Deck 10: Criticisms of Absorption Cost Systems: Incentive to Over-Produce

Question 1

Variable and Absorption Costing
Varilux manufactures a single product and sells it for $10 per unit.At the beginning of the year there were 1,000 units in inventory.Upon further investigation,you discover that units produced last year had $3.00 of fixed manufacturing cost and $2.00 of variable manufacturing cost.During the year Varilux produced 10,000 units of product.Each unit produced generated $3.00 of variable manufacturing cost.Total fixed manufacturing cost for the current year was $40,000.There were no inventories at the end of the year.
Required:
Prepare two income statements for the current year,one on a variable cost basis and the other on an absorption cost basis.Explain any difference between the two net income numbers and provide calculations supporting your explanation of the difference.

Answer 1

Solution to Variable and Absorption Costing (15 minutes) The $3/unit fixed cost of making the beginning inventory would have been expensed in the previous year under variable costing.
Under absorption costing the cost per unit this period is:
[($3/unit)(10,000 units)+ $40,000]/10,000 units = $7/unit
Income statement under absorption costing: The difference is due to the ($3/unit)(1,000 units)or $3,000 of fixed cost that is carried over to this year from last year in the beginning inventory.

Question 2

An Extreme Version of Variable Costing
Eli Goldratt advocates that all manufacturing costs other than materials be treated as operating expenses for the period.Periodic profits would be calculated as:
Operating data for last year are
There is no beginning inventory.
Required:
a.Compare profits under absorption costing and Goldratt's method.
b.Evaluate Goldratt's proposal.

Answer 2

Solution to An Extreme Version of Variable Costing (20 minutes)
a.The following table shows that profits are lower by $1,460 if computed using Goldratt's suggestion: b.Goldratt's proposal extends variable costing to the writing off of direct labor and variable overhead cost when incurred.The proposal creates strong incentives against building inventories.Labor and overhead costs in inventories are written off against earnings instead of being capitalized into inventory.Thus,profits and assets are lower when inventories are added compared to full absorption costing.Since product costs contain labor and overhead,calculating product costs using only materials understates true product costs.

Question 3

Average Costs and Variable Costs as Performance Measures
The manager of the manufacturing unit of a company is responsible for the costs of the manufacturing unit.The president is in the process of deciding whether to evaluate the manager of the manufacturing unit by the average cost per unit or the variable cost per unit.Quality and timely delivery would be used in conjunction with the cost measure to reward the manager.
Required:
a.What problems are associated with using the average cost per unit as a performance measure?
b.What problems are associated with using the variable cost per unit as a performance measure?

Answer 3

Solution to Average Costs and Variable Costs as Performance Measures (10 minutes)
a.The average cost can be reduced by overproduction.Fixed costs are spread over more units.Overproduction (production greater than sales)is costly to the company in the handling and maintaining of greater inventory.
b.The variable cost of manufacturing can be reduced by simply converting variable resources to fixed resources.For example,direct labor could be replaced by machines that would be treated as a fixed cost.Also,variable and fixed costs are not easily defined and depend on the cost driver.

Question 4

Absorption Costing's Effect on Earnings when Volumes Fluctuate
BBG Corporation is a manufacturer of a synthetic chemical.Gary Voss,president of the company,has been eager to get the operating results for the just-completed fiscal year.He was surprised when the income statement revealed that income before taxes had dropped to $885,500 from $900,000,even though sales volume had increased by 100,000 kilograms.The drop in net income occurred even though Voss had implemented two changes during the past 12 months to improve the company's profitability:
1.In response to a 10 percent increase in production costs,the sales price of the company's product was increased by 12 percent.This action took place on December 1,1994,the first day of the current fiscal year.
2.The managers of the selling and administrative departments were given strict instructions to spend no more in the current fiscal year than last year.
BBG's accounting department prepared and distributed to top management the comparative income statements presented below.
The accounting staff also prepared related financial information to assist management in evaluating the company's performance.BBG uses the FIFO inventory method for finished goods.Budgeted and fixed overhead are equal and the beginning inventory last year has $3.00/kg.of fixed overhead.
Required:
a.Explain to Gary Voss why BBG Corporation's net income decreased in the current fiscal year despite the sales price and sales volume increases.
b.A member of BBG's accounting department has suggested that the company adopt variable (direct)costing for internal reporting purposes.
(i)Prepare an operating income statement through income before taxes for the current year ended November 30,using the variable (direct)costing method.
(ii)Present a numerical reconciliation of the difference in income before taxes using the absorption costing method as currently employed by BBG and the proposed variable costing method.
c.Identify and discuss the advantages and disadvantages of using variable costing for internal reporting purposes.