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Classic Container Corp notes the following results for 2016 for variable versus absorption costing. The company's...

Classic Container Corp notes the following results for 2016 for variable versus absorption costing. The company's base volume is 4,000,000.

Classic Container Corp
Budgeted Income Statement Variable Costing units
For the year 2016 3,800,000
Revenues $ 4,750,000
Variable Costs:
Material $ 950,000
Labor $ 950,000
Variable Overhead $570,000
Total Variable Costs $2,470,000
Contribution Margin $2,280,000
Fixed manufacturing Costs $2,000,000
Fixed non-manufacturing Costs $100,000
Operating Income $180,000
Absorption Costing
units
3,800,000
Revenues $4,750,000
Cost of Goods Sold:
Material $950,000
Labor $950,000
Variable Overhead $570,000
Fixed Overhead $1,900,000
Production Volume Variance $200,000
Total Manufacturing Costs $4,570,000
Gross Margin $180,000
Fixed non-manufacturing Costs $100,000
Operating Income $80,000

The company presently uses absorption costing to provide additional compensation and incentivize managers to achieve their production goals. The compensation formula is 10% of operating income. Calculate the amount of the difference of additional compensation between the two income statement methods. If the decline in volume continues and Classic makes 3.6 million units in 2017, should the company switch to variable costing as the basis of compensation? Why or why not? What might be other implications of switching costing methodologies?

Solutions

Expert Solution

Compensation as per Variable costing - 180,000 * 10% = 18,000

Compensation as per Absorbtion costing - 80,000 * 10% = 8,000

Difference - $10,000

Absorbtion rate for Manufacturing Overheads = 2,000,000/4,000,000 = 0.5 per unit.

(This can be verified, as at a level of 3.8 Million units, the Overheads absorbed are 3.8*0.5 = 1,900,000.

Therefore, the company will be better off switching to the variable method.

In absorbtion costing, the Overheads absorbed depend upon the levels of production. Thus, lower production levels lead to lower costs being absorbed, giving a misguided picture.

The unabsorbed costs end up as variances. This eventually is detrimental to company performance.

ekkarill92 answered 10 months ago
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