Question

Required

a. Prepare income statements based on full absorption costing and based on variable costing. Based

on the reported incomes using these methods, did Smooth Ride exceed the expectations of Ben

and Chris?

b. Smooth Ride follows generally accepted accounting standards. Which method, full absorption or

variable costing, will the company use to report its net income?

Business Decision Case Ben and Chris have been lifelong friends. They are engineer-minded and

have always dreamed of starting a manufacturing company. They want to manufacture tires, but

realize that this industry is heavily regulated and that achieving profitable operations will require

skillful management. Despite the odds, they form Smooth Ride, Inc., and resolve to only stay in

business if they report a positive net income after the company’s first year of operations. At the end

of 2016, its first year of operations, Smooth Ride reported the following summarized data:

Sales (105,000 tires)....................................... $13,125,000

Production costs (120,000 tires):

Direct material.......................................... 4,750,000

Direct labor ............................................ 3,675,000

Manufacturing overhead:

Variable ............................................... 2,300,000

Fixed ................................................. 950,000

Operating expenses:

Variable ............................................... 1,050,000

Fixed ................................................. 800,000

Depreciation on machinery ................................. 455,000

Property taxes ........................................... 330,000

Personnel department expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000

Answer 1

SOLUTION:

Income Statement - Absorption Costing
Sales (105,000 tires)		13,125,000
COGS
Inventory Beginning	nil
Direct Material	4,750,000
Direct Labor	3,675,000
Manufacturing OH (fixed and variable)	3,250,000
Total Manufacturing Cost (120,000 tires)	11,675,000
Minus: Ending Inventory	1,459,375
($11,675,000/120,000) * 15,000 = 1,459,375
COGS		10,215,625
Gross Profit		2,909,375
Operating Exp (fixed and variable)		1,850,000
Net Income/ Loss		1,059,375
Income Statement - Variable Costing
Sales (105,000 tires)		13,125,000
COGS-Variable
Inventory Beginning	nil
Direct Material	4,750,000
Direct Labor	3,675,000
Manufacturing OH (Variable)	2,300,000
Total Manufacturing Cost (120,000 tires)	10,725,000
Minus: Ending Inventory	1,340,625
(10,725,000/120,000) * 15,000 = 1,340,625
COGS-Variable		9,384,375
Manufacturing Margin		3,740,625
Operating Exp (Variable)		1,050,000
Contribution Margin		2,690,625
Minus: Fixed Costs and Expenses
Manufacturing OH (Fixed)	950,000
Operating Exp (Fixed)	800,000
Total Fixed Costs and Expenses		1,750,000
Net Income		940,625