Question

Absorption and Variable Costing Income Statements for Two Months and Analysis

During the first month of operations ended July 31, Head Gear Inc. manufactured 34,800 hats, of which 32,700 were sold. Operating data for the month are summarized as follows:

Sales			$261,600
Manufacturing costs:
Direct materials	$160,080
Direct labor	41,760
Variable manufacturing cost	20,880
Fixed manufacturing cost	17,400		240,120
Selling and administrative expenses:
Variable	$13,080
Fixed	9,550		22,630

During August, Head Gear Inc. manufactured 30,600 hats and sold 32,700 hats. Operating data for August are summarized as follows:

Sales			$261,600
Manufacturing costs:
Direct materials	$140,760
Direct labor	36,720
Variable manufacturing cost	18,360
Fixed manufacturing cost	17,400		213,240
Selling and administrative expenses:
Variable	$13,080
Fixed	9,550		22,630

Required:

1a. Prepare income statement for July using the absorption costing concept.

Head Gear Inc.
Absorption Costing Income Statement
For the Month Ended July 31
		$
Cost of goods sold:
	$
		$
		$

1b. Prepare income statement for August using the absorption costing concept.

Head Gear Inc.
Absorption Costing Income Statement
For the Month Ended August 31
		$
Cost of goods sold:
	$
		$
		$

2a. Prepare income statement for July using the variable costing concept.

Head Gear Inc.
Variable Costing Income Statement
For the Month Ended July 31
		$
Variable cost of goods sold:
	$
		$
		$
Fixed costs:
	$
		$

2b. Prepare income statement for August using the variable costing concept.

Head Gear Inc.
Variable Costing Income Statement
For the Month Ended August 31
		$
Variable cost of goods sold:
	$
		$
		$
Fixed costs:
	$
		$

3a. For July, operating income reported under   costing is less than   costing due to part of   manufacturing costs that are expensed.

3b. When large changes in inventory levels occur from one period to the next, it is possible for management to misinterpret such increases (or decreases) in operating income as due to changes in:

1. costs.
2. prices.
3. sales volume.
4. "sales volume", "prices" and "costs" are correct.
5. None of these choices is correct.

The correct answer is: _______

4. Based on your answers to (1) and (2), did Head Gear Inc. operate more profitably in July or in August? Explain.

Head Gear Inc. was _____ under the variable costing concept. The difference in operating income reported under the absorption costing concept is due to allocating ______ to the _______ .

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Answer 1

1a.

Answer:

Head Gear Inc.
Absorption Costing Income Statement
For the Month Ended July 31
Sales		261,600
Cost of Goods Sold:
Beginning Inventory
Cost of Goods Manufactured	240,120
Less Ending Inventory	14,490
Cost of Goods Sold		225,630
Gross Profit		35,970
Selling & Administrative Expenses		22,630
Income from Operations		13,340

Calculation

To prepare income statement for July using the absorption costing concept, we deduct theending inventory from cost of goods manufactured to calculate the cost of goods sold.

Direct materials, direct labor, and Fixed overhead are part of cost of goods manufactured.

Cost of Goods Manufactured = Direct materials + direct labor + variable manufacturing overhead+ Fixed manufacturing overhead = 160,080 + 41,760 + 20,880 + 17,400 = 240,120

Cost per Unit = Cost of Goods Manufactured / units manufactured

Cost of Goods Manufactured = 240,120

Units manufactured = 34,800

Cost per Unit = 240,120/34,800 = 6.9

Units at ending = Produced units - sold = 34,800 - 32,700 = 2,100

Ending Units * Cost per Unit = 6.9 * 2,100 = 14,490

Cost of Goods Sold = 240,120 - 14,490 = 225,630

And then we need to deduct cost of goods sold from sales to get the gross profit and deduct Selling & Administrative Expenses to get the income from operations.

1b.,

Answer:

Head Gear Inc.
Absorption Costing Income Statement
For the Month Ended August 31
Sales		261,600
Cost of Goods Sold:
Beginning Inventory	14,490
Cost of Goods Manufactured	213,240
Less Ending Inventory	-
Cost of Goods Sold		227,730
Gross Profit		33,870
Selling & Administrative Expenses		22,630
Income from Operations		11,240

Calculation

To prepare income statement for August using the absorption costing concept, we add the beginning inventory to cost of goods manufactured to calculate the cost of goods sold. Here the beginning invetory is the ending inventory of July.

Direct materials, direct labor, and Fixed overhead are part of cost of goods manufactured.

Cost of Goods Manufactured = Direct materials + direct labor + variable manufacturing overhead+ Fixed manufacturing overhead = 140,760 + 36,720+ 18,360 + 17,400 = 213,240

So, Cost of Goods Sold = 213,240 +14,490 = 227,730

And then we need to deduct cost of goods sold from sales to get the gross profit and deduct Selling & Administrative Expenses to get the income from operations.

2a.

Answer:

Head Gear Inc.
Variable Costing Income Statement
For the Month Ended July 31
Sales		261,600
Variable Cost of Goods Sold:
Beginning Inventory
Variable Cost of Goods Manufactured	222,720
Less Ending Inventory	13,440
Variable Cost of Goods Sold		209,280
Manufacturing Margin		52,320
Variable selling & administrative expenses		13,080
Contribution margin		39,240
Fixed costs:
Fixed manufacturing costs	17,400
Fixed selling & administrative expenses	9,550
Total fixed costs		26,950
Income from Operations		12,290

Calculation

To prepare an income statement for July using the variable costing concept, we need to calculate the Variable Cost of Goods Manufactured.

Under variable costing, the cost of goods manufactured includes only variable costs that is, the direct materials, direct labor, and variable manufacturing costs.

Cost of Goods Manufactured = Direct materials + direct labor + variable manufacturing overhead = 160,080 + 41,760 + 20,880 = 222,720

Cost per Unit = Cost of Goods Manufactured / units manufactured

Variable Cost of Goods Manufactured = 222,720

Units manufactured = 34,800

Cost per Unit = 222,720/34,800 = 6.4

Units at ending = Produced units - sold = 34,800 - 32,700 = 2,100

Ending Units * Cost per Unit = 6.4 * 2,100 = 13,440

Cost of Goods Sold = 222,720 - 13,440 = 209,280

Then we need to calculate the Manufacturing Margin, which is the difference of sales and Variable Cost of Goods Sold. And then, we need to deduct the Variable selling & administrative expenses from Manufacturing Margin to get the Contribution margin.

Next, we need to expense the fixed costs, so Fixed manufacturing costs and Fixed selling & administrative expenses are deducted from the Contribution margin to get the Income from Operations.

2b.

Answer

Head Gear Inc.
Variable Costing Income Statement
For the Month Ended August 31
Sales		261,600
Variable Cost of Goods Sold:
Beginning Inventory	13,440
Variable Cost of Goods Manufactured	195,840
Less Ending Inventory	-
Variable Cost of Goods Sold		209,280
Manufacturing Margin		52,320
Variable selling & administrative expenses		13,080
Contribution margin		39,240
Fixed costs:
Fixed manufacturing costs	17,400
Fixed selling & administrative expenses	9,550
Total fixed costs		26,950
Income from Operations		12,290

Calculation

To prepare an income statement for August using the variable costing concept, we need to calculate the Variable Cost of Goods Manufactured.

Under variable costing, the cost of goods manufactured includes only variable costs that is, the direct materials, direct labor, and variable manufacturing costs.

Cost of Goods Manufactured = Direct materials + direct labor + variable manufacturing overhead = 140,760 + 36,720+ 18,360 = 195,840

We add the beginning inventory to variable cost of goods manufactured to calculate the variable cost of goods sold. Here the beginning invetory is the ending inventory of July.

So, Cost of Goods Sold = 195,840 +13,440 = 209,280

Then we need to calculate the Manufacturing Margin, which is the difference of sales and Variable Cost of Goods Sold. And then, we need to deduct the Variable selling & administrative expenses from Manufacturing Margin to get the Contribution margin.

Next, we need to expense the fixed costs, so Fixed manufacturing costs and Fixed selling & administrative expenses are deducted from the Contribution margin to get the Income from Operations.

3a.

Answer:

For July , operating income reported under variable costing is less than absorption costing due to part of fixed manufacturing costs that are expensed.

Explanation

As we can infer from the required 1 and 2 that, in July the income from operations reported under the variable costing is 12,290 which is less than the income from operations reported under the absorbtion costing. The difference is due to the expensing of the fixed manufacturing oost. The part of fixed costs are expensed, and that lead to this difference.

3b.

Answer:

d. "sales volume", "prices" and "costs" are correct.

Explanation

When large changes in inventory levels occur from one period to the next, it is possible for management to misinterpret such increases (or decreases) in operating income as due to changes in costs, prices and sales volume.

4.

Answer:

Head Gear Inc. was equally profitable in July and in August under the variable costing concept. The difference in income reported under the absorption costing concept is due to allocating fixed manufacturing costs to the July 31 ending inventory.

Explanation

Under absorption costing, the cost of goods manufactured includes the direct materials, direct labor, and fixed overhead. But in variable costing, the cost of goods manufactured includes the direct materials, direct labor, and fixed overhead costs changes according to production. So, The fixed overhead costs is not included in cost of goods manufactured, and it is expensed for the period. Here under variable costing concept, both july and august showed profit. The difference between variable and absorbtion costing is due to expensing of fixed manufacuring costs.