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

Question 1

Zipp Cards
Zipp Cards buys baseball cards in bulk from the companies that produce them. Zipp buys sheets of 48 cards, then cuts the sheets into individual cards, and sorts and packages them, usually by team. Zipp then sells the packages to large discount stores. The accompanying table provides information regarding operations for 2012 and 2013.
*One unit equals 48 cards.
Volume is measured in terms of 48-card sheets processed. Budgeted production and actual production in 2012 were both 50,000 units. There were no beginning inventories on January 1, 2012. In 2013, budgeted and actual production rose to 75,000 units.
At the beginning of 2013, the president of Zipp was pleasantly surprised when the accountant showed her the income statement for the year 2012. The president remarked, "I'm surprised we made more money in 2013 than 2012. We had to cut prices and we didn't sell as many units, yet we still made more money. Well, you're the accountant and these numbers don't lie."
Required:
a. Prepare income statements for 2012 and 2013 using absorption costing.
b. Prepare a statement reconciling the change in net income from 2012 to 2013. Explain to the president why the firm made more money in 2013 than in 2012.

Answer 1

Absorption costing
Under absorption costing both the fixed and variable manufacturing costs are considered while calculating the product cost and thus the ending inventory is also calculated using the total manufacturing costs. In absorption costing the fixed overhead to the extent of goods sold are charged to current year income statement and the balance overhead is carry forwarded to the next year by including it as part of ending inventory.
a.Prepare net income for 2012 as follows:
Prepare net income for 2012 using excel spreadsheet as follows:
Thus, gross margin for 2012 is $40,000
Prepare net income for 2013 as follows:
Prepare net income for 2013 using excel spreadsheet as follows:
Thus, gross margin for 2012 is $84,800
b.Prepare reconciliation of change in net income from 2012 to 2013 as follows:
Prepare reconciliation of change in net income from 2012 to 2013 using excel spreadsheet as follows:
The net income for 2013 is higher than for 2012 as in 2013 company has produced more goods then sold and so most of its fixed costs are charged to ending inventory then costs of goods sold. This has led to increase in net income in 2013

Question 2

Weststar Appliances
Weststar manufactures and distributes a complete line of home appliances worldwide. Lynn Tweedie is the U.S. Space Saver Dishwasher product manager for Weststar Appliances. Her responsibilities include pricing, planning, and sales of Weststar's Space Saver dishwasher in the United States. It is the end of the third quarter and Tweedie is deciding how many Space Saver washers to produce in the fourth quarter. Given sales from the first three quarters and orders for the last quarter, she expects total sales for the year to be 73,000 washers at $200 per unit. There are 12,000 washers in inventory at a (LIFO) cost of $90 per washer. The factory produced 58,000 washers in the first three quarters of this year and Tweedie is considering ordering an additional 10,000, 15,000, or 20,000 washers in the fourth quarter. The plant's capacity can easily accommodate any of these volume levels without affecting fixed costs or variable cost per unit. The variable manufacturing cost of the washer is $75 and the plant has fixed annual costs of $1.3 million. Manufacturing overhead is allocated to dishwashers based on units. Tweedie's selling and administrative expenses consist of $15 of variable cost per washer and fixed cost of $2.92 million. The dishwasher division has a 17 percent weighted-average cost of capital and invested capital (not including inventories) of $18 million. Weststar uses full absorption costing.
Required:
a. Prepare a table showing annual accounting earnings prepared under absorption costing for the Space Saver dishwasher for annual production levels of 68,000, 73,000, and 78,000 washers.
b. If Lynn Tweedie's bonus depends on reported accounting earnings from Space Saver dishwashers, what production quantity is she likely to select for the fourth quarter?
c. Prepare a table computing the valuation of the ending inventory (under LIFO) for annual production levels of 68,000, 73,000, and 78,000 washers.
d. If Lynn Tweedie's bonus depends on residual income from Space Saver dishwashers, what production quantity is she likely to select for the fourth quarter?
e. How would your answer change in part ( d ) if Tweedie's bonus was based on return on assets?

Answer 2

Absorption costing
Under absorption costing both the fixed and variable manufacturing costs are considered while calculating the product cost and thus the ending inventory is also calculated using the total manufacturing costs. In absorption costing the fixed overhead to the extent of goods sold are charged to current year income statement and the balance overhead is carry forwarded to the next year by including it as part of ending inventory.
Variable costing
Under variable costing only the variable manufacturing costs are considered while calculating the product cost and thus the ending inventory is calculated using the variable costs. The fixed overhead incurred are charged to income statement in the current year itself and there is no carry forward of overhead to the next year.
Return on assets (ROA)
Return on assets is calculated as percentage of operating income earned on the total invested assets of company. Higher return on assets indicates higher profitability of company while lower return on assets indicates lower profitability.
Formula to calculate return on assets
Residual income
Residual income is another method used to determine performance of division. It subtracts the opportunity cost of capital employed from divisional performance. Residual income is therefore excess of earnings earned over the cost of capital.
Formula to calculate residual income
a.Prepare a table showing annual accounting earnings under absorption costing as shown below
Thus, operating income for 68,000 units produce is
, for 73,000 units produce is
and for 78,000 units produce is
Following shows the working
b.LT would chose production level of 78,000 units as at this units the operating income of company is maximum
c.LIFO is Last in First Out. This means the units produced latest are sold first and then earlier available units are sold or held as ending inventory
Prepare a table computing valuation of ending inventory as shown below
Following shows the working
d.Prepare residual income for each production levels as shown below
Thus, LT would prefer production of
if residual income was used for bonus purpose
Following shows the working
e.Calculate return on assets for each production level as shown below
Thus, LT would prefer
which would maximize its return on assets
Following shows the working
5

Question 3

Transpacific Bank
You are working as a loan officer at Transpacific Bank and are analyzing a loan request for a client when you come across the following footnote in the client's annual report:
Inventories are priced at the lower of cost or market of materials plus other direct (variable) costs. Fixed overheads of $4.2 million this year and $3.0 million last year are excluded from inventories. Omitting such overhead resulted in a reduction in net income (after taxes) of $720,000 for this year. Our tax rate is 40 percent.
In preparing to present the loan application to the bank's loan committee, write a brief paragraph in nontechnical terms describing what this footnote means and how it affects the bank's evaluation of the financial condition of the borrower.

Answer 3

Fixed Costs:
These costs remains fixed irrespective of the level of output. It is immaterial that the company produces any product or not or it generates any income or not, these costs have to be paid by the company due to their fixed obligation. Fixed costs are irrelevant in relevant costing.
Variable Costs:
These costs changes with the level of output. Variable costs are considered relevant under relevant costing.
In the present case, the income of the year reported by the client and such income is computed after providing for all the taxes. Such income is computed by using variable costing method but if the client has used the absorption costing method then the income would have been more than by $720,000.
This is because under that method, all the overheads incurred during the process of manufacturing are being charged into the products by the management.
As per the data provided, the amount of overheads as written by the company has rapidly gone up and thus decreasing the amount of taxes and finally increasing the amount of net income in the hands of the company.
In other terms, the experts can a raise a query on the sudden increase of fixed overheads by that much rate. But due to such increase the firm is able to generate more capacity and hence the profits are increased.

Question 4

Blauvelt Products
Blauvelt Products uses a flexible budget to set the overhead rate at the beginning of the year based on units produced. In year 1 budgeted fixed overhead is $1 million and budgeted variable overhead is $2 per unit. Direct material and direct labor together are $5 per unit. Blauvelt sells the completed product for $30. There is no beginning inventory. Budgeted volume is 80,000 units. Production and sales are 80,000 units. Actual overhead incurred in year 1 is $1,160,000. Any under- or overabsorbed overhead is written off to cost of goods sold.
In year 2, budgeted volume and production are again both 80,000 units. However, only 60,000 units are sold. Budgeted fixed overhead is $1 million and budgeted variable overhead is $2 per unit. Direct material and direct labor are $5 per unit. Final selling price remains at $30 per unit. Actual overhead incurred in year 2 is $1.35 million.
Required:
a. Calculate net income in year 1 first using absorption costing and then using variable costing. Explain any difference between the two net income numbers.
b. Calculate net income in year 2 using absorption costing, where the overhead rate used to assign overhead to products is based on actual overhead incurred.
c. Calculate net income in year 2 using variable costing, where any difference between budgeted overhead and actual overhead is treated as a fixed cost.
d. Calculate net income in year 2 using variable costing, where any difference between budgeted overhead and actual overhead is treated as a variable cost.
e. Explain why your answers in parts ( b ), ( c ), and ( d ) differ.

Question 5

Zeflax Bottles
Zeflax manufactures insulated plastic bottles for bikes that the company sells for $4.00 per bottle. Last year the company produced 230,000 bottles and sold 200,000 bottles. This year Zeflax produced 200,000 bottles and sold 230,000 bottles. In both years Zeflax's fixed manufacturing cost was $500,000 and its variable manufacturing cost was $1.00 per bottle. The president of Zeflax commented, "I don't understand these crazy financial statements. Our prices and costs didn't change, we sell more bottles this year, and we show lower income. Something has got to be wrong."
Required:
a. Prepare income statements for Zeflax for last year and this year using absorption costing. Assume that Zeflax's only costs are the fixed and variable manufacturing costs given in the problem.
b. Prepare income statements for Zeflax for last year and this year using variable costing. Assume that Zeflax's only costs are the fixed and variable manufacturing costs given in the problem.
c. Explain to the president of Zeflax in nontechnical terms why the financial statements prepared by the accountant in part ( a ) are not in error. In other words, explain to the president why net income fell this year from last year even though Zeflax sold more bottles.

Question 6

UniCom
UniCom produces a wide range of consumer electronics. UniCom's Newark, New York, plant produces two types of cordless phones: 2.4 GHz and 6.0 GHz. The following table summarizes operations at the Newark UniCom plant for the years 2012 and 2013.
Fixed manufacturing overhead amounted to $4 million in each year. At the start of 2012, there were no beginning inventories of either 2.4-GHz or 6.0-GHz cordless phones. UniCom uses FIFO to value inventories.
Required:
a. Prepare variable costing income statements for 2012 and 2013.
b. Prepare absorption costing income statements for 2012 and 2013. At the end of the year, fixed manufacturing overhead is absorbed to the two phone models using direct material as the allocation base.
c. Prepare a table that reconciles any differences in variable costing and absorption costing net incomes for 2012 and 2013.

Question 7

Alliance Tooling
Alliance Tooling produces a single product in its plant. At the beginning of the year, there were no units in inventory. During the year, Alliance produced 120,000 units and sold 100,000 units at $26.75 per unit. Variable manufacturing costs are $13.50 per unit. Alliance pays $2.70 per unit for sales commissions and shipping. It has fixed costs of $720,000 for selling and administration. Its tax rate is 40 percent.
Required:
a. Prepare an income statement for Alliance Tooling using absorption costing.
b. Prepare an income statement for Alliance Tooling using variable costing.
c. Explain why the net income figures computed in ( a ) and ( b ) differ.

Question 8

Sants Brakes Co.
The current year's income statement for Sants Brakes Co. on a variable costing basis appears in the accompanying table.
Inventories of finished stock were increased during the year in anticipation of increases in sales volume in the current year. Inventories in units of product for the beginning and end of the year follow.
The budgeted operating level for assigning fixed overhead to production is 1.8 million machine hours. One-half hour is required to produce a unit of G-226, two hours are required for a unit of G-348, and four hours are required for a unit of G-714.
Required:
a. Recast the income statement on an absorption costing basis.
b. Explain why the income from manufacturing on the absorption costing statement differs from the income on the variable costing statement. Show your computations.

Question 9

Aspen View
Aspen View produces a full line of sunglasses. This year it began producing a new model of sunglasses, the Peak 32. It produced 5,300 pairs and sold 4,900 pairs. The following table summarizes the fixed and variable costs of producing Peak 32 sunglasses. Aspen View uses variable costing to value its ending inventory.
Required:
a. What is Aspen View's ending inventory value of Peak 32 sunglasses?
b. Aspen View is considering switching from variable costing to absorption costing. Would this year's net income from Peak 32 sunglasses be higher or lower using absorption costing? Explain why.
c. Suppose Aspen View uses absorption costing. If, instead of producing 5,300 pairs of Peak 32s it produced only 5,000, would net income from Peak 32 sunglasses be higher or lower from the smaller production compared to the larger production? Explain why.
d. Aspen View has an opportunity cost of capital of 20 percent. What is the cost of producing 5,300 pairs of Peak 32s instead of 4,900 pairs?

Question 10

CLIC Lighters
CLIC manufactures two types of cigarette lighters: Basic and Super. A new plant began producing both lighter models this year. The following variable costing statement summarizes the first year of operations:
For internal control purposes, variable costing is used. Management also wants income from manufacturing calculated using absorption costing. Fixed overhead is allocated to the two lighters using actual machine minutes. Each Basic lighter requires 1.1 machine minutes and each Super lighter requires 1.2 machine minutes.
Required:
a. Calculate the fixed overhead rate per machine minute.
b. Calculate the plant's income from manufacturing for both Basic and Super lighters and for the entire plant using absorption costing.
c. Prepare a table that reconciles the difference in income from manufacturing reported using variable costing and absorption costing.
d. Explain in one or two sentences why income from manufacturing differs depending on whether variable costing or absorption costing is used.

Question 11

Medford Mug Company
The Medford Mug Company is an old-line maker of ceramic coffee mugs. It imprints company logos and other sayings on mugs for both commercial and wholesale markets. The firm has the capacity to produce 50 million mugs per year, but the recession has cut production and sales in the current year to 15 million mugs. The accompanying table shows the operating statement for 2010.
At the end of 2010, there was no ending inventory of finished goods.
The board of directors is very concerned about the $1.5 million operating loss. It hires an outside consultant who reports back that the firm suffers from two problems. First, the president of the company receives a fixed salary, and since she owns no stock, she has very little incentive to worry about company profits. The second problem is that the company has not aggressively marketed its product and has not kept up with changing markets. The current president is 64 and the board of directors makes her an offer to retire one year early so that they can hire a new president to turn the firm around. The current president accepts the offer to retire and the board immediately hires a new president with a proven track record as a turnaround specialist.
The new president is hired with an employment contract that pays a fixed wage of $50,000 a year plus 15 percent of the firm's operating profits (if any). Operating profits are calculated using absorption costing. In 2011, the new president doubles the selling and administration budget to $8million (which includes the president's salary of $50,000). He designs a new line of "politically correct" sayings to imprint on the mugs and expands inventory and the number of distributors handling the mugs. Production is increased to 45 million mugs and sales climb to 18 million mugs at $2 each. Variable costs per mug remain at $.50 and fixed costs at $20 million in 2011.
At the end of 2011, the president meets with the board of directors and announces he has accepted another job. He believes he has successfully gotten Medford Mug back on track and thanks the board for giving him the opportunity. His new job is helping to turn around another struggling company.
Required:
a. Calculate the president's bonus for 2011.
b. Evaluate the performance of the new president in 2011. Did he do as good a job as the numbers in ( a ) suggest?

Question 12

Kothari Inc.
The telecom division of Kothari Inc. produces and sells 100,000 line modulators. Half of the modulators are sold externally at $150 per unit, and the other half are sold internally at variable manufacturing costs plus 10 percent. Kothari uses variable costing to evaluate the telecom division. The following summarizes the cost structure of the telecom division.
Required:
a. Calculate the net income of the telecom division (before taxes) using variable costing.
b. Telecom can outsource the final assembly of all 100,000 modulators for $9.00 per modulator. If it does this, it can reduce variable manufacturing cost by $1.00 per unit and fixed manufacturing overhead by $700,000. If the managers of the telecom unit are compensated based on telecom's net income before taxes, do you expect them to outsource the final assembly of the modulators? Show calculations.
c. What happens to the net cash flows of Kothari Inc. if the final assembly of the modulators is outsourced?

Question 13

Mystic Mugs
Sanjog and Rajiv Gupta have started a business that manufactures and sells thermal mugs. Users personalize the mugs by plugging them into a laptop and downloading their favorite images from a digital camera. The company makes two mug sizes: 16 and 24 ounce mugs. This is its first year of business. The following data summarize operations for the first year.
There were no beginning inventories. Overhead is assigned to products using direct labor dollars.
Required:
a. Calculate Mystic Mugs's net income before taxes using absorption costing.
b. Calculate Mystic Mugs's net income before taxes using variable costing.
c. Prepare a table that reconciles any difference between the two net income figures calculated in parts ( a ) and ( b ).
d. Write a short memo explaining in lay terms any difference between the two net income figures calculated in parts ( a ) and ( b ).

Question 14

Avant Designs
Avant Designs designs and manufactures polished-nickel fashion bracelets. It offers two bracelets: Aztec and Mayan. The following data summarize budgeted operations for the current year:
Budgeted fixed manufacturing overhead for the year was $258,000.
Required:
a. Prepare the budgeted income statement for the year using variable costing.
b. Prepare the budgeted income statement for the year using absorption costing. Budgeted fixed manufacturing overhead is allocated to the two bracelets using machine minutes.
c. Explain the difference in the two net income figures computed in parts ( a ) and ( b ). That is, reconcile any difference in earnings and explain why it occurs.

Question 15

Taylor Chains
Taylor designs and manufactures high-performance bicycle chains for professional racers and serious amateurs. Two new titanium chain sets, the Challenger and the Tour, sell for €110 and €155, respectively. The following data summarize the cost structure for the two chain sets:
Taylor uses an absorption costing system. Overhead is applied to these two products based on direct labor hours using a flexible budget to calculate the overhead rate before production begins for the year. Taylor budgeted (and produced) 43,000 Challenger chains and 55,000 Tour chains. Fixed manufacturing overhead was estimated to be €1.65 million and variable manufacturing overhead was estimated to be €1.75 per direct labor hour. Actual overhead incurred amounted to €2.1 million. Any over- or underabsorbed overhead is written off to cost of goods sold.
Required:
a. Calculate the overhead rate Taylor used to absorb overhead to the chains.
b. Using the predetermined overhead rate you calculated in ( a ), and assuming any over or underabsorbed overhead is written off to cost of goods sold, calculate Taylor Chains' net income before taxes for both the Challenger and Tour chains and for the entire firm.
c. Instead of using absorption costing, use variable costing to calculate Taylor Chains' net income before taxes for both the Challenger and Tour chains and for the entire firm. Assume that any over- or underabsorbed overhead is treated as a fixed cost and is written off to cost of goods sold.
d. Explain why the net income numbers calculated in parts ( b ) and ( c ) differ and reconcile the difference numerically.
e. Suppose that next year Taylor incurs total manufacturing overhead of €2.3 million and sells all the chains it produces next year as well as the 6,000 chains it had in inventory from the first year of production. How much manufacturing overhead will appear on Taylor's income statement if the company uses (i) absorption costing or (ii) variable costing?

Question 16

Conner Coffees
The Breckenridge, Colorado, plant of Conner Coffees roasts, grinds, and packages premier coffees for upscale coffee cafes. The manager of the Breckenridge plant is evaluated and rewarded based on absorption costing net income of her plant. The Breckenridge plant sells its coffees in five-pound vacuum sealed foil packs for $60 per five-pound pack. Each pack has a variable manufacturing cost of $30. Annual total fixed manufacturing cost is $48,000. The Breckenridge plant expects to sell 10,000 packs this year and the manager can produce 10,000, 11,000, or 12,000 packs. Variable cost per pack of $30 will not change if the plant manager produces between 10,000 and 12,000 packs. Assume there are no beginning inventories, fixed and variable period costs are zero, and the corporate income tax rate is zero.
Required:
a. If the manager of the Breckenridge plant has the discretion to set the production level and seeks to maximize her bonus, what production level (10,000, 11,000, or 12,000) will be chosen and how much absorption costing net income will be reported?
b. Instead of evaluating the Breckenridge manager based on absorption costing net income, the Breckenridge manager is evaluated based on absorption costing residual income of her plant using a 12 percent weighted average cost of capital. What production level (10,000, 11,000, or 12,000) will the Breckenridge manager select and how much absorption costing residual income will be reported?
c. Critically analyze the statement: "The use of residual income solves the overproduction problem created by absorption costing." Under what conditions is this statement true and under what conditions is it false?

Question 17

Joon
Joon manufactures and sells to retailers a variety of home care and personal care products. Joon has a single plant that produces all four of its product lines: Stick Goods (brooms and mops), Floor Care (strippers, soaps, and waxes), Brushes (hair brushes and shoe brushes), and Aerosols (room deodorizers, bug spray, furniture wax). The following statement summarizes Joon's financial performance for the most recent fiscal year.
Direct labor costs $21 per hour. Fixed manufacturing overhead of $4.433 million is allocated to products based on direct labor hours. Last year, the fixed manufacturing overhead rate was $31 per direct labor hour ($4.433 million/143,000 direct labor hours). Variable manufacturing overhead is $3.50 per direct labor hour. Selling, general, and administrative (SG A) expenses consist of fixed costs ($1.35 million) and variable costs ($2,951 million). The variable SG A is 20 percent of revenues.
The Joon plant has considerable excess capacity. Senior management has identified a potential acquisition target, Snuffy, that sells a line of automotive products (car waxes, soaps, brushes, and so forth) that are complementary to Joon's existing products and that can be manufactured in Joon's plant. Snuffy does not have any manufacturing facilities, but rather outsources the production of its products to contract manufacturers. Snuffy can be purchased for $38 million. The following table summarizes Snuffy's current operating data:
Senior management argues that the reason Joon is currently losing money is that volumes have fallen in the plant and that the remaining products are having to carry an increasingly larger share of the overhead. This has caused some Joon product managers to raise prices. Senior managers realize that they must drive more volume into the plant if Joon is to return to profitability. Since organic growth (i.e., growth from existing products) is difficult due to a very competitive marketplace, management proposes to the board of directors the purchase of Snuffy as a way to drive additional volume into the plant. With volume of 60,000 cases and 1.9 direct labor hours per case, Snuffy's car care product line will add 114,000 direct labor hours to the plant and increase volume about 80 percent (114,000/143,000). This additional volume will significantly reduce the overhead the existing products must absorb and allow the product managers to lower prices. To incorporate Snuffy's manufacturing and distribution into Joon's current operations, Joon will have to incur additional fixed manufacturing overhead of $450,000 per year for new equipment, and $400,000 per year for additional SG A expenses.
Required:
a. Prepare a pro forma financial statement that shows Joon's financial performance (net income) for the most recent fiscal year assuming that Joon has already acquired Snuffy's car care products and has incorporated them into Joon's manufacturing and SG A processes. In preparing your analysis, make the following assumptions:
(i) Snuffy's products have the same fixed and variable cost structure as Joon's exisiting lines (i.e., variable overhead is $3.50 per direct labor hour and variable SG A is 20 percent of revenues).
(ii) The addition of Snuffy products does not change the demand for Joon's existing products.
(iii) There are no positive or negative externalities in manufacturing from having the additional Snuffy volume in the plant.
(iv) There is sufficient excess capacity in the plant and the local labor markets to absorb the additional Snuffy volume without causing labor rates or raw material prices to rise.
b. Based on your financial analysis in part ( a ), should Joon acquire Snuffy?
c. Evaluate management's arguments in favor of acquiring Snuffy.
d. What other advice would you offer Joon's management?

Question 18

Kathy's Mats
Kathy's Mats produces and sells artistic placemats for dining room tables. These placemats are manufactured out of recycled plastics. For last year and this year each mat has a variable manufacturing cost of $3, and fixed manufacturing overhead is $150,000 per year (both Last Year and This Year). Kathy's Mats incurs no other costs. The following table summarizes the selling price and the number of mats produced and sold Last Year and This Year:
Kathy's Mats uses FIFO (First-in First Out) to value its ending inventory. Last Year Kathy's Mats had no beginning inventory.
Required:
a. Prepare income statements for Last Year and This Year using absorption costing.
b. Prepare income statements for Last Year and This Year using variable costing.
c. Write a short memo explaining why the net income amounts for Last Year and This Year are the same or different in parts ( a ) and ( b ).
d. Assume all the same facts (and data) as given in the problem EXCEPT that This Year Kathy's Mats produced 60,000 mats rather than 50,000 mats. Compute net income for Last Year and This Year using (i) absorption costing and (ii) variable costing.
e. Write a short memo explaining why the net income amounts for Last Year and This Year are the same or different in (i) and (ii) of part ( d ).

Question 19

Federal Mixing
Federal Mixing (FM) is a division of Federal Chemicals, a large diversified chemical company. FM provides mixing services for both outside customers and other Federal divisions. FM buys or receives liquid chemicals and combines and packages them according to the customer's specifications. FM computes its divisional net income on both a fully absorbed and variable costing basis. For the year just ending, it reported
Overhead is assigned to products using machine hours.
There is no finished goods inventory at FM, only work-in-process (WIP) inventory. As soon as a product is completed, it is shipped to the customer. The beginning inventory based on absorption costing was valued at $6.3 million and contained 70,000 machine hours. The ending WIP inventory based on absorption costing was valued at $9.9 million and contained 90,000 machine hours.
Required:
Write a short nontechnical note to senior management explaining why variable costing and absorption costing net income amounts differ.

Question 20

Navisky
Navisky designs, manufactures, and sells specialized GPS (Global Positioning System) devices for commercial applications. For example, Navisky currently sells a system for environmental studies and is planning systems for private aviation and fleet management. The firm has a design team that identifies potential commercial GPS applications, then designs and develops prototypes. Once a prototype is deemed successful and senior management determines that a market exists for the new application, the new design is put into production and the firm markets the new product through independent salespeople, direct marketing, trade shows, or whatever channel is most appropriate for that market.
Currently, Navisky has one very successful system in production (for environmental studies) and several others in development. Navisky, located in Austria, is one of nine wholly owned subsidiaries of a large Swiss conglomerate. Andreas Hoffman, president of Navisky, expects to retire next year. He receives a fixed salary and a bonus based on reported accounting earnings. The bonus is 5 percent of earnings in excess of €850,000 for actual earnings between €850,000 and €1,400,000. If actual earnings exceed €1,400,000, the bonus is capped at €27,500 (5% × [€1,400,000 - €850,000]). (Earnings, both actual and target, are before taxes.)
The following data summarize Navisky's current operations (in euros).
Senior management at Navisky, including Mr. Hoffman, expects to sell about 1,200 units of the environmental GPS device this year. However, they have considerable discretion in setting production levels. Their plant has excess capacity and can produce up to 1,500 environmental devices without seeing any increase in the variable manufacturing costs per unit.
Navisky uses a traditional absorption costing system to absorb manufacturing overhead into product costs for inventory valuation and to calculate earnings for internal compensation purposes as well as external reporting. At the beginning of the current fiscal year, there was no beginning inventory of the environmental GPS devices.
Required:
a. How many units of the environmental GPS device would Mr. Hoffman like to see Navisky produce if he expects to sell 1,200 devices this year?
b. Suppose Mr. Hoffman's bonus calculation was based on net income after including a charge for inventory holding costs at 20 percent of the ending inventory value. In other words, his bonus is 5 percent of net income in excess of $850,000 up to $1,400,000 where net income includes a 20 percent inventory holding cost. How many units of the environmental GPS device would Mr. Hoffman like to see produced if he expects to sell 1,200 devices this year?
c. Explain why your answers in parts ( b ) and ( c ) differ, if they do.
d. How many units of the environmental GPS device would Mr. Hoffman like to see produced assuming he expects to sell 1,200 devices this year if Navisky's net income is calculated using variable costing and net income includes a 20 percent inventory holding cost?

Question 21

Xerox
An October 25, 1999, article in BusinessWeek by D. Brady, "Why Xerox Is Struggling," reported:
President and Chief Executive G. Richard Thoman is a big-picture guy. For the past two years, he has preached a digital revolution at the copier giant. Get down to the detail, though, and it's clear that the revolution isn't going as planned: In both copiers and printers, Xerox is losing ground. On October 18, the company announced lower than expected earnings and the stock price tumbled more than 13% on that day. Xerox stock is down 60% from its recent high of $60 in July. Xerox blamed the bad news on short-term surprises: sagging productivity in the sales force after a big reorganization as well as weakness in Brazil. But the sheer scope of bad news shocked even Thoman, who told investors in a conference call that he was "disappointed and sad about this quarter."
Thoman took the top job in April and vowed annual earnings growth in the "mid-to-high teens."
Beginning November 1, 1999, Xerox factories increased their hours from five eight-hour days a week to six ten-hour days a week through the end of the year. The factory managers were told to build inventories in expectation of higher sales in the fourth quarter of 1999. Fourth-quarter sales were expected to be higher because of anticipation that the new sales force reorganization would increase sales.
Required:
Offer an alternative reason(s) for Xerox's decision to increase output in its factories.

Question 22

DIM
Diagnostic Imaging Medical (DIM) has introduced a revolutionary new magnetic resonance imaging (MRI) device that it sells to hospital radiology departments. Their new device has a much larger chamber that reduces patients' claustrophobic reactions compared to current machines. The following table displays how total cost per year varies with annual production. In other words, if DIM produces nine machines, the nine machines have a total manufacturing cost of $2.93 million.
To simplify the analysis, assume DIM has no period costs, only the product costs in the above table. Management receives a bonus based on reported profits, where profits are calculated using absorption costing.
Required:
a. At a selling price of $500,000 per MRI, management expects to sell six units next year and plans to produce a few extra machines. The extra units are for training, marketing, and temporary spare parts in case an installed MRI fails and spare parts are needed.
Management has financing and production capacity to vary production between 6 and 10 units. How many MRIs do you expect management to produce? Show your analysis that leads to this conclusion.
b. Instead of expecting to sell six units at $500,000 each as in part ( a ), management expects to sell 11 units at $400,000 per unit. With expected sales at 11 units and a price of $400,000, DIM has the resources to produce between 11 and 15 MRIs. How many MRIs do you expect management to produce if expected sales are 11 units? Show your analysis that leads to this conclusion.
c. Describe the differences and similarities in your answers to parts ( a ) and ( b ). Pay particular attention to the relation between units sold [6 in part ( a ) and 11 in part ( b )] and expected units produced, and how this relation differs or does not differ between parts ( a ) and ( b ). Also, explain what is causing your answers in parts ( a ) and ( b ) to differ or not differ.
d. Provide some plausible explanations of why average costs may increase beyond a certain quantity of production.

Question 23

Varilux
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 of fixed manufacturing costs and $2 of variable manufacturing costs. During the year, Varilux produced 10,000 units of product. Each unit produced generated $3 of variable manufacturing cost. Total fixed manufacturing cost for the current year was $40,000. Selling and administrative costs consisted of $12,000 of variable costs and $18,000 of fixed costs. 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.

Question 24

Easton Plant
The Easton plant produces sheet metal chassis for flat-panel televisions. The chassis are manufactured on a computerized, numerically controlled (NC) machine that cuts, drills, and bends the metal to form the chassis for the television set. Two different chassis are produced: HX-3 and DX-55.
Easton has a single plantwide overhead account. Actual machine minutes on the NC machine are used to distribute overhead to the two products. There were no beginning inventories of work in process or finished goods. The following table summarizes the planned and actual production data for the year:
The following data summarize the flexible overhead budget:
At the end of the year, the following overhead amounts had been incurred:
Any over- or underabsorbed overhead is written off to cost of goods sold. The ending finished goods inventory consists of 2,000 units of HX-3 and 1,000 units of DX-55, representing 13,400 minutes and 10,300 minutes of actual machine time, respectively.
Required: (Round all dollars, including overhead rates, to two decimal places.)
a. Calculate the overhead absorption rate set at the start of the year.
b. Calculate the over- or underabsorbed overhead for the year.
c. The firm is considering switching to variable costing. What effect would this decision have on Easton's reported profit for this year? To implement variable costing at the end of the year, variable overhead is calculated as $3.00 per machine minute times the actual number of machine minutes. Fixed overhead is the difference between total actual overhead and variable overhead.
d. Instead of defining fixed overhead as all overhead in excess of variable overhead as in part ( c ), assume the following: Fixed overhead is budgeted fixed overhead ($820,000), and variable overhead is the difference between total actual overhead and budgeted fixed overhead. What is the difference between absorption net income and variable costing income given these new assumptions?