Question

Absorption costing and production-volume variance-alternative capacity bases. Earth Light First (ELF), a producer of energy-efficient light bulbs, expects that demand will increase markedly over the next decade. Due to the high fixed costs involved in the business, ELF has decided to evaluate its financial performance using absorption costing income. The production-volume variance is written off to cost of goods sold. The variable cost of production is $2.50 per bulb. Fixed manufacturing costs are $1,000,000 per year. Variable and fixed selling and administrative expenses are $0.25 per bulb sold and $250,000, respectively. Because its light bulbs are currently popular with environmentally-conscious customers, ELF can sell the bulbs for $9.00 each.

ELF is deciding whether to use, when calculating the cost of each unit produced:

1. Calculate the inventoriable cost per unit using each level of capacity to compute fixed manufacturing cost per unit.

2. Calculate the production-volume variance using each level of capacity to compute the fixed manufacturing overhead allocation rate and this year’s production of 220,000 bulbs.

3. Assuming ELF has no beginning inventory, calculate operating income for ELF using each type of capacity to compute fixed manufacturing cost per unit and this year’s sales of 200,000 bulbs.

 

Answer 1

Absorption costing and production-volume variance-alternative capacity bases.

1.        

Inventoriable cost per unit = Variable production cost + Fixed manufacturing overhead/Capacity

Capacity Type	Capacity Level	Fixed Mfg. Overhead	Fixed Mfg. Overhead Rate	Variable Production Cost	Inventoriable Cost Per Unit
Theoretical	800,000	$1,000,000	$1.25	$2.50	$3.75
Practical	500,000	$1,000,000	$2.00	$2.50	$4.50
Normal	250,000	$1,000,000	$4.00	$2.50	$6.50
Master Budget	200,000	$1,000,000	$5.00	$2.50	$7.50

2. 

ELF’s actual production level is 220,000 bulbs. We can compute the production-volume variance as:

Production Volume Variance = Budgeted Fixed Mfg. Overhead – (Fixed Mfg. Overhead Rate × Actual Production Level)

Capacity Type	Capacity Level	Fixed Mfg. Overhead	Fixed Mfg. Overhead Rate	Fixed Mfg. Overhead Rate × Actual Production	Production Volume Variance
Theoretical	800,000	$1,000,000	$1.25	$ 275,000	$725,000 U
Practical	500,000	$1,000,000	$2.00	$ 440,000	$560,000 U
Normal	250,000	$1,000,000	$4.00	$ 880,000	$120,000 U
Master Budget	200,000	$1,000,000	$5.00	$1,100,000	$100,000 F

3. 

Operating Income for ELF given production of 220,000 bulbs and sales of 200,000 bulbs @ $9 apiece:

	Theoretical	Practical	Normal	Master Budget
Revenue	$1,800,000	$1,800,000	$1,800,000	$1,800,000
Less: Cost of goods sold a	750,000	900,000	1,300,000	1,500,000
Production-volume variance	725,000 U	560,000 U	120,000 U	(100,000)F
Gross margin	325,000	340,000	380,000	400,000
Variable selling b	50,000	50,000	50,000	50,000
Fixed selling	250,000	250,000	250,000	250,000
Operating income	$  25,000	$ 40,000	$ 80,000	$ 100,000

a200,000 × 3.75, × 4.50, × 6.50, × 7.50

b200,000 × 0.25

Operating income

$  25,000

$ 40,000

$ 80,000

$ 100,000