Question

Let’s think about a company that produces dinner ware (plates, bowls, cups and saucers, for example). Some of the dinner ware is intended for daily use (stoneware that is dishwasher and microwave safe), and other dinner ware is for special occasion (fine china or bone china, with gold trim that cannot go in the microwave!) Daily use dinnerware is less expensive than special occasion dinnerware. Imagine that there is consistent demand year-round for the “daily use” dinnerware, but there are seasonal spikes in demand for the “special occasion” dinnerware (i.e. wedding season and the holiday season). Additionally, gold is an important component of special use dinner ware, yet the price of gold varies.

Explain how fixed manufacturing overhead costs are shifted from one period to another under absorption costing. Would you recommend absorption costing for the daily dinner ware, the special occasion dinner ware, or both?

What arguments are there in favor of treating fixed manufacturing overhead costs as product costs? As period costs?

Under absorption costing, how is it possible to increase net operating income without increasing sales? Explain using the dinner ware example.

Answer 1

1. Explain how fixed manufacturing overhead costs are shifted from one period to another under absorption costing. Would you recommend absorption costing for the daily dinner ware, the special occasion dinner ware, or both?

Answer:-

First of all we need to understand what Absorption costing advocates ?

Absorption costing  argue that absorption costing does a better job of matching costs with revenues than variable costing.

But How ? lets understand :-

They argue that all manufacturing costs must be assigned to products to properly match the costs of producing units of product with the revenues from the units when they are sold.

the above lines provides you the answer of 1st question how fixed manufacturing overhead costs are shifted from one period to another under absorption costing.

lets understand this in more details :-

Fixed manufacturing overhead costs are monthly or annual expenses that remain constant regardless of production volume or the total number of hours production equipment was in operation.

Examples include depreciation, rent, property taxes, production manager and supervisor wages, professional memberships and training for manufacturing personnel.

Absorption costing requires a portion of the total fixed manufacturing overhead costs to be allocated to each item produced. Once allocated, that portion stays with the unit or item until it is ultimately sold.

That means Fixed manufacturing overhead cost of period shifted to another period being a part of asset ( closing Inventory) and When the units are finally sold, the fixed manufacturing overhead cost that has been carried over with the units is included as part of that period's cost of goods sold.

From my point of view i would recommend absorption costing for special occasion dinner ware only because demand for such product is lesser as compared to daily dinner ware and this will lead to increase in operating income because a portion of fixed manufacturing overhead will be a part of closing inventory of Special Occasion Dinner Ware.

and as Demand for daily dinner ware is quite satisfactory these should be valued as per variable costing and their portion of fixed cost should be a part of income statement for the period in which they were incurred.

2.What arguments are there in favor of treating fixed manufacturing overhead costs as product costs? As period costs?

Answer:-

As we already discussed above

Absorption costing advocates argue that absorption costing does a better job of matching costs with revenues than variable costing.

They argue that all manufacturing costs must be assigned to products to properly match the costs of producing units of product with the revenues from the units when they are sold. They believe that no distinction should be made between variable and fixed manufacturing costs for the purposes of matching costs and revenues.

While on the other hand Varibale costing advocates argue that fixed manufacturing costs are not really the cost of any particular unit of product.

If a unit is made or not, the total manufacturing costs will be exactly the same. Therefore, how can one say that these costs are part of the costs of the products? These costs are incurred to have the capacity to make products during a particular period and should be charged against the period as period costs according to the matching principle.

3.Under absorption costing, how is it possible to increase net operating income without increasing sales? Explain using the dinner ware example.

Answer:-

Under absorption costing it is possible to increase net operating income without increasing sales by increasing the level of production. If production exceeds sales, that means there is going to be closing Inventrory - units of product are added to inventory. These units carry a portion of the current period’s fixed manufacturing overhead costs into the inventory account, thereby reducing the current period’s reported expenses and casing net operating income to rise.

Lets take an exmaple of above situation

suppose we have Fixed Manufacturing overhead of $ 100,000

and a Portion attributable to Daily dinner ware = $40,000

and a portion attributable to Special Occasion dinner ware = $60,000

this apportionment can be done on the basis of Direct Labour Hours or Activity based costing .

now While preparing Income statement

Sales $400,000

Less : Varibale Cost $150,000

Less : Fixed Costs $ 50,000 ( only portion of daily dinner ware and the protion of sold special occasion dinner ware will be a part, rest portion which are attributable to unsold inventory will be carried forwarded to that year in which such inventrory is going to be sold. so this will reduce the Fixed manufacturing overhead cost with a significant amount and leads rise in net operating income )

Net Operating profit = $200,000

if variable costing method was followed for both of them

then what will happen lets see :-

Sales = $400,000

Variable cost = $(150,000)

Fixed costs = $ (100,000)

Net operating Income = $ 150,000