Exercise 8-5

1. Under variable costing, only the variable manufacturing costs are included in product
costs.
Direct materials ............................................... $ 8
Direct labour ................................................... 10
Variable manufacturing overhead ..................... 2
Unit product cost............................................. $20
Note that selling and administrative expenses are not treated as product costs; that
is, they are not included in the costs that are inventoried. These expenses are al-
ways treated as period costs and are charged against the current period’s revenue.

2. The variable costing income statement appears below:

Sales (21,500 × $35) ................................... $752,500
Variable expenses:
Variable cost of goods sold:
Beginning inventory ............................... $ 0
Add variable manufacturing costs
(25,000 units × $20 per unit) .............. 500,000
Goods available for sale .......................... 500,000
Less ending inventory (3,500 units × $20
per unit) ............................................. 70,000
Variable cost of goods sold* ...................... 430,000
Variable selling and administrative (21,500
units × $4 per unit) ............................... 86,000 516,000
Contribution margin ..................................... 236,500
Fixed expenses:
Fixed manufacturing overhead ................... 75,000
Fixed selling and administrative ................. 110,000 185,000
Operating profit ........................................... $51,500

* The variable cost of goods sold could be computed more simply as: 21,500
units sold × $20 per unit = $430,000.

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1 Managerial Accounting, 13th Canadian Edition
Exercise 8-5 (continued)

3. The break-even point in units sold can be computed using the contribution margin
per unit as follows:

Selling price per unit.............................. $35

Variable product cost per unit ................ 20
Variable selling and admin cost per
unit……………………………………….. 4
Contribution margin per unit .................. $ 11

Fixed expenses
Break-even unit sales =
Unit contribution margin
$185,000
=
$11 per unit
= 16,819 units

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2 Managerial Accounting, 13th Canadian Edition
Exercise 8-6

1. Under absorption costing, all manufacturing costs (variable and fixed) are included
in product costs.
Direct materials ............................................... $ 8
Direct labour ................................................... 10
Variable manufacturing overhead ..................... 2
Fixed manufacturing overhead
($75,000 ÷ 25,000 units).............................. 3
Unit product cost............................................. $23

2. The absorption costing income statement appears below:

Sales (21,500 units × $35 per unit).................... $752,500
Cost of goods sold:
Beginning inventory ....................................... $ 0
Add cost of goods manufactured
(25,000 units × $23 per unit) ...................... 575,000
Goods available for sale .................................. 575,000
Less ending inventory
(3,500 units × $23 per unit) ........................ 80,500 494,500
Gross margin .................................................... 258,000
Selling and administrative expenses:
Variable selling and administrative (21,500
units × $4 per unit) .................................... 86,000
Fixed selling and administrative ...................... 110,000 196,000
Operating income ............................................. $ 62,000

Note: Operating income is larger under absorption costing because the company defers
$10,500 ($3 x 3,500 units) worth of fixed costs in ending inventory.

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3 Managerial Accounting, 13th Canadian Edition
Exercise 8-8

1. The company is using variable costing. The computations are:

Variable Absorption
Costing Costing
Direct materials ....................................... $20 $20
Direct labour ........................................... 10 10
Variable manufacturing overhead ............. 4 4
Fixed manufacturing overhead
($180,000 ÷ 30,000 units) .................... — 6
Unit product cost..................................... $34 $40
Total cost, 2,500 units ............................. $85,000 $100,000

2. a. The total cost based on variable costing of $85,000 would be acceptable for tax
purposes, but not for external reporting.

b. The finished goods inventory account should be stated at $100,000, which repre-
sents the absorption cost of the 2,500 unsold units. Thus, the account should be
increased by $15,000 for external reporting purposes. This $15,000 consists of
the amount of fixed manufacturing overhead cost that is allocated to the 2,500
unsold units under absorption costing:
2,500 units × $6 per unit fixed manufacturing overhead cost = $15,000

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4 Managerial Accounting, 13th Canadian Edition
Exercise 8-9

1. Sales (40,000 units × $33.75 per unit)………… $1,350,000

Variable expenses:
Variable cost of goods sold
(40,000 units × $16 per unit*)………………….. $640,000
Variable selling and administrative expenses
(40,000 units × $3 per unit) ……………………… 120,000 760,000
Contribution margin………………………………….. 590,000
Fixed expenses:
Fixed manufacturing overhead……………………. 250,000
Fixed selling and administrative expenses…….. 300,000 550,000
Operating income……………………………………… $ 40,000

* Direct materials…………………………. $10

Direct labour……………………………… 4
Variable manufacturing overhead… 2
Total variable manufacturing cost.. $16

2. The difference in operating income can be explained by the $50,000 in fixed manu-
facturing overhead deferred in inventory under the absorption costing method:

Variable costing operating income ………………………… $40,000

Add: Fixed manufacturing overhead cost deferred in inventory un-
der absorption costing: 10,000 units × $5 per unit in fixed manu-
facturing overhead cost………………. 50,000
Absorption costing operating income……………………… $90,000

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5 Managerial Accounting, 13th Canadian Edition
Problem 8-11

1. The unit product cost under the absorption costing approach would be computed as
follows:
Direct materials ............................................... $ 8
Direct labour ................................................... 10
Variable manufacturing overhead ..................... 2
Fixed manufacturing overhead ($350,000 ÷
25,000 units) .............................................. 14
Unit product cost............................................. $34
With this figure, the absorption costing income statements can be prepared:
Year 1 Year 2
Sales ..................................................................... $1,000,000 $1,500,000
Cost of goods sold:
Beginning inventory ............................................ 0 170,000
Add cost of goods manufactured @$34 per unit.... 850,000 850,000
Goods available for sale ....................................... 850,000 1,020,000
Less ending inventory@$34 per unit .................... 170,000 0
Cost of goods sold ................................................. 680,000 1,020,000
Gross margin ......................................................... 320,000 480,000
Selling and administrative expenses* ...................... 310,000 340,000
Operating income (loss) ......................................... $ 10,000 $ 140,000
*$3 per unit variable; $250,000 fixed each year

2. Variable costing operating income (loss) ................. $ (60,000) $ 210,000

Add: Fixed manufacturing overhead cost deferred
in inventory under absorption costing (5,000
units × $14 per unit) .......................................... 70,000
Deduct: Fixed manufacturing overhead cost re-
leased from inventory under absorption costing
(5,000 units × $14 per unit) ................................ (70,000)
Absorption costing operating income....................... $ 10,000 $ 140,000

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6 Managerial Accounting, 13th Canadian Edition
Problem 8-12

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

Direct materials ............................................... $12
Direct labour ................................................... 9
Variable manufacturing overhead ..................... 5
Fixed manufacturing overhead
(600,000 ÷ 20,000 units).............................. 30
Unit product cost............................................. $56

b. The absorption costing income statement follows:

Sales (15,000 units × $80 per unit) .................... $1,200,000
Cost of goods sold:
Beginning inventory ....................................... $ 0
Add cost of goods manufactured
(20,000 units × $56 per unit) ...................... 1,120,000
Goods available for sale .................................. 1,120,000
Less ending inventory
(5,000 units × $56 per unit) ........................ 280,000 840,000
Gross margin .................................................... 360,000
Selling and administrative expenses* ................. 565,000
Operating loss................................................... $ (205,000)
*(15,000 units × $6 per unit) + $475,000 = $565,000.

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

Direct materials ............................................... $12
Direct labour ................................................... 9
Variable manufacturing overhead ..................... 5
Unit product cost............................................. $26

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7 Managerial Accounting, 13th Canadian Edition
Problem 8-12 (continued)

b. The variable costing income statement follows:

Sales (15,000 units × $80 per unit) ......................... $1,200,000
Variable expenses:
Variable cost of goods sold:
Beginning inventory.......................................... $ 0
Add variable manufacturing costs
(20,000 units × $26 per unit)......................... 520,000
Goods available for sale .................................... 520,000
Less ending inventory
(5,000 units × $26 per unit) .......................... 130,000
Variable cost of goods sold .................................. 390,000
Variable selling expense
(15,000 units × $6 per unit) ............................. 90,000 480,000
Contribution margin................................................ 720,000
Fixed expenses:
Fixed manufacturing overhead ............................. 600,000
Fixed selling and administrative expense............... 475,000 1,075,000
Operating loss ........................................................ $ (355,000)

3. The difference in the ending inventory relates to a difference in the

handling of fixed manufacturing overhead costs. Under variable costing, these costs
have been expensed in full as period costs. Under absorption costing, these costs
have been added to units of product at the rate of $30 per unit ($600,000 ÷ 20,000
units produced = $30 per unit). Thus, under absorption costing a portion of the
$600,000 fixed manufacturing overhead cost of the month has been added to the
inventory account rather than expensed on the income statement:
Added to the ending inventory
(5,000 units × $30 per unit) .................................................... $ 150,000
Expensed as part of cost of goods sold
(15,000 units × $30 per unit)................................................... 450,000
Total fixed manufacturing overhead cost for the month ................ $600,000

Because $150,000 of fixed manufacturing overhead cost has been deferred in inven-
tory under absorption costing, the operating income
reported under that costing method is $150,000 higher than the operating income
under variable costing, as shown in parts (1) and (2) above.

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8 Managerial Accounting, 13th Canadian Edition
Problem 8-15

1. a. and b. Absorption Variable

Costing Costing
Direct materials .............................................. $ 36 $ 36
Direct labour .................................................. 72 72
Variable manufacturing overhead ..................... 24 24
Fixed manufacturing overhead
($720,000 ÷ 45,000 units) ........................... 16 —
Unit product cost ............................................ $148 $132

2. October November
Sales (39,000 units, 51,000 units) .......................... $9,360,000 $12,240,000
Less Variable expenses:
Variable cost of goods sold:
Beginning inventory ............................................ 0 792,000
Add variable production costs @ $132 per unit 5,940,000 5,940,000
Good available for sale ....................................... 5,940,000 6,732,000
Less ending inventory ......................................... 792,000 0
Variable cost of goods sold 5,148,000 6,732,000
Variable selling and administrative @ $18 per unit ... 702,000 918,000
Total variable expenses .......................................... 5,850,000 7,650,000
Contribution margin ............................................... 3,510,000 4,590,000
Fixed expenses:
Fixed manufacturing overhead ............................ 720,000 720,000
Fixed selling and administrative ........................... 540,000 540,000
Total fixed expenses .............................................. 1,260,000 1,260,000
Operating income (loss) ......................................... $ 2,250,000 $ 3,330,000

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9 Managerial Accounting, 13th Canadian Edition
Problem 8-15 (continued)

3. October November
Variable costing operating income (loss) ........................................
$2,250,000 $3,330,000
Add: Cost deferred in inventory under absorption
costing (6,000 units × $16 per unit) ...........................................
96,000
Deduct: Cost released from inventory under absorp-
tion costing (6,000 units × $16 per unit) ..................................... (96,000)
Absorption costing operating income..............................................
$ 2,346,000 $ 3,234,000

4. The CVP analysis was not in error. The issue is that it was prepared, correctly, based
on variable costing which does not include fixed manufacturing costs in ending in-
ventory. As shown by the variable costing income statement prepared for require-
ment 2 above, at sales of 39,000 units variable costing operating income is indeed
$2,250,000 for October. However, as shown in the reconciliation between variable
costing and absorption costing, $96,000 of fixed manufacturing overhead was de-
ferred to the balance sheet under absorption costing. This resulted in operating in-
come of $2,346,000 rather than $2,250,000 based on variable costing when unit
sales hit 39,000. This highlights one of the key problems with absorption costing in
that it makes it more complicated to predict operating income at different levels of
activity since the level of production relative to the number of units sold also impacts
profits. As such, variable costing is the superior approach for planning purposes.
5.
a. Variable costing operating income

Contribution margin: $90 x 60,000 units $5,400,000

Less fixed costs:
Fixed manufacturing overhead (720,000)
Fixed selling and administrative expenses (540,000)
Operating income $4,140,000

b. Because production is expected to equal sales in December, absorption costing oper-

ating income will also be $4,140,000.

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10 Managerial Accounting, 13th Canadian Edition
Problem 8-16

1. Because of soft demand for the New Zealand Division’s product, the inventory
should be drawn down to the minimum level of 1,500 units. Drawing inventory down
to the minimum level would require production as follows during the last quarter:
Desired inventory, December 31 ....................... 1,500 units
Expected sales, last quarter ............................. 18,000 units
Total needs ..................................................... 19,500 units
Less inventory, September 30 .......................... 12,000 units
Required production ........................................ 7,500 units
Drawing inventory down to the minimum level would save inventory carrying costs
such as storage (rent, insurance), interest, and obsolescence.
The number of units scheduled for production will not affect the reported operating
income or loss for the year if variable costing is in use. All fixed manufacturing over-
head cost will be treated as an expense of the period regardless of the number of
units produced. Thus, no fixed manufacturing overhead cost will be shifted between
periods through the inventory account and income will be a function of the number
of units sold, rather than a function of the number of units produced.

2. To maximize the New Zealand Division’s operating income, Ms. Hartley could pro-
duce as many units as storage facilities will allow. By building inventory to the max-
imum level, Ms. Hartley will be able to defer a portion of the year’s fixed manufac-
turing overhead costs to future years through the inventory account, rather than
having all of these costs appear as charges on the current year’s income statement.
Building inventory to the maximum level of 30,000 units would require production as
follows during the last quarter:
Desired inventory, December 31 ....................... 30,000 units
Expected sales, last quarter ............................. 18,000 units
Total needs ..................................................... 48,000 units
Less inventory, September 30 .......................... 12,000 units
Required production ........................................ 36,000 units

Thus, by producing enough units to build inventory to the maximum level that stor-
age facilities will allow, Ms. Hartley could relieve the current year of fixed manufac-
turing overhead cost and thereby maximize the current year’s operating income.

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11 Managerial Accounting, 13th Canadian Edition
Problem 8-16 (continued)

3. By setting a production schedule that will maximize her division’s operating income—
and maximize her own bonus— Ms. Hartley will be acting against the best interests
of the company as a whole. The extra units aren’t needed and will be expensive to
carry in inventory. Moreover, there is no indication that demand will be any better
next year than it has been in the current year, so the company may be required to
carry the extra units in inventory a long time before they are ultimately sold.
The company’s bonus plan undoubtedly is intended to increase the company’s prof-
its by increasing sales and controlling expenses. If Ms. Hartley sets a production
schedule as shown in part (2) above, she will obtain her bonus as a result of produc-
ing rather than as a result of selling. Moreover, she will obtain it by creating greater
expenses—rather than fewer expenses—for the company as a whole. Further, the
following year the fixed costs will release from inventory and the profit will fall dra-
matically but Ms. Hart will not have to ‘pay back’ the bonus that the inventory build
created.
In summary, producing as much as possible so as to maximize the division’s operating
income and the manager’s bonus would be unethical because it subverts the goals
of the overall organization.

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12 Managerial Accounting, 13th Canadian Edition