Question

Mark Hancock Inc. manufactures a specialized surgical instrument called the HAN-20. The firm has grown rapidly in recent years because of the product’s low price and high quality. However, sales have declined this year primarily due to increased competition and a decrease in the surgical procedures for which the HAN-20 is used. The firm is concerned about the decline in sales and has hired a consultant to analyze the firm’s profitability. The consultant was provided the following information:

		2018		2019
Sales (units)		3,600		3,200
Production		4,120		2,720
Budgeted production and sales		4,400		3,800
Beginning inventory		800		1,320
Data per unit (all variable)
Price	$	2,095	$	1,995
Direct materials and labor		1,200		1,200
Selling costs		125		125
Fixed costs
Manufacturing overhead	$	770,000	$	665,000
Selling and administrative		120,000		120,000

Top management at Hancock explained to the consultant that a difficult business environment for the firm in 2018 and 2019 had caused the firm to reduce its price and production levels and reduce its fixed manufacturing costs in response to the decline in sales. Even with the price reduction, there was a decline in sales in both years. This led to an increase in inventory in 2018, which the firm was able to reduce in 2019 by further reducing the level of production. In both years, Hancock’s actual production was less than the budgeted level so that the overhead rate for fixed overhead, calculated from budgeted production levels, was too low, and a production volume variance was calculated to adjust cost of goods sold for the underapplied fixed overhead (the calculation of the production volume variance is explained fully in Chapter 15 and reviewed briefly below).

The production volume variance for 2018 was determined from the fixed overhead rate of $175 per unit ($770,000/4,400 budgeted units). Because the actual production level was 280 units short of the budgeted level in 2018 (4,400 − 4,120), the amount of the production volume variance in 2018 was 280 × $175 = $49,000. The production volume variance is underapplied because the actual production level is less than budgeted, and the production volume variance is therefore added back to cost of goods sold to determine the amount of cost of goods sold in the full costing income statement. The full costng income statement for 2018 is shown below:

Sales				7,542,000
Cost of goods sold:
Beginning inventory	$	1,100,000
Cost of goods produced		5,665,000
Cost of goods available for sale	$	6,765,000
Less ending inventory		1,815,000
Cost of goods sold:			$	4,950,000
Plus unfavorable production volume variance				49,000
Adjusted cost of goods sold			$	4,999,000
Gross margin			$	2,543,000
Less selling and administrative costs
Variable	$	450,000
Fixed		120,000		570,000
Operating income			$	1,973,000

Required:

1. Using the full costing method, prepare the income statement for 2019.

2-a. Using variable costing, prepare an income statement for each period.

2-b. Prepare a reconciliation of the difference each year in the operating income resulting from the full- and variable-costing methods.

Answer 1

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		2018	2019
	Sales (units)	3,600	3200	a
	Actual production	4,120	2720	b
	Budgeted production and sales	4,400	3800
	Beginning inventory, units	800	1320	c
	Ending inventory, units	1320	840	c+b-a
	Selling Price	$2,095	$1,995
	Variable cost per unit
	Direct materials and labor	$1,200	$1,200
	Selling costs	$125	$125
	Fixed Costs:
	Manufacturing overhead	$770,000	$665,000
	Selling and administrative	120,000	120,000
	Fixed Overhead Rate	175	175
	Sales				$7,542,000
	Cost of Goods Sold
	Beginning Inventory		$1,100,000
	Cost of Goods Produced		$5,665,000
	Cost of Goods Available for Sale		$6,765,000
	Less: Ending Inventory		$1,815,000
	Cost of Goods Sold:				$4,950,000
	Plus: Underapplied Prod. Vol. Variance				$49,000
	Adjusted Cost of Goods Sold				$4,999,000
	Gross Margin				$2,543,000
	Less: Selling and Admin Costs
	Variable		$450,000
	Fixed		$120,000		$570,000
	Net Income				$1,973,000
	SOLUTION
	1. Full-Cost Income Statement
			2018			2019
	Sales		$7,542,000			$6,384,000
	Cost of Goods Sold:
	Beginning Inventory	$1,100,000			$1,815,000
	Cost of Goods Manufactured	$5,665,000			$3,740,000
	Goods Available for Sale	$6,765,000			$5,555,000
	Ending Inventory	$1,815,000			$1,155,000
	Cost of Goods Sold	$4,950,000			$4,400,000
	Under (over) Applied Fixed Ovh	$49,000			$189,000
	Adjusted CGS		$4,999,000			$4,589,000
	Gross Margin		$2,543,000			$1,795,000
	Less: Selling & Administrative Costs
	Variable	$450,000			$400,000
	Fixed	$120,000	$570,000		120,000	$520,000
	Operating Income		$1,973,000			$1,275,000
	2. Variable Costing Income Statement
			2018			2019
	Sales		$7,542,000			$6,384,000
	Cost of Goods Sold:
	Beginning Inventory	$960,000			$1,584,000
	Cost of Goods Manufactured	$4,944,000			$3,264,000
	Goods Available for Sale	$5,904,000			$4,848,000
	Ending Inventory	$1,584,000			$1,008,000
	Cost of Goods Sold		$4,320,000			$3,840,000
	Less: Variable Selling and Admin		$450,000			$400,000
	Contribution Margin		$2,772,000			$2,144,000
	Less: Fixed Mfg. Costs	$770,000			$665,000
	Less: Fixed Selling and Admin	120,000	$890,000		$120,000	$785,000
	Net Income		$1,882,000			$1,359,000
	Reconciling Difference in Net Income between Absorption and Variable Costing
					2009	2010
	Change in Inventory in units				520	-480
	Multiply time Fixed Overhead Rate				$                  175	$               175
	= Difference in net income				$             91,000	$         (84,000)
	Recap below:
	Full Cost Net Income				$1,973,000	$1,275,000
	Variable Cost Net Income				$1,882,000	$1,359,000
	= Difference in Net Income				$91,000	-$84,000