Question

Impact of Inventory Changes on Absorption-Costing Income: Divisional Profitability Dana Baird was manager of a new Medical Supplies Division. She had just finished her second year and had been visiting with the company’s vice president of operations. In the first year, the operating income for the division had shown a substantial increase over the prior year. Her second year saw an even greater increase. The vice president was extremely pleased and promised Dana a $5,000 bonus if the division showed a similar increase in profits for the upcoming year. Dana was elated. She was completely confident that the goal could be met. Sales contracts were already well ahead of last year’s performance, and she knew that there would be no increases in costs. At the end of the third year, Dana received the following data regarding operations for the first three years:

Year 1 Year 2 Year 3

Production 10,000 11,000 9,000

Sales (in units) 8,000 10,000 12,000

Unit selling price $10 $10 $10

Unit costs: Fixed overhead* $2.90 $3.00 $3.00

Variable overhead $1.00 $1.00 $1.00

Direct materials $1.90 $2.00 $2.00

Direct labor $1.00 $1.00 $1.00

Variable selling $0.40 $0.50 $0.50

Actual fixed overhead $29,000 $30,000 $30,000

Other fixed costs $ 9,000 $10,000 $10,000

*The predetermined fixed overhead rate is based on expected actual units of production and expected fixed overhead. Expected production each year was 10,000 units. Any under- or overapplied fixed overhead is closed to Cost of Goods Sold.

Yearly Income Statements Year 1 Year 2 Year 3

Sales revenue $80,000 $100,000 $120,000

Less: Cost of goods sold* 54,400 67,000 86,600

Gross margin $ 25,600 $ 33,000 $ 33,400

Less: Selling and administrative expenses 12,200 15,000 16,000

Operating income $13,400 $ 18,000 $ 17,400

*Assumes a LIFO inventory flow.

Upon examining the operating data, Dana was pleased. Sales had increased by 20 percent over the previous year, and costs had remained stable. However, when she saw the yearly income statements, she was dismayed and perplexed. Instead of seeing a significant increase in income for the third year, she saw a small decrease. Surely, the Accounting Department had made an error.

Required:

1. Explain to Dana why she lost her $5,000 bonus.

2a. Prepare variable-costing income statements for each of the three years.

Medical Supplies Division

Variable Costing Income Statements

For the Previous 3 Years Year 1 Year 2 Year 3

Sales $ $ $

Less: Variable cost of goods sold

Variable selling expense

Contribution margin $ $ $

Less: Fixed overhead

Other fixed costs

Operating income $ $ $

2b. What is the difference between the absorption-costing and variable-costing incomes?

$

3. If you were the vice president of Dana’s company, which income statement (variable-costing or absorption-costing) would you prefer to use for evaluating Dana’s performance?

Answer 1

ANS:-1 Dana will not receive bonus because profit has been reduced to 73.33% in third year in comparison to 97.36% in second year under absorption costing method.

similarly it may also be noted that profit has been reduced to 20% in third year in comparison to 20.61% in second year under variable costing method. This is very nominal decline in profit.

ANS :2A   VARIABLE COSTING INCOME STATEMENT

PARTICULARS	YEAR1	YEAR2	YEAR3
SALES	80000	100000	120000
DIRECT MATERIAL	-15200	-20000	-24000
DIRECT LABOUR	-8000	-10000	-12000
VARIABLE OVERHEAD	-8000	-10000	-12000
VARIABLE SELLING OVERHEAD	-3200	-5000	-6000
CONTRIBUTION MARGIN	45600	55000	66000
FIXED OVERHEAD	-29000	-30000	-30000
FIXED COST	-9000	-10000	-10000
OPERATING INCOME	7600	15000	26000
% INCREASE IN PROFIT OVER PREV YR		97.36%	73.33%

ANS 2B:- Difference between absorption costing and variable costing is:-

(i) Variable costing includes variable cost which are directly incurred for production where as absorption costing includes all cost including fixed cost related to production.

(ii) Under Variable costing we get Contribution and under absorption costing we calculate Net profit

(iii) Under Variable costing there is no concept of over/under absorption of overheads. whereas under absorption costing fixed cost are absorbed on actual basis.

ANS 3:- Under Variable costing method we calculate contribution which is difference between sales and variable cost of sales, whereas under absorption costing we calculate the net profit. profit is more easier to predict as it is a function of sales. it is more difficult to predict the effect of change in sales on profit.

Hence I would prefer absorption costing income statement over variable costing income statement.