80,000/100,000 = $0.80 There are no fixed costs in beginning inventory since it was purchased from an outside supplier. Those units were not manufactured.
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15.40 Absorption and Variable Costing Income Statements – KopyKat Company A. The following calculations will be used in the solution. i) Units in beginning and ending inventory Beginning inventory Production Good available for sale Sales Ending inventory
October
November
10,000 units 25,000 35,000 15,000 20,000
20,000 units ---20,000 20,000 0
ii) Product cost per unit Variable manufacturing Fixed manufacturing
September
October
November
$ 18 $ 101 $ 28
$ 18 $ 122 $ 30
$ 18 N/A3 $ 18
1
Total product of beginning inventory is given in the question: $280,000 / 10,000 units = $28 per unit total product cost. $28 - $18 variable costs = $10 fixed costs allocated to beginning inventory. 2
Total fixed manufacturing cost/production =
$300,000 = $12 25,000
3
Since there is no production in November, fixed costs for the period cannot be unitized. Absorption Format Income Statement October Sales1 Cost of goods sold Beginning inventory2 Costs of goods manufactured3 Ending inventory4 Cost of goods sold Gross margin Selling and administration costs Variable5 Fixed Total selling and administrative costs Net income © 2012 John Wiley and Sons Canada, Ltd.
November
$ 750,000
$1,000,000
280,000 750,000 (600,000) $430,000 $ 320,000
600,000 300,000 ( 0) $ 900,000 $ 100,000
45,000 260,000 $ 305,000 $ 15,000
60,000 260,000 $ 320,000 $ (220,000)
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Cost Management
1
October: 15,000 * $50 November: 20,000 * $50
2
October: Given November: Same as October ending inventory
3
October: 25,000 * $30 November: This is the fixed manufacturing cost; no production occurred, thus no variable costs were incurred. 4
October: 20,000 * $30 November: 0
5
October: 15,000 * $3 November: 20,000 * $3
B. Absorption costing net income Plus fixed cost in beginning inventory1 Minus fixed cost in ending inventory2 Equals variable costing net income
October
November
$ 15,000 $ 100,000 $ 240,000 $(125,000)
$ (220,000) $ 240,000 0 $ 20,000
1
October: Unit fixed cost * Units in inventory = $10 * 10,000 = $100,000 November: Unit fixed cost * Units in inventory = $12 * 20,000 = $240,000
2
October: Unit fixed cost * Units in inventory = $12 * 20,000 = $240,000 November: Unit fixed cost * Units in inventory = $12 * 0 = $0
C. The CEO’s confusion stems from the fact that in November the sales were filled entirely from inventory, and thus the costs in inventory that were deferred in October flow to the income statement as a cost in November. Additionally, since there is no production in November, the company must still cover the fixed manufacturing costs from the sales. Thus the cost of goods sold is $900,000. With no excess production in November to absorb the fixed costs, all of this cost is expensed and net income is affected negatively.
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15.41 Absorption and Variable Inventory and Income, Reconcile Incomes - Wild Bird Feeders A sample spreadsheet showing the calculations for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg). A and B. Absorption and variable costing ending inventory The problem states the 2012 actual costs for direct materials, direct labour, and variable manufacturing overhead are the same as the planned costs (i.e., $3,120,000/130,000 units = $24.00 for direct materials, $2,340,000/130,000 units = $18.00 for direct labour, and $520,000/130,000=$4.00 for variable manufacturing overhead). The problem also states that all over- or underapplied overhead is assigned directly to cost of goods sold. Therefore, the 2012 overhead costs assigned to inventory are the same as the planned costs. Thus, the prior year inventory costs are the same as the current year inventory costs, and it does not matter which cost flow assumption the company uses. COST OF ENDING INVENTORY Production cost per unit: Direct materials (actual) Direct labour (actual) Variable manufacturing overhead (allocated=actual) Fixed manufacturing overhead (allocated) Total Units: Beginning inventory Production Sales Ending inventory
2011 Absorption Variable Costing Costing $24.00 $24.00 18.00 18.00 4.00 4.00 5.00 $51.00 $46.00
2012 Absorption Variable Costing Costing $24.00 $24.00 18.00 18.00 4.00 4.00 5.00 $51.00 $46.00
30,000 130,000 (125,000)
5,000 35,000
Cost of ending inventory
$1,785,000
$1,610,000
C. Manufacturing and total contribution margin VARIABLE COSTING Revenue Variable production costs Manufacturing contribution margin Other variable costs: Variable selling Variable administrative Total contribution margin Fixed costs: Manufacturing overhead Selling Administrative Operating income
$12,375,000 (5,750,000) 6,625,000 $1,750,000 125,000
$710,000 980,000 850,000
(1,875,000) 4,750,000
(2,540,000) $2,210,000
D. This question asks for the total fixed costs on the income statement and then proceeds to develop that cost in steps as follows. 1. Fixed selling and administration = ($980,000 + $850,000) = $1,830,000 © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management 2. Fixed manufacturing overhead allocated to COGS: Fixed overhead at given allocation rate (125,000 x $5)
$625,000
3. As noted in the answer to Parts A and B, the cost per unit during 2011 was the same as the cost per unit assigned to inventory during 2012. Therefore, the cost per unit assigned to cost of goods sold and to inventory is not affected by whether the company’s inventory levels increased or decreased during 2012. In other words, sales of units that were produced last year do not need to be considered. 4. Calculation of overapplied (underapplied) overhead: Overhead allocated to production Actual overhead (Underapplied) overhead
$625,000 710,000 $ (85,000)
5. Total fixed costs on income statement = $1,830,000 + $625,000 + $85,000 (because the underapplied overhead is closed to COGS) = $2,540,000. E. Variable costs on variable costing income statement (see the solution to Part C): $5,750,000 + $1,875,000 = $7,625,000. F. Absorption income would be higher than variable income because the company produced more units that it sold, and the units remaining in ending inventories include an allocation of fixed manufacturing overhead cost under absorption costing. Therefore, total overhead expense on the income statement is less under absorption than under variable costing, where the total fixed cost for the period is expensed. G. There are two ways to answer this question. The first method is to calculate the amount of fixed overhead added to inventory under absorption costing. The fixed overhead allocation rate is $5 per unit, and 5,000 units were added to inventory. Therefore, absorption costing income should be $25,000 higher than variable costing income. The second method is to prepare the two income statements and compare the results. The difference in income is (income statements are available on the sample spreadsheet for this problem): Absorption costing operating income $2,235,000 Variable costing operating income 2,210,000 Difference $ 25,000 15.42 Differences in Income, Choice of Absorption and Variable Costing – Nova Scotia Lobsters Company A. Absorption income statements assign all direct production costs and allocate all indirect production costs to inventory. At the time of sale, per unit revenue is matched with per unit expense on the income statement. Variable income statements categorize costs into fixed and variable, and production related and non-production related costs. © 2012 John Wiley and Sons Canada, Ltd.
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B. If the company has no shareholders, the company may have no need for GAAP-based income statements. The variable income statement would be more useful for internal management use. C. If the company wishes to apply for external funds, such as a bank loan, the company may be required to prepare GAAP-basis financial statements. D. It is easy to prepare both types of statements. However, for decision-making purposes the variable statements are better. E. If Nova Scotia Lobsters wants other family members to know how the business is doing, GAAP statements would be prepared in a manner that would allow comparison with other businesses. 15.43 Absorption, Variable, and Throughput Income; Normal Capacity; Choice of Denominator - Giant Jets A. Production and sales data: Year Production Sales
2010 10 10
2011 6 4
2012 8 10
2010 €10,000,000
2011 €4,000,000
2012 €10,000,000
Variable costing income statements: Revenues (jets sold x €1,000,000) Variable costs: Production [jets sold *( €200,000 + €150,000 + €50,000)] Selling (jets sold * €100,000) Contribution margin Fixed costs: Production Administrative and selling Operating income
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(4,000,000) (1,000,000) 5,000,000 (600,000) (100,000) € 4,300,000
(1,600,000) (400,000) 2,000,000
(4,000,000) (1,000,000) 5,000,000
(600,000) (600,000) (100,000) (100,000) €1,300,000 € 4,300,000
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Cost Management B. Throughput costing income statements: Revenues (jets sold * €1,000,000) Direct materials (jets sold * €200,000) Throughput margin Operating expenses: Direct labour(jetsproduced * €150,000) Variable production overhead (jets produced * €50,000) Variable selling (jets sold * €100,000) Fixed production overhead Fixed administrative and selling Operating income
2010 €10,000,000 (2,000,000) 8,000,000 (1,500,000) (500,000) (1,000,000) (600,000) (100,000) € 4,300,000
2011 2012 €4,000,000 €10,000,000 (800,000) (2,000,000) 3,200,000 8,000,000 (900,000)
(1,200,000)
(300,000) (400,000) (400,000) (1,000,000) (600,000) (600,000) (100,000) (100,000) € 900,000 € 4,700,000
C. Cost per jet under absorption costing: 2010 €200,000 150,000 50,000
2011 €200,000 150,000 50,000
2012 €200,000 150,000 50,000
100,000 €500,000
75,000 €475,000
10 10
4 6
10 8
€4,600,000 0 €4,600,000
€2,000,000 0 €2,000,000
€3,800,000 1,000,000 €4,800,000
Direct materials Direct labour Variable production overhead Fixed production overhead per unit: €600,000/units produced 60,000 Total cost per jet €460,000 Jets sold Jets produced Cost of goods sold: Units produced this year Units produced last year Total Absorption costing income statements: Revenues (jets sold * €1,000,000) Cost of goods sold Gross margin Administrative and selling [€100,000 + (jets sold * €100,000)] Operating income
2010 €10,000,000 (4,600,000) 5,400,000
2011 2012 €4,000,000 €10,000,000 (2,000,000) (4,800,000) 2,000,000 5,200,000
(1,100,000) € 4,300,000
(500,000) (1,100,000) €1,500,000 € 4,100,000
D. Normal capacity is an average capacity over time. It represents the volume of production that is expected to occur in a typical year. E. There are likely to be differences of opinion on the normal volume. One way to estimate the normal volume is to calculate the average over the three years presented, or 8 jets per year. The following income statement is calculated using 8 jets as the normal volume. © 2012 John Wiley and Sons Canada, Ltd.
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Cost per jet under absorption costing: Direct materials €200,000 Direct labour 150,000 Variable production overhead 50,000 Fixed production overhead per unit: €600,000/8 jets 75,000 Total cost per jet €475,000 Volume variance: Jets produced Fixed production overhead allocated Actual fixed production overhead Over (under)applied overhead
2010 10 €750,000 600,000 €150,000
2011 6 € 450,000 600,000 €(150,000)
2012 8 €600,000 600,000 € 0
The volume variance does not appear to be material relative to total production costs in 2010 and 2011. Therefore, all of it is allocated to cost of goods sold. Absorption costing income statements: Revenues (jets sold x €1,000,000) Cost of goods sold (jets sold * €475,000) Volume variance adjustment Throughput margin Administrative and selling [€100,000 + (jets sold * €100,000)] Operating income
2010 €10,000,000 (4,750,000) 150,000 5,400,000
2011 2012 €4,000,000 €10,000,000 (1,900,000) (4,750,000) (150,000) 0 1,950,000 5,250,000
(1,100,000) € 4,300,000
(500,000) (1,100,000) €1,450,000 € 4,150,000
F. The textbook is not clear about which absorption costing income (the one in Part C or the one in Part E) to use in the reconciliation. Therefore, reconciliations are shown for both income statements. 2010 2011 2012 Jets produced 10 6 8 Jets sold 10 4 10 Increase (decrease) in inventory of jets 0 2 (2) Throughput costing income (Part B) Direct labour and variable production overhead added to (subtracted from) ending variable costing inventory [Change in inventory * (€150,000+€50,000)]
€4,300,000
€ 900,000
0 4,300,000
400,000 1,300,000
(400,000) 4,300,000
200,000 €1,500,000
(200,000) € 4,100,000
Variable costing income (Part A) Fixed overhead costs allocated to ending absorption costing income Change in inventory * €100,000 0 Absorption costing income (Part C) € 4,300,000 © 2012 John Wiley and Sons Canada, Ltd.
€4,700,000
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Cost Management Variable costing income (Part A) €4,300,000 Fixed overhead costs allocated to ending absorption costing income Change in inventory * €75,000 (a) 0 Absorption costing income (Part E) € 4,300,000
€1,300,000
€4,300,000
150,000 €1,450,000
(150,000) € 4,150,000
(a) Because the volume variance was allocated 100% to cost of goods sold, it can be ignored in this reconciliation. 15.44 Absorption, Variable, and Throughput Income and Inventory; Method for Manager Bonus - Fighting Kites A, B, and C. Product costs: Direct materials Other variable production costs Fixed production costs (a) Total product costs
Variable $ 40,000 60,000
Throughput $40,000
$100,000
$40,000
Absorption $ 40,000 60,000 80,000 $180,000
(a) Absorption costing fixed production rate: $100,000/25,000 denominator level = $4 per kit Fixed production cost allocated to kits produced: $4 * 20,000 kits = $80,000 Cost per kit (20,000 produced)
$5
Cost for 2,000 kits from beginning inventory Cost for 16,000 kits produced and sold Cost of Goods Sold Cost for 4,000 kits added to inventory 4,000 kits * $5 4,000 kits * $2 4,000 kits * $9 + volume variance $4,000
$10,000 80,000 $90,000
$2 $ 4,000* 32,000 $36,000
$9 $15,000 144,000 $159,000
$20,000 $8,000 $ 40,000
*The value of the beginning inventory assumes the same proportion of direct materials and other variable production costs as this year. Variable Costing Revenue (a) Variable costs: Production (above) Selling Contribution margin Fixed costs: Production Selling and admin. Operating income
$540,000 (90,000) (18,000) 432,000
Throughput Costing Revenue (a) Raw materials (above) Throughput margin Operating expenses (b) Operating income
(100,000) (100,000) $232,000
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$540,000 (36,000) 504,000 (278,000) $226,000
Absorption Costing Revenue (a) $540,000 Cost of goods sold (above)(159,000) Volume variance (c) (16,000) Gross margin 365,000 Selling and admin. (d) (118,000) Operating income $247,000
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Calculation details: (a) Revenue = 18,000 kits x $30 = $540,000 (b) Throughput costing operating expenses: Other variable production costs Fixed production costs Variable selling costs Fixed selling and administrative costs Total (c) Volume variance: Fixed production cost allocated ($4 x 20,000 kits) Actual fixed production cost (Underallocated) fixed production costs
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$ 60,000 100,000 18,000 100,000 $278,000 $ 80,000 100,000 $ (20,000)
Because the volume variance is material, it is prorated between cost of goods sold and ending inventory: Cost of goods sold ($20,000 *16,000/20,000 kits) $(16,000) Ending inventory ($20,000 *4,000/20,000 kits) (4,000) Total volume variance adjustment $(20,000) (d) Selling and administrative: Variable selling costs $ 18,000 Fixed selling and administrative costs 100,000 Total $118,000 Although the problem does not ask for a reconciliation of income across the three methods, it is useful to prepare a reconciliation to double-check the preceding computations: Throughput costing operating income Direct labour and variable overhead costs added to ending variable costing inventory ($60,000 x 4,000/20,000 kits) Direct labour and variable overhead costs resulting from beginning inventory sold this year (assuming same ratio as this year) Variable costing operating income Difference in fixed overhead costs assumed this year resulting from beginning inventory sold this year (10,000 – 15,000) Fixed overhead costs allocated to ending absorption costing inventory (after the volume variance adjustment, this is equal to actual fixed overhead cost per unit) $100,000 x 4,000/20,000 kits Absorption costing operating income
$226,000 12,000 (6,000) 232,000 (5,000)
20,000 $247,000
D. Student answers to this question should demonstrate that they have considered how the managers might use the absorption costing information, and they should also clarify their assumptions. If the managers’ primary goal in using absorption costing is to assign actual costs to inventory as accurately as possible, then next year’s expected production volume should be used as the denominator value. If demand and production volumes are © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management expected to remain at 20,000, then a volume of 20,000 would be appropriate. If production volumes are not stable, then next year’s volume could be estimated using sales forecasts for next year and/or production volumes over several past years. On the other hand, the managers may wish to monitor use of capacity, particularly if production volumes vary. In that case, a volume such as practical capacity might be best. E. Student responses will vary. Following is an example of a good response. I recommend that Fighting Kites use variable income or throughput income because both of these methods provide less incentive to build up inventories and more incentive to control fixed and overhead costs. In addition, these statements provide information about current period costs to those individuals charged with evaluating managers’ performance. The variable income statement displays fixed and variable, production and nonproduction costs in such a manner that they are easily compared across time for meaningful performance evaluation. For example, if manufacturing fixed costs are considerably higher or lower in one period than in the prior periods, this information would be easy to identify and managers could be rewarded or encouraged to control costs better. In addition, the information from both variable and throughput costing income statements is broken down into categories that are useful for decision-making. When Fighting Kites needs to make a short or long term production decision, the variable costing income statement provides ample relevant information. When capacity constraints exist, throughput costing information may be better. If Fighting Kites guarantees its direct labour employees a 40-hour work week, then throughput costing information provides the best information for decision-making.
15.45 Absorption and Variable Income and Uses, Reconcile Incomes - Security Vehicles A. Variable costing income statement for January: Revenue (3 vehicles * $100,000) Variable costs: Production (3 vehicles * $60,000) Administrative and selling (3 vehicles * $5,000) Contribution margin Fixed costs: Production Administrative and selling Operating income B. Absorption costing income statement for January: Revenue (3 vehicles * $100,000) Cost of goods sold (a) Gross margin Operating expenses: Administrative and selling [$20,000 + ($5,000 * 3 vehicles)] Operating income © 2012 John Wiley and Sons Canada, Ltd.
$300,000 (180,000) (15,000) 105,000 (60,000) (20,000) $ 25,000 $300,000 (225,000) 75,000 (35,000) $ 40,000
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(a) Absorption cost per unit (assuming that fixed costs are allocated based on actual costs and actual production volume): Variable production costs $60,000 Fixed production costs ($60,000/4 vehicles) 15,000 Total absorption cost per unit $75,000 Cost of goods sold (3 vehicles * $75,000)
$225,000
C. This question calls for a reconciliation of February incomes under variable and absorption costing. First calculate February income under these two methods: Variable Costing Revenue (6 * $100,000) $600,000 Variable costs: Production (6 * $60,000) (360,000) Selling (6 * $5,000) (30,000) Contribution margin 210,000 Fixed costs: Production (60,000) Administrative and selling (20,000) Operating income $130,000
Absorption Costing Revenue (6 * $100,000) $600,000 Cost of goods sold (a) (435,000) Gross margin 165,000 Administrative and selling ($20,000 + $5,000 * 6 vehicles) (50,000) Operating income $115,000
Computation details: (a) Absorption cost per unit (assuming that fixed costs are allocated based on actual costs and actual production volume): Variable production costs $60,000 Fixed production costs ($60,000/5 vehicles) 12,000 Total absorption cost per unit during February $72,000 Cost of goods sold: Vehicles produced during February (5 vehicles * $72,000) Vehicle produced during January (1 vehicle * $75,000) Total
$360,000 75,000 $435,000
In February, under absorption cost income, one vehicle was sold from January’s production. In January, overhead allocated to production was $15,000, so February’s income under absorption costing is $15,000 less than variable costing. D. An organization could produce absorption cost income statements for external users such as shareholders, creditors, and suppliers. For internal decision-making information, variable cost income statements could be produced.
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15.46 Throughput Costing, Reconciling Income – Security Vehicles (Continued) A. Throughput costing income statement for January: Revenue (3 vehicles * $100,000) Materialcosts (3 vehicles * $50,000) Contribution margin Other costs: Other Variable Production (4vehicles * $10,000) Fixed Production Variable Administrative and selling (3 vehicles * $5,000) Fixed Administrative and selling Operating income
$300,000 (150,000) 150,000 (40,000) (60,000) (15,000) (20,000) $ 15,000
B. This question calls for a reconciliation of February incomes under variable and throughput costing. First calculate February income under these two methods: Variable Costing Revenue (6 * $100,000) $600,000 Variable costs: Production (6 * $60,000) (360,000) Selling (6 * $5,000) (30,000) Contribution margin 210,000 Fixed costs: Production (60,000) Administrative and selling (20,000) Operating income $130,000
Throughput Costing Revenue (6 * $100,000) $600,000 Cost of materials (a) (300,000) Throughput margin 300,000 Other costs: Other production (110,000) Administrative and selling (50,000) Operating income $140,000
Computation details: (a) Throughput cost of materials ($50,000*6 vehicles) (b) Other Costs: Production Vehicles produced during February (5 vehicles * $10,000) Fixed production costs Total Administration and Selling: Variable administration and selling costs (6 vehicles * $5,000) Fixed administration and selling costs Total In February one vehicle from January inventory was sold.
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$300,000
$50,000 60,000 $110,000 $30,000 20,000 $50,000
Chapter 15: Measuring and Assigning Costs for Income Statements Throughput costing operating income January inventory variable costing (1 vehicle * $60,000) January inventory throughput costs (1 vehicle * $50,000) Variable costing operating income
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$140,000 ($60,000) 50,000 130,000
15.47 Overapplied/Underapplied Overhead, Units Versus Machine Hours as Allocation Base - Northcoast Manufacturing Company [Note: Parts B and C require students to use and evaluate overhead allocation methods introduced in Chapters 5 and 11.] A. Among the 3 budgeted levels of activity presented in the problem, the one closest to the actual production of 500,000 units is for 540,000 units of production. Based on this budgeted level of activity, the amount of over/underapplied overhead is calculated as follows: Overhead can be allocated based on labour hours or labour costs and the question does not indicate which base to use so both will be shown here. The over or under applied overhead is the same for either base. Based on labour dollars: Estimated overhead allocation rate = Total budgeted overhead/budgeted direct labour cost = $961,200/(36,000 * $15) = 178% of direct labour cost Allocated overhead [(35,000 * $15) * 178%] Actual incurred overhead Overapplied (Underapplied) Overhead
$ 934,500 1,130,000 $ (195,500)
This amount is material because it is over 11% of COGS ($195,500/$1,720,960) Based on labour hours: Estimated overhead allocation rate = Total budgeted overhead/budgeted direct labour hours = $961,200/36,000 = $26.70 per labour hour Allocated overhead (35,000 * $26.70) Actual incurred overhead Overapplied (Underapplied) Overhead
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$ 934,500 1,130,000 $ (195,500)
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Cost Management B. If machine hours were used, the amount of over/underapplied overhead would have been: Overhead allocation rate $961,200/108,000 machine hours = $8.90 per machine hour Allocated overhead ($8.90 * 130,000 machine hours) Actual incurred overhead Overapplied (Underapplied) Overhead
$1,157,000 1,130,000 $ 27,000
C. Machine hours would be a more appropriate allocation base for Northcoast Manufacturing’s fixed manufacturing overhead because the company appears to have a capital-intensive manufacturing process where each direct labourer operates two to four machines simultaneously. In this type of setting, the use of machines drives a large portion of overhead costs, such as depreciation, maintenance, and utilities. Consequently, using machine hours as the allocation base results in more reliable cost information and better decisions. D. If units are used as the denominator volume, managers can shift costs from the income statement to the balance sheet by producing more inventory than is sold. Each unit of inventory carries with it a portion of fixed cost that is booked as an asset (inventory) on the balance sheet and so fixed overhead cost is not completely expensed for the accounting period. 15.48 Recommend Income Format - GameZ A. Three choices are available for income statement formats, absorption costing, variable costing, and throughput costing. Absorption costing meets GAAP standards and is used for income statements required by banks and creditors. Variable and throughput costing income statements produce detailed information that can be used in decision-making. B. Absorption costing matches revenues with expenses under accrual accounting. Because this is required for GAAP, these statements are appropriate for external reports to creditors and shareholders. Variable costing separates costs into fixed and variable categories and expenses all fixed costs as period costs. Income levels are not affected by changes in inventory levels so managers have no incentive to manipulate inventory when income is reported using variable costing. The same advantages and disadvantages apply to absorption costing. C. As mentioned above, the bank and other creditors will want the absorption income statement, but the brother will want information produced by either the variable cost or throughput income statements. Variable cost statements provide more detail than throughput costing so variable income statements would likely be preferred for developing information for decision-making. For compensation purposes, variable or © 2012 John Wiley and Sons Canada, Ltd.
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throughput income statements are best because income is less subject to manipulation through inventory level adjustments. 15.49 Cumulative Exercise (Chapter 3): Breakeven, Absorption and Variable Income, Volume Alternatives - Schatzberg Company [Note: This exercise requires application of knowledge from Chapter 3.] A. To determine the breakeven point, set profit to 0 and solve for the quantity Q: Revenue – Variable costs – Fixed costs = 0 $25Q – ($10 + $5)Q – ($150,000 + $200,000) = 0 $10Q = $350,000 Q = 35,000 units at the breakeven point B. Absorption costing income statement with volume variance closed to COGS Fixed overhead rate = $150,000/50,000 = $3 per unit Ending inventory = ($3 per unit fixed + $10 per unit variable) = $13 per unit Ending inventory = 40,000 units produced – 35,000 units sold = 5,000 units Revenue ($25 * 35,000 units) Cost of goods sold ($13 * 35,000) Volume variance [(50,000 – 40,000) * $3] Gross Margin Selling and administrative [$200,000 + ($5 * 35,000)] Operating income
$875,000 (455,000) (30,000) 390,000 (375,000) $ 15,000
C. Absorption costing income statement with volume variance prorated Revenue ($25 * 35,000) Cost of goods sold ($13 * 35,000) Volume variance [$30,000 * (35,000/40,000)] Gross Margin Selling and administrative [$200,000 + ($5 * 35,000)] Operating income Reconciliation of volume variance: Included in cost of goods sold (above) Added to inventory [$30,000 * (5,000/40,000)] Total volume variance (in Part B)
$875,000 (455,000) (26,250) 393,750 (375,000) $ 18,750
$26,250 3,750 $30,000
D. Under U.S. GAAP (and IFRS), when volumes are abnormally lower than normal capacity, the volume variance should be closed to COGS. In this exercise, volume is lower than normal by 20% (10,000/50,000), which would probably be considered abnormal (i.e., it would be outside of the normal range for production). Thus, the volume variance should be closed to COGS. E. Variable costing income statement © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management Revenue ($25 * 35,000) Variable costs: Production ($10 * 35,000) Selling and administration ($5 * 35,000) Contribution margin Fixed costs: Manufacturing Selling and administration Operating income
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$875,000 350,000 175,000 350,000 150,000 200,000 $ 0
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MINI-CASES 15.50 Bonuses and Production Decisions, Profit Variances, Income Statement Format Pine Producers A. Grand Forks plant manager’s bonus Third quarter = 5% of $2,338 = $116.90 Fourth quarter = 5% of $12,646 = $632.30 Singapore plant manager’s bonus Third quarter = 5% of $3,190 = $159.50 Fourth quarter = 5% of $5,791 = $289.55 Each plant manager would prefer higher income to receive higher bonus amounts. This may encourage them to produce in excess and build up inventories. The fixed costs would then be spread out over all units and a portion of the fixed costs would be allocated to the balance sheet causing larger incomes. B. For the Grand Forks plant, sales increased but cost of goods sold decreased. Either cost reductions were instituted or there was a build-up of inventory over the period, which would reduce the amount of fixed overhead in cost of goods sold. C. If variable costs are immaterial, the difference in inventory amounts between the last two quarters is assumed to be expense that is on the balance sheet instead of on the income statement. Grand Forks Plant Singapore Plant Fourth quarter income $12,646 $5,791 Change in inventory (18,100) (2,508) Variable costing income (loss) $ (5,454) $3,283 D I would conclude that the Grand Forks plant manager’s performance was poor during the last quarter of the year, and certainly not as good as the performance of the Singapore plant manager. E. There is no one answer to this part. Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).
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15.51 Communication of Information The answers below provide suggestions for improved communication. Additional ideas can be found in the following article: Jim Cole, “Speak English Please! How to Communicate Financial Information to Non-Accountants,” SmartPros, October 2004, available at http://accounting.smartpros.com/x44566.xml. A. Here are a few ideas for improving the conciseness and clarity of written and spoken communications; students may think of others. •
• • •
•
Practice eliminating unnecessary words. Re-read what you have written and remove words or phrases that do not add meaning. Think of ways to say the same thing with fewer words. Reflect on phrases or sentences you have spoken and identify ways to simplify them. Avoid using jargon and overly-technical language. Adopt words that will convey your professionalism and also communicate effectively. Read any written communication out loud to detect wordy passages or sentences with unclear meaning. If you stumble over a phrase, it should be rewritten to reflect simple, yet concise language. Learn from your listeners’ reactions. Requests to repeat what you have said might suggest that you mumble or speak too softly. Watch for nonverbal cues, such as frowns or puzzled faces, which indicate your audience does not understand. Avoid speaking too quickly, particularly when leaving telephone messages. Speak slowly and distinctly when providing information such as your name and telephone number. Also slow down when you are trying to make a point.
B. 1. Audience members vary in terms of their expectations, prior experience with the subject matter, learning styles, and so on. It is not possible to fully anticipate the needs of everyone in an audience. 2. Group brainstorming is an excellent way to learn about other peoples’ perceptions. Try this activity and see what you learn! 3. There will be many different types of answers to this question. The purpose is to help students recognize that communication styles should vary from setting to setting. 4. There are two major differences in communication among the three methods introduced in this chapter. First, each costing method assigns a different proportion of production costs to the cost of goods manufactured. All production costs are assigned to products under absorption costing, whereas only variable production costs are assigned to products under variable costing, and only direct materials costs are assigned under throughput costing. Under all three methods, costs not assigned to products are treated as period costs when calculating operating income. Second, each method presents a subtotal on the operating statement that has a unique meaning. © 2012 John Wiley and Sons Canada, Ltd.
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Under absorption costing, the gross margin is the excess of revenues over the product cost of goods sold. Under variable costing, the contribution margin is the excess of revenues over both production and nonproduction variable costs. Under throughput costing, the throughput margin in the excess of revenues over direct material costs of goods sold. C. 1. Indirect messages are any part of communication that is not explicit but that may convey meaning. Examples include posture, facial and other body expressions, tone of voice, connotation of words used, eye contact, personal appearance, quality of penmanship, and physical materials used for written communications. 2. Indirect messages can help communication by conveying information, emphasizing what is said, and improving interactions. Indirect messages can also hinder communication because they may be misinterpreted, particularly between people from different backgrounds who may fail to understand their intended meaning. 3. Effective communication over time involves engaging in continuous improvement in both communicating and understanding others’ communications and ensuring that interactions do not break down. Students’ examples for this question are likely to vary widely. The purpose is to help students use what they have learned from past communication experiences to actively promote more effective future communication. 4. Again, student responses will vary.
15.52 Integrating Across the Curriculum: Financial Accounting and Auditing – Channel stuffing, uncertainties, error versus fraud, fraud incentives and costs A. Channel stuffing is the practice of coercing customers to take delivery of excess merchandise for the purpose of improving the seller’s reported financial results. B. Sales volumes are uncertain for most companies because they are subject to a variety of economic factors that cannot be fully anticipated, such as shifts in customer tastes, changes in competition, introduction of substitute products, changes in customer perceptions about product quality, consumer spending habits, fluctuations in the economy, variations in the sales effort of product distributors, and so on. Uncertainties about sales quantities make it more difficult for companies to plan production volumes, particularly when they cannot be rapidly increased or decreased. C. In the case of McAfee and Harley-Davidson, customers were dealers or distributors with whom they had developed long-term relationships. Accordingly, these customers were willing to accept excess inventories because they were afraid that sufficient future inventories could be in doubt if they failed to cooperate. Sometimes the threat is explicit. For example, in the Bausch & Lomb case discussed in chapter 1, the distributors were © 2012 John Wiley and Sons Canada, Ltd.
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Cost Management told that they would lose their distributorships if they refused to take additional shipments at the end of 1993. D. Here is a possible paragraph, written from the perspective of a Coca-Cola manager: The demand for our products has not slowed down. We have been investing in our company, products and our communities. Following is a list of our achievements in 20071: • Launched more than 150 low- and no-calorie drinks in 2007, increasing our portfolio of low- and no-calorie beverages to more than 700 beverage products. • Spent $366 million with diverse suppliers (first- and second-tier minority- and women-owned businesses) in 2007, a 23-percent increase over 2006. • Invested $40 million to build the world’s largest PET bottle-to-bottle recycling plant. Expected to be operational in 2009 in Spartanburg, South Carolina, the plant will produce approximately 100 million pounds of PET plastic for reuse each year (the equivalent of 2 billion 20-ounce PET bottles). • Achieved a 2 percent improvement in water use efficiency. Coca-Cola plants used an average of 2.47 litres of water to make one litre of beverage. Since 2002, the Coca-Cola system has improved water use efficiency by more than 20-percent, saving more than 160 billion litres of water. • Announced plans to purchase and put into service 100,000 coolers that use CO2 as a refrigerant gas by the end of 2010 – the largest deployment of this new technology by anyone in the industry to date. • Created more than 7,500 jobs in East Africa through the Company’s Manual Distribution Centres program, which has helped start more than 1,800 small distribution businesses and generated more than $500 million in revenue. • Made $99 million in charitable contributions from The Coca-Cola Company and The Coca-Cola Foundation, funding programs in the areas of community and economic development, education, health and wellness, environment, arts and culture, disaster relief, and HIV/AIDS. • Ranked No. 2 on DiversityInc magazine's "Top 50 Companies for Diversity" in 2008, up from the Company's No. 4 ranking in 2007. • Increased its supplier audits by 28-percent for a total of 1,313 audits in 2007, over its 1,029 facility audits in 2006. For several years, we have steadily increased our production to better meet customer demand. Our goal is to keep our customers happy, which includes reducing delivery time. In the past, we have lost sales to competitors because we could not deliver products fast enough. Now we are in a better position to compete, and we expect even stronger sales over the next few years. E. The first step is to examine the CICA’s accounting standards. Then the SEC’s accounting guidelines will be examined. There are two major pronouncements by the CICA with implications for revenue recognition in cases of channel stuffing. The first deals with Revenue recognition which can be found in the accounting standards
1
The Coca-Cola Company, http://www.thecocacolacompany.com/presscentre/nr_20081021_sustainability_review.html © 2012 John Wiley and Sons Canada, Ltd.
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handbook section 3400. The appropriate sections have been included here for discussion purposes:2 3400.07 In a transaction involving the sale of goods, performance should be regarded as having been achieved when the following conditions have been fulfilled: (a) the seller of the goods has transferred to the buyer the significant risks and rewards of ownership, in that all significant acts have been completed and the seller retains no continuing managerial involvement in, or effective control of, the goods transferred to a degree usually associated with ownership; and (b) reasonable assurance exists regarding the measurement of the consideration that will be derived from the sale of goods, and the extent to which goods may be returned. [OCT. 1986] 3400.10 Revenue from a transaction involving the sale of goods would be recognized when the seller has transferred to the buyer the significant risks and rewards of ownership of the goods sold. When the seller retains significant risks of ownership, it is normally inappropriate to recognize the transaction as a sale. Examples of a significant risk of ownership being retained by a seller are: when there is a liability for unsatisfactory performance not covered by normal warranty provisions; when the purchaser has the right to rescind the transaction; when the goods are shipped on consignment. 3400.18 Uncertainties relating to the measurement of revenue may result from one or both of the following issues: (a) Consideration When consideration is not determinable within reasonable limits, for example, when payment relating to goods sold depends on the resale of the goods by the buyer, revenue would not be recognized. (b) Returns Revenue would not be recognized when an enterprise is subject to significant and unpredictable amounts of goods being returned, for example, when the market for a returnable good is untested. If an enterprise is exposed to significant and predictable amounts of goods being returned, it may be sufficient to provide therefore. This is relevant in the situation of McAfee because they were accepting returns from their distributors through Net Tools Inc., a company that was a wholly owned subsidiary of McAfee.These returns were not being declared in the books of McAfee and this was a true intentional misrepresentation of their revenue earned. The second indication that revenue should not have been recognized is brought forth by the Emerging Issues Committee Abstract of Issues Discussed EIC-1413. Following are excerpts from the Abstract that are relevant to channel stuffing: 2
CICA Accounting Standards Handbook, section 3400. © 2012 John Wiley and Sons Canada, Ltd.
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3. Fixed or determinable sales price Paragraph 3400.07(b) requires that the reasonable assurance exists regarding the measurement of the consideration (price) for the sale of goods, and the extent to which goods may be returned. Paragraph 3400.18 then provides brief guidance on uncertainties relating to measurement of the revenue. (b) Right of return arrangements In some sales transactions, a product may be returned, whether as a matter of contract or as a matter of existing practice, either by the ultimate customer or by a party who resells the product to others. The product may be returned for a refund of the purchase price, for a credit applied to amounts owed or to be owed for other purchases, or in exchange for other products. The purchase price or credit may include amounts related to incidental services, such as installation. The existence of a right of return raises significant concerns as to whether the enterprise has reasonable assurance with respect to whether the consideration that will be derived from the sale of the goods is fixed or determinable. Reasonable estimate of future returns (item 3(b)(vi)) The Committee noted that the ability to make a reasonable estimate of the amount of future returns, as required by item (vi), depends on many factors and circumstances that will vary from one case to the next. However, the following factors may impair the ability to make a reasonable estimate: (i)
the susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand;
The existence of one or more of the above factors, in light of the significance of other factors, may not be sufficient to prevent making a reasonable estimate; likewise, other factors, such as the following, may preclude a reasonable estimate: (i)
significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as "channel stuffing");
(ii) lack of "visibility" into or the inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users; (c) Price protections and/or inventory credit arrangements Under some sales arrangements, when an enterprise reduces its published price list for products, it provides cash refunds ("price protection") or credit on future purchases ("inventory credit") to customers (resellers) for products held in their inventories. In many instances, price protection and inventory credit arrangements are offered in lieu of 3
CICA Accounting Standards Handbook, Emerging Issues Committee (EIC) Abstracts, EIC-141 Revenue Recognition © 2012 John Wiley and Sons Canada, Ltd.
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or in addition to a right of return (i.e., the seller reduces the price that the customer paid for the goods in inventory to the price on the revised price list, rather than have the customer return the goods and then re-order the same goods at the new price). The existence of price protection and inventory credit arrangements raise similar concerns to right of return provisions as to whether the enterprise has reasonable assurance with respect to whether the consideration that will be derived from the sale of the goods is fixed or determinable. The Committee reached a consensus that an enterprise should recognize revenue on sales for which it offers, or reasonably expects to offer, price protection or inventory credit arrangements, only if the amount of price protection or inventory credit adjustments can be reasonably estimated, taking into consideration the above discussion of the factors relating to the ability to reasonably estimate product returns. This is relevant here because McAfee offered “distributors a number of incentives, including deep price discounts, cash payments, and rebates, to continue to hold excess inventory.”4 The discounts and rebates along with the returns made to Net Tools Inc., discussed above, indicate that the SEC could claim that McAfee had improperly recognized revenue and channel stuffing violates GAAP. Because channel stuffing involves selling customers more merchandise than they need, a risk exists that the customers might later return the excess merchandise. In recent years, the SEC has investigated numerous instances of channel stuffing, and its staff has expanded its revenue recognition guidelines to address this problem. The SEC’s accounting standards for revenues refer to FASB Concepts Statement No. 5 and FAS 48.5 The standards also contain a series of questions and answers about whether revenue should be recognize in various situations. Two of these issues may apply to channel stuffing and are discussed below. Question 9 Facts: Paragraph 8 of SFAS No. 48 lists a number of factors that may impair the ability to make a reasonable estimate of product returns in sales transactions when a right of return exists. The paragraph concludes by stating "other factors may preclude a reasonable estimate." Question: What "other factors," in addition to those listed in paragraph 8 of SFAS No. 48, has the staff identified that may preclude a registrant from making a reasonable and reliable estimate of product returns? Interpretive Response: The staff believes that the following additional factors, among others, may affect or preclude the ability to make reasonable and reliable estimates of product returns: (1) significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as "channel stuffing"), (2) lack of "visibility" into or the 4
Cost Management textbook, Focus on Ethical Decision Making – Channel Stuffing at McAfee Inc, page 618 SEC Staff Accounting Bulletin, Codification of Staff Accounting Bulletins, Staff Accounting Bulletin 101: Revenue Recognition in Financial Statements, Revised as of December 2003, available at http://www.sec.gov/interps/account/sab101.htm. © 2012 John Wiley and Sons Canada, Ltd. 5
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Cost Management inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users, (3) expected introductions of new products that may result in the technological obsolescence of and larger than expected returns of current products, (4) the significance of a particular distributor to the registrant's (or a reporting segment's) business, sales and marketing, (5) the newness of a product, (6) the introduction of competitors' products with superior technology or greater expected market acceptance, and other factors that affect market demand and changing trends in that demand for the registrant's products. Registrants and their auditors should carefully analyze all factors, including trends in historical data, that may affect registrants' ability to make reasonable and reliable estimates of product returns. Persuasive evidence that an arrangement exists. The SEC states that companies should not recognize revenue unless they have reached a clear understanding with their customer about the nature and terms of the transaction. When channel stuffing occurs, the seller often requires the buyer to sign a purchase agreement. On the surface revenue recognition appears to be appropriate; however, the substance of the transaction may be different than its legal form. If the seller did not voluntarily agree to the terms, then it could be argued that no agreement exists and that revenue should not be recognized. Inability to reasonably estimate product returns. The SEC staff expanded the list of conditions for FAS 48 to include additional factors that might prevent a company from making a reasonable estimate of its product returns and, therefore, from recognizing revenue. These factors include: •
Significant increases in or excess levels of inventory in a distribution channel (sometimes referred to as “channel stuffing”).
•
The inability to determine or observe the levels of inventory in a distribution channel and the current level of sales to end users.
The SEC guidelines provide a more stringent test for evaluating whether revenue can be recognized in cases where channel stuffing might have occurred. These guidelines require managers and auditors to evaluate the trends in inventory levels not only at the company but also in its distribution channels. If customer inventory levels have increased significantly, then the revenue probably cannot be recognized. F. As stated in the problem, an error is defined as an unintentional mistake, while fraud is intentional. Thus, the auditor must evaluate whether McAfee’s misstatement was intentional or unintentional. This is a difficult question, because one cannot read the minds of the managers. Were they simply aggressive in meeting sales goals? Or did they intentionally force customers to take inventories that they knew might later be returned? The auditing standards provide some guidance in this area. According to CICA General Assurance and Auditing section, the auditor should maintain an attitude of professional scepticism as shown below. Thus, an auditor is likely to conclude that the McAfee misstatement constituted fraud. © 2012 John Wiley and Sons Canada, Ltd.
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5135.024 ¨The auditor should maintain an attitude of professional scepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding the auditor's past experience with the entity about the honesty and integrity of management and those charged with governance. [JAN. 2006]6 G. Managers have many incentives to continue reporting sales and earnings growth. These incentives include performance-based bonuses, the value of the manager’s stock or stock options, manager reputation, and job security. H. Behaviour such as channel stuffing imposes both direct and indirect costs on the company. Direct costs include higher income taxes, foregone opportunities to reduce production costs, and possible increases in customer bad debts. Indirect costs include loss of reputation, which in turn increases the company’s cost of capital, weakens its relationships with customers, and encourages higher employee turnover. In addition to the company’s own effects, the stockholders often experience a large decline in the value of their investment. This type of fraud can also lead to greater financial trouble for the company, which often increases employee layoffs and can cause financial distress for the company’s suppliers and customers.
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CICA Assurance Handbook/Assurance Recommendations, General Assurance and Auditing Section 5135 – the auditor’s responsibility to consider fraud, paragraph .023 © 2012 John Wiley and Sons Canada, Ltd.
