Question

Federal Mixing (FM) is a division of Federal Chemicals, a large diversified chemical
company. FM provides mixing services for both outside customers and other Federal
divisions. FM buys or receives liquid chemicals and combines and packages them according to the
customer's specifications. FM computes its divisional net income on both a fully absorbed and variable
costing basis. For the year'just ending, it reported
Net Income
Absorption
costing $13,800,000
Variable
costing 12.600,000
Difference $ 1.200,000
Overhead is assigned to products using machine hours.
There is no finished goods inventory at FM. only work-in-process (WIP) inventory. As soon as a
product is completed, it is shipped to the customer. The beginning inventory based on absorption
costing was valued at $6.3 million and contained 70,000 machine hours. The ending WIP inventory
based on absorption costing was valued at $9.9 million and contained 90,000 machine hours.
Required:
Write a short nontechnical note to senior

Answer 1

NET INCOME REPORTED UNDER ABSORPTION COSTING AND VARIABLE COSTING:
The net income reported under absorption costing is higher by $1200000.
The reason for this is the difference in the method of valuing inventory under
the two methods.
While fixed costs are not included in the value of inventory under variable
costing, under absorption costing the fixed costs are included in the value of
inventory. This will mean that the value of inventory under absorption costing
would be higher.
For the year just ended, the fixed costs carried over in beginning inventory under
absorpton costing is the fixed overhead assigned for 70000 hours, whereas
the fixed costs deferred in the ending inventory is for 90000 hours.
As the machine hours are higher for the ending inventory more of fixed costs
would be deferred than that is carried over from the previous period through
the fixed costs in the beginning inventory. The fixed costs in the ending inventory
is more by $1200000, which is reflected in the higher net income under
absorption costing.
Fixed costs are to be treated as period costs for better evaluation of performance
as it does not permit such costs to be carried over for the next period. Hence,
the net income should be reported under variable costing for performance
evaluation purpose.
The suggestion is that the net income should be taken as $12,600,000 for
perfomance evaluation.