Ch8 Absorption and Variable Costing

There are two commonly used methods for determining product costs and reporting income in a
manufacturing firm, depending on the accounting treatment of fixed manufacturing overhead. Which is income-
reporting alternatives, called absorption costing and variable costing. In addition, a third alternative for
product costing and income reporting, which is called throughput costing

Fixed Manufacturing Overhead: The Key

-In product-costing systems, included both variable and fixed manufacturing overhead in the product costs that
flow through the manufacturing accounts. This approach to product costing is called absorption costing (or
full costing ) , because all manufacturing-overhead costs are applied to (or absorbed by) manufactured goods.

-An alternative approach to product costing is called variable costing (or direct costing ) , in which only
variable manufacturing overhead is applied to Work-in-Process Inventory as a product cost.

The distinction between absorption and variable costing is the timing with which fixed manufacturing
overhead becomes an expense. Eventually, fixed overhead is expensed under both product-costing systems.

-Under variable costing fixed overhead is expensed immediately, as it is incurred.

-Under absorption costing, fixed overhead is inventoried until the accounting period during which the
manufactured goods are sold.

Reconciling Income under Absorption and Variable Costing

the income reported under absorption and variable costing is sometimes different. Although income is the same
for the two product-costing methods. why these results occur.

No Change in Inventory

There is no change in inventory over the course of the year. Beginning and ending inventory are the same,
because actual production and sales are the same.

-Think about the implications of the stable inventory level for the treatment of fixed manufacturing overhead.

-On the variable-costing statement, the fixed manufacturing overhead incurred in y0 is an expense in y0.

-Under absorption costing fixed manufacturing overhead was applied to production at the predetermined rate.
Since all of the units produced in y0 also were sold in y0, all of the fixed manufacturing-overhead cost flowed
through into Cost of Goods Sold. Thus, fixed manufacturing overhead was expensed in y0 under absorption
costing also.

The reconciliation focuses on the two places in the income statements where differences occur between
absorption and variable costing.

Increase in Inventory
In y1 inventory increased. The increase in inventory was the result of production exceeding sales.

-Under variable costing, the fixed overhead cost incurred in y1 is expensed, just as it was in y0.

-Under absorption costing only a portion of the y1 fixed manufacturing overhead is expensed in y1. Since the
fixed overhead is inventoried under absorption costing, some of this cost remains in inventory at the end of y1.

-As before, the reconciliation focuses on the two places in the income statements where differences occur
between absorption and variable costing.

Decrease in Inventory

When inventory decreased. Sales during the year exceeded production.

-Under variable costing, the fixed manufacturing overhead incurred in y2 is expensed in y2.

Under absorption costing, more fixed overhead is expensed in y2. Why? Because some of the fixed overhead
incurred during the prior year, which was inventoried then, is now expensed in y2 as the goods are sold.

A Shortcut to Reconciling Income

When inventory increases or decreases during the year, reported income differs under absorption and variable
costing.

This results from the fixed overhead that is inventoried under absorption costing but expensed immediately
under variable costing.

The following formula may be used to compute the difference in the amount of fixed overhead expensed in a
given time period under the two product-costing methods

Length of Time Period

The discrepancies between absorption-costing and variable costing income occur because of the changes in
inventory levels.

It is common for production and sales to differ over the course of a week, month, or year.

Therefore, the income measured for those time periods often will differ between absorption and variable
costing.

This discrepancy is likely to be smaller over longer time periods. Over the course of a decade, cannot sell much
more or less than it produces.

Thus, the income amounts under the two product-costing methods, when added together over a lengthy time
period, will be approximately equal under absorption and variable costing.

Cost-Volume-Profit Analysis

Explain the implications of absorption and variable costing for cost-volume-profit analysis.
-Variable costing is consistent with CVP analysis coz they highlight the separation between fixed and variable
costs, as do cost-volume-profit analysis and break-even calculations. Both of these techniques account for fixed
manufacturing overhead as a lump sum.

-In contrast, absorption costing is inconsistent with CVP analysis, because fixed overhead is applied to goods as
a product cost on a per-unit basis.

Evaluation of Absorption and Variable Costing

Some managers find the inconsistency between absorption costing and CVP analysis troubling enough to
warrant using variable costing for internal income reporting.

Variable costing dovetails much more closely than absorption costing with any operational analyses that require
a separation between fixed and variable costs.

1. Pricing Decisions

Many managers prefer to use absorption-costing data in cost-based pricing decisions.

-They argue that fixed manufacturing overhead is a necessary cost incurred in the production process. To
exclude this fixed cost from the inventoried cost of a product, as is done under variable costing, is to understate
the cost of the product.

-Proponents of variable costing argue that a product’s variable cost provides a better basis for the pricing
decision.

They point out that any price above a product’s variable cost makes a positive contribution to covering fixed
cost and profit.

2. Definition of an Asset

An asset is a thing of value owned by the organization with future service potential. Since fixed costs comprise
part of the cost of production, advocates of absorption costing argue that inventory (an asset) should be valued
at its full (absorption) cost of production.

Moreover, they argue that these costs have future service potential since the inventory can be sold in the future
to generate sales revenue.

-Proponents of variable costing argue that the fixed-cost component of a product’s absorption-costing value has
no future service potential.

Their reasoning is that the fixed manufacturing-overhead costs during the current period will not prevent these
costs from having to be incurred again next period. Fixed-overhead costs will be incurred every period,
regardless of production levels.

-In contrast, the incurrence of variable costs in manufacturing a product does allow the firm to avoid incurring
these costs again.

3. External Reporting
For external reporting purposes, generally accepted accounting principles require that income reporting be
based on absorption costing. Federal tax laws also require the use of absorption costing in reporting income for
tax purposes.

Why Not Both?

Using computerized accounting systems, it is straightforward for a company to prepare income statements
under both absorption and variable costing.

-Since absorption-costing statements are required for external reporting, managers will want to keep an eye on
the effects of their decisions on financial reports to outsiders.

-Yet the superiority of variable-costing income reporting as a method for dovetailing with operational analyses
cannot be denied. ‫ال يمكن رفض تفوق اإلبالغ عن الدخل المتغير كطريقة للتوافق مع التحليالت التشغيلية‬.

-Preparation of both absorption-costing and variable-costing data is perhaps the best solution to the controversy.

JIT Manufacturing Environment

How would the difference between variable and full costing be impacted if the company switched to a JIT
system? Explain.

In a just-in-time inventory and production management system, all inventories are kept very low.

Since finished-goods inventories are minimal, there is little change in inventory from period to period. Thus, in
a JIT environment, the income differences under absorption and variable costing generally will be insignificant.

Throughput Costing

Some managers advocate throughput costing as an alternative to either absorption or variable costing for
product costing and income reporting.

Throughput costing assigns only the unit-level spending for direct costs as the cost of products or services.

A unit level cost is one that is incurred every time a unit of product is manufactured and will not be incurred if
another unit is not manufactured.

-Advocates of throughput costing argue that classifying any other past or committed cost as a product cost
creates an incentive to drive down the average cost per unit simply by manufacturing more units on non-
bottleneck processes.

Throughput-Costing Income Statements

All costs other than the throughput cost (only direct material) are considered to be operating cost of the period.

Proponents of throughput costing argue that this method alone eliminates the incentive to produce excess
inventory simply to reduce unit costs by spreading committed resource costs (i.e., direct labor and variable and
fixed manufacturing overhead) across more units.
The incentive for such overproduction disappears under throughput costing, because all non-throughput costs
(direct labor and manufacturing overhead) will be expensed as period costs regardless of how many units are
produced.

59. Webster, Inc. began operations at the start of the current year, having a production target of 60,000 units.
Actual production totaled 60,000 units, and the company sold 95% of its manufacturing output at $50 per unit.
The following costs were incurred:

   

Required:
A. Assuming the use of variable costing, compute the cost of Webster's ending finished-goods inventory.
B. Compute the company's contribution margin. Would Webster disclose the contribution margin on a variable-
costing income statement or an absorption-costing income statement?
C. Assuming the use of absorption costing, how much fixed selling and administrative cost would Webster
include in the ending finished-goods inventory?
D. Compute the company's gross margin. 

A. Variable production costs total $1,080,000 ($240,000 + $480,000 + $360,000), or $18 per unit ($1,080,000 
60,000 units). Since 3,000 units remain in inventory [0 + 60,000 - (60,000  95%)], the ending finished goods
totals $54,000 (3,000  $18).

B.

   
The contribution margin is disclosed on a variable-costing income statement.
C. None. All fixed selling and administrative cost is treated as a period cost and expensed against revenue.
D. The cost of a unit would increase by $10 ($600,000  60,000 units) because of the addition of fixed
manufacturing overhead. Thus:

   
63. Hirsch Company has per-unit fixed and variable manufacturing costs of $40 and $15, respectively. Variable
selling and administrative costs are $9 per unit. Consider the two independent cases that follow for the firm.
Case A: Variable-costing income, $110,000; sales, 6,000 units; production, 6,000 units
Case B: Variable-costing income, $178,000; sales, 7,500 units; production, 7,100 units
Required:
A. From a product-costing perspective, what is the basic difference between absorption costing and variable
costing?
B. Compute Hirsch's absorption-costing income in Case A.
C. Compute Hirsch's absorption-costing income in Case B. 

A. The difference between absorption costing and variable costing lies in the treatment of fixed manufacturing
overhead. Under absorption costing, fixed manufacturing overhead is a product cost and attached to each unit
produced. In contrast, under variable costing, it is written off (expensed) as a period cost.
B. Since the number of units sold equals the number of units produced, variable- and absorption-income figures
are the same: $110,000.
C. With sales of 7,500 units and production of 7,100 units, income computed under absorption costing includes
$16,000 (400 units  $40) of prior-period fixed manufacturing overhead. Absorption income is therefore
$162,000 ($178,000 - $16,000).

67. Absorption and variable costing are two different methods of measuring income and costing inventory.
Required:
A. Product costs are defined as costs associated with the manufacturing process. How does the operational
definition of product cost differ between absorption costing and variable costing?
B. An absorption-costing income statement will report gross profit or gross margin whereas a variable-costing
income statement will report contribution margin. What is the difference between these terms? 

A. The sole difference between the two methods is that fixed manufacturing overhead costs are defined as a
product cost under absorption costing and as a period cost under variable costing.
B. Gross profit (gross margin) is the difference between sales and cost of goods sold. Cost of goods sold
includes variable and fixed manufacturing costs. Contribution margin, on the other hand, is the difference
between sales and variable expenses, namely, variable cost of goods sold and variable operating expenses.
Fixed costs are ignored when calculating the contribution margin.

64. Beach Bum Corporation has fixed manufacturing cost of $12 per unit. Consider the three independent cases
that follow.
Case A: Absorption- and variable costing income each totaled $240,000 in a period when the firm produced
18,000 units.
Case B: Absorption-costing income totaled $320,000 in a period when finished-goods inventory levels rose by
7,000 units.
Case C: Absorption-costing income and variable-costing income respectively totaled $220,000 and $250,000 in
a period when the beginning finished-goods inventory was 14,000 units.
Required:
A. In Case A, how many units were sold during the period?
B. In Case B, how much income would Beach Bum report under variable costing?
C. In Case C, how many units were in the ending finished-goods inventory? 
A. Absorption- and variable costing income will be the same amount when inventory levels are unchanged.
Thus, sales totaled 18,000 units.
B. The difference between absorption-costing income and variable-costing income is $84,000 (7,000 units 
$12). Given that inventories are rising, variable-costing income will amount to $236,000 ($320,000 - $84,000).
C. The $30,000 difference in income ($250,000 - $220,000) is explained by the change in inventory units,
multiplied by the fixed overhead per unit. Thus, the inventory changed by 2,500 units ($30,000  $12). Given
that absorption income is less than income computed by the variable-costing method, inventory levels must
have decreased, resulting in an ending inventory level of 11,500 units (14,000 - 2,500).

198. Cassin Corporation manufactures a variety of products. Last year, the company's variable costing net
operating income was $86,300 and ending inventory decreased by 1,700 units. Fixed manufacturing overhead
cost per unit was $8.

Required:

Determine the absorption costing net operating income for last year. Show your

work! 

  68. The difference in income between absorption and variable costing can be explained by the change in
finished-goods inventory (in units) multiplied by the standard fixed manufacturing overhead rate.
Required:
Explain why this calculation accounts for the difference noted. The only difference between the two methods is
the treatment of fixed manufacturing overhead. Such amounts are expensed under variable costing whereas with
absorption costing, a predetermined amount is attached to each unit manufactured. This applied overhead moves
back and forth between the balance sheet and the income statement depending on what happens to inventory
during the period (i.e., increase or decrease). Because of this situation, the change in inventory multiplied by the
fixed manufacturing overhead per unit corresponds with the difference in reported income between absorption
costing and variable costing.

199. Gordy Corporation manufactures a variety of products. Last year, variable costing net operating income
was $81,000. The fixed manufacturing overhead costs released from inventory under absorption costing
amounted to $39,000.

Required:
Determine the absorption costing net operating income last year. Show your

work! 

130. Can a company continue to increase income indefinitely by using full costing?

It is possible that a growing company can do this. The only way to do this is to produce more than is sold in each
year. This will result in a continuous buildup of inventory. For most companies, that would not be a good
strategy as it would lead to expensive cash outflow for buildups of inventories along with all the associated
carrying costs.

131. What is the implication of a company using JIT with full costing versus using JIT with variable costing?
JIT companies have very little inventory and so there is very little difference between full and variable costing
income.
66. Krell Corporation, which uses throughput costing, began operations at the start of the current year (20x1).
Planned and actual production equaled 40,000 units, and sales totaled 35,000 units at $80 per unit. Cost data for
20x1 were as follows:

   

The company classifies direct materials as a throughput cost.

Required:
A. What is meant by the term "throughput costing"?
B. Compute the cost of the company's year-end inventory.
C. Prepare Krell's income statement for the year. 

A. Throughput costing is a technique that assigns only the unit-level spending amounts for direct manufacturing
costs as the cost of products or services. In this case, direct materials is the only item that qualifies as a
throughput cost.
B. Ending inventory: 0 + 40,000 units - 35,000 units = 5,000 units; 5,000 units  $20 = $100,000
C.

   

 
**Why Is Variable Costing Not Allowed With GAAP?

1. GAAP Compliance

the generally accepted accounting principles (GAAP).These principles don’t recognize variable costing.
Variable costs are added as product costs, while all the total fixed costs are expensed in the year of production
as period costs. (1)This is in conflict with the GAAP requirement that all costs of manufacturing a particular
product be expensed at once.

2. Taxation

Variable costing is not accepted by GAAP because(2) it reports a lower taxable figure as inventory increases.

Matching Costs

The variable costing approach (3)doesn’t provide correct matching of costs because fixed costs incurred in
manufacturing the inventory are charged to expenses, irrespective of whether the inventory is sold in the period
or not. However, variable costing is used in managerial decision making through the use of (CVP) analysis.

3. Shareholders’ Wealth

Managers as agents of shareholders have a duty to protect and generally increase the value of the shareholders’
wealth. One avenue through which shareholders can monitor the progress of the management is through
financial statements. Since the variable costing approach(4) doesn’t present accurate income figures

4. Understatement

In preparing financial statements, the GAAP states that the cost of inventory should include all costs incurred in
the production of the inventory. This includes a reasonable portion of fixed manufacturing costs incurred to
produce the inventory. The variable costing approach(5) ignores such fixed manufacturing costs, thereby
understating the overall cost of the product.

**Advantages of Variable Costing and the Contribution Approach

(1) Enabling CVP Analysis

CVP analysis requires that we break costs down into their fixed and variable components. Because variable
costing income statements categorize costs as fixed and variable, it is much easier to use this income statement
format to perform CVP analysis than attempting to use the absorption costing format, which mixes together
fixed and variable costs. Moreover, absorption costing net operating income may or may not agree with the
results of CVP analysis.

(2) Explaining Changes in Net Operating Income

The variable costing income statements are clear and easy to understand. All other things the same, when sales
go up, net operating income goes up. When sales go down, net operating income goes down. When sales are
constant, net operating income is constant. The number of unit produced does not affect net operating income.
Absorption costing income statements can be confusing and are easily misinterpreted.

(3) Supporting Decision Making

The variable costing method correctly identifies the additional variable costs that will be incurred to make one
more unit.

(4) It also emphasizes the impact of fixed costs on profits.

The total amount of fixed manufacturing costs appears explicitly on the income statement, highlighting that the
whole amount of fixed manufacturing costs must be covered for the company to be truly profitable.

Under absorption costing, fixed manufacturing overhead costs appear to be variable with respect to the number
of units sold, but they are not.

The Theory of Constraints (TOC), suggests that the key to improving a company’s profits is managing its
constraints. For reasons this requires careful identification of each product’s variable costs.

Consequently, companies involved in TOC use a form of variable costing. Variable costing income statements
require one adjustment to support the TOC approach.

Direct labor costs need to be removed from variable production costs and reported as part of the fixed
manufacturing costs that are entirely expensed in the period incurred.
**The TOC treats direct labor costs as a fixed cost for three reasons.

First, even though direct labor workers may be paid on an hourly basis, many companies have a commitment to
guarantee workers a minimum number of paid hours.

Second, direct labor is not usually the constraint; therefore, there is no reason to increase it. Hiring more direct
labor workers would increase costs without increasing the output of saleable products and services.

Third, TOC emphasizes continuous improvement to maintain competitiveness. Without committed and
enthusiastic employees, sustained continuous improvement is virtually impossible. Because layoffs often have
devastating effects on employee morale, managers involved in TOC are extremely reluctant to lay off
employees.

**evaluation of variable costing:

1- easy to understand.2- consistent with C.P.V.3-emphasize contribution in short pricing decision.

4-Profit for period is not affected by changes in fixed manufacturing overhead inventory.

5-impact of fixed costs on profit emphasized.

**Evaluation of absorption:

1-fixed overhead is treated the same as other product costs.

2- consistent with long run pricing decision.

3-for external reporting and income tax law.

**Four reasons for using absorption cost as the cost base in cost-plus formulas:

1-In the long run, the price must cover all costs and normal profit margin.

2-Absorption-cost and total-cost pricing formulas provide justifiable price that tends to be perceived as
equitable by parties.

3-When company’s competitors have similar operations and cost structures, cost-plus pricing based on full costs
gives management an idea of how competitors may set prices.

4-Absorption-cost information is provided by firm’s cost-accounting system, because it is required for external
financial reporting under generally accepted accounting principles. Since absorption-cost information already
exists, it is cost-effective to use for pricing.
** The primary disadvantage of absorption-cost and total-cost pricing formulas is that they obscure the
cost behavior pattern of the firm. Since absorption-cost and total-cost data include allocated fixed costs, it is not
clear from these data how the firm’s total costs will change as volume changes.

** Three advantages of pricing based on variable costs:

1-Variable-cost data do not obscure the cost behavior pattern by unitizing fixed costs and making them appear
variable.

2- Variable-cost data do not require allocation of common fixed costs to individual product lines.

3- Variable-cost data are exactly the type of information managers need when facing certain decisions, such as
whether to accept a special order.

128. Why is a variable costing income statement more useful for internal purposes?

AnswerThe format separates fixed and variable costs facilitating cost-volume-profit analysis. Also, it discourages over-
production since managers cannot increase income by increasing production.

129. Under full costing, how does increasing production increase income? Does this work under variable
costing? Why or why not?

AnswerSince fixed production costs are included in the unit product cost using full costing, increasing production will
reduce the fixed cost per unit. When these reduced costs are included in cost of goods sold, income will be higher.
Variable costing treats fixed production costs as a period cost, and expenses the full amount regardless of production.
Thus, income is unaffected by increasing production.

126. Bucket Zone had 2,200 buckets in its beginning inventory. It manufactured 23,000 buckets and sold 23,400
buckets during the year. Costs involved in production are $3 for direct materials, $2 for direct labor, and $1.20 for
variable overhead, each on a per unit basis. The company has annual fixed selling and administrative costs of
$78,000 and fixed annual manufacturing overhead costs totaling $86,250. Operating income using variable
costing is $33,000.

a. Determine the amount by which net income will differ under absorption costing compared to variable
costing.
b. Determine operating income under absorption costing.
c. How would the difference between variable and full costing be impacted if the company switched to a JIT
system? Explain.
Answer

a. Change in inventory level = 23,400 – 23,000 = 400 units decrease

Fixed manufacturing cost per unit = $86,250 ÷ 23,000 = $3.75 per unit

Difference = $3.75 × 400 units = $1,500

b. Variable costing operating income $33,000

Less fixed costs difference (1,500)

Absorption costing operating income $31,500

 c.Companies that use JIT inventory systems have very low inventory levels since they don’t produce until they
are ready to sell products. Units they produce are approximately equal to those they sell, so the change in
the inventory level is very close to zero. Since the difference in variable and full costing income is due to
the change in inventory units, the net income difference will be close to zero as well.

22) What is throughput costing? What advantages is it purported to have over variable and
absorption costing?

Answer: Throughput costing treats all costs except direct materials as costs of the period in
which they are incurred. Throughput costing results in a lower amount of manufacturing cost
put into inventory than either variable or absorption costing. Supporters of throughput costing
claim that it provides less incentive to produce for inventory than absorption costing or even
variable costing.

27) a. Explain the difference between the variable and absorption costing methods.
b. Which method(s) are required for external reporting? For internal reporting?
Answer:
*The difference is based on the treat of fixed manufacturing overhead cost, under variable cost
fixed manu OH cost is treated as period cost and expensed as it is incurred,
Absorption cost fixed manu OH is considered a cost that become part of inventory and not
expensed until the goods are sold.

* Absorption costing is required for external reporting to shareholders and for income tax
reporting. Variable cost use for internal purpose as it is separate fixed and variable manu OH
cost which is facilitating CVP analysis and discourage over production as managers cannot
increase income by increasing production

*Disadvantage absorption: obscure the cost behavior pattern of the firm as including fixed
manu cost, it is not clear for the firm how total cost will change as volume change.

60) Galliart Company has two identical divisions, East and West. Their sales, production volume, and fixed
manufacturing costs have been the same for the last five years. The amounts for each division were as follows:
20X1 20X2 20X3 20X4 20X5
Units produced 50,000 55,000 55,000 44,000 44,000
Units sold 45,000 45,000 50,000 50,000 50,000
Fixed manufacturing costs$55,000$55,000$55,000 $55,000 $55,000

East Division uses absorption costing and West Division uses variable costing.
Both use FIFO inventory methods.
Variable manufacturing costs are $5 per unit.
Selling and administrative expenses were identical for each division.
There were no inventories at the beginning of 20X1.
Which division reports the highest income each year? Explain.
Answer: East Division had the higher income during the first three years because production exceeded sales;
this stored some of the fixed manufacturing costs each year in the ending inventory balances. West had the
higher income during the last two years because sales exceeded production. During these years, East incurred
all of the year's fixed manufacturing costs plus those costs that were in inventory from the prior years.
Diff: 2
Terms: variable costing, absorption costing
Objective: 2

58) The manager of the manufacturing division of Iowa Windows does not understand why income went down
when sales went up. Some of the information he has selected for evaluation include:
January February
Units produced 40,000 30,000
Units sold 30,000 40,000

Sales $600,000 $800,000

Beginning inventory 0 150,000
Cost of production 600,000 550,000
Ending inventory 150,000 0
Operating income 70,000 35,000

The division operated at normal capacity during January.

Variable manufacturing cost per unit was $5, and the fixed costs were $400,000.
Selling and administrative expenses were all fixed.

Required:
Explain the profit differences. How would variable costing income statements help the manager understand the
division's operating income?
Answer: The 10,000 units in inventory being assigned fixed manufacturing costs cause the operating income
difference. The fixed manufacturing cost assigned to the inventory is carried into the next month. The fixed
costs per unit were $10 per unit ($400,000/40,000), therefore, $100,000 (10,000 × $10) were carried into
February.

Variable costing helps avoid confusion by relating variations in expenses to sales rather than to inventory
fluctuations. Under variable costing, the total fixed amount ($400,000) would be expensed in January and none
carried forward into February. Therefore, January's income would be $100,000 less than reported and
February's $100,000 more than reported.
Diff: 2
Terms: variable costing, absorption costing
Objective: 1, 2
AACSB: Reflective thinking

59) Explain the difference between the gross margin format and the contribution margin format for the income
statement. What information is highlighted with each?
Answer: The gross margin format divides costs into product and period costs while the contribution format
divides costs into variable and fixed costs. The gross margin format highlights cost function while the
contribution format highlights cost behavior.
Diff: 2
Terms: variable costing, absorption costing
Objective: 2
AACSB: Reflective thinking

20) Kaiser Company just hired its fourth production manager in three years. All three previous managers had
quit because they could not get the company above the break-even point, even though sales had increased
somewhat each year. The company was operating at about 60 % of plant capacity. The flatware industry was
growing, so increased sales were not out of the question.

I. R. Thinking took the job as manager of the production division with a very attractive salary package. After
interviewing for the position, he proposed a salary and bonus package that would give him a very small salary
but a large bonus if he took the operating income (using absorption costing) above the breakeven point during
his very first year.

Required:
What do you think Mr. Thinking had in mind for increasing the company's operating income?

Answer
he could think to increase both production and sales during the coming years. also he could increase the
production as he knows that the extra costs would be hidden in unsold inventory. If the new production level
could be sold by the sales force in the growing market, the profits would increase.
Also, he could combine increased production with reduced fixed manufacturing costs such as maintenance. In
the short run, several combinations could be taken to ensure that the profit picture would improve.

**21) Explain three methods under absorption costing that managers can use to improve operating income.
Answer: 1) A plant manager may switch to manufacturing products that absorb the highest amount of fixed
manufacturing costs, regardless of the demand for the product.

2) A plant manager may accept a particular order to increase production, even though another plant in the same
company may be better suited to handle the order.

3) To increase production, a manager may defer maintenance beyond the current period.

22) Briefly discuss two methods of reducing the undesirable incentives associated with the use of absorption
costing to evaluate the performance of a plant manager.
Answer: There are several ways to reduce the undesirable incentives associated with the use of absorption
costing to evaluate the performance of a plant manager. Any two of the following would be sufficient to answer
this question:

1) Use budgeted balance sheets to limit the ability of a manager to exceed those amounts without providing an
explanation.

2) Incorporate a carrying charge for inventory in the internal accounting system. This will serve to reduce the
amount of profit a manager reports in proportion to the amount of any inventory buildup.

3) Extend the period of the plant manager's evaluation to a 3 to 5 year period. This will reduce the manager's
incentive to produce into the inventory to increase quarterly or short run profits.

4) Include non-financial as well as financial measures in the manager's performance evaluation. These might
include ratios of units produced to units sold to make producing to inventory more visible to top management.
22) What is throughput costing? What advantages is it purported to have over variable and absorption costing?
Answer: Throughput costing treats all costs except direct materials as costs of the period in which they are
incurred. Throughput costing results in a lower amount of manufacturing cost put into inventory than either
variable or absorption costing. it provides less incentive to produce for inventory than absorption costing or
even variable costing so it revokes their intention to over-production (economic of scale)

22) Match each of the following items with one or more of the denominator-level capacity concepts by putting
the appropriate letter(s) by each item:
a. Theoretical capacity
b. Practical capacity
c. Normal capacity utilization
d. Master-budget capacity utilization

1. Reduces theoretical capacity by considering unavoidable operating interruptions

2. Producing at full efficiency all the time
3. Measures capacity levels in terms of demand
4. Level of capacity utilization that satisfies average customer demand over a period
5. Does not allow for plant maintenance
6. Engineering and human resource factors are important when estimating capacity
7. Level of capacity utilization that managers expect for the current budget period
8. Ideal goal of capacity utilization
9. Takes into account seasonal, cyclical, and trend factors
10. Measures capacity levels in terms of what a plant can supply
Answer:
1. b
2. a
3. c, d
4. c
5. a
6. a, b
7. d
8. a
9. c
10. a, b

31) a. List the four different measures of capacity.

b. Which measure of capacity is best for setting prices? Why?
c. Which measure of capacity is best for evaluating the performance of the marketing manager for the current
year? Why?
Answer:
a. Theoretical capacity, practical capacity, normal capacity utilization, and master-budget capacity utilization
are the four measures of capacity.
b. Practical capacity is best to use when setting prices because only the actual cost of capacity used for
production is included in the cost of a unit.
c. Master-budget capacity utilization is best for evaluating performance of managers over the current year
because the manager should only be held accountable for budgeted sales of the current year and not production
capacity, especially when there is unused capacity.
11) The breakeven points are the same under both variable costing and absorption costing.
Answer: FALSE
Explanation: The breakeven points are generally different under both variable costing and absorption costing.
If variable costing is used, the breakeven point (that’s where operating income is $0) is computed in the usual
manner. If absorption costing is used, the required number of units to be sold to earn a specific target operating
income is not unique because of the number of variables involved. The breakeven point under absorption
costing depends on (1) fixed manufacturing costs, (2) fixed operating (marketing) costs, (3) contribution margin
per unit, (4) unit level of production, and (5) the capacity level chosen as the denominator to set the fixed
manufacturing cost rate.

13) Discuss the three methods to dispose of production volume variance.

Answer: 1) Adjusted allocation-rate approach - This approach restates all amounts by using actual, rather than
budgeted, cost rates.
2) Proration approach - The underallocated or overallocated overhead is spread among the ending balances in
work-in-Process Control, finished Goods Control, and Cost of Goods Sold.
3) Write-off variances to cost of goods sold approach - The variance is written off to cost of goods sold.

12) How does the capacity level chosen to compute the budgeted fixed overhead cost rate affect the production-
volume variance?
Answer: The chosen capacity level is directly related to the size and direction of the production-volume
variance. When the chosen capacity level exceeds the actual production level, there will be an unfavorable
production-volume variance; when the chosen capacity level is less than the actual production level, there will
be a favorable production-volume variance.

11) Should a company with high fixed costs and unused capacity raise selling prices to try to fully recoup its
costs?
Answer: No, companies in this situation might face reductions in the demand for their products if they continue
to raise selling prices. This would result in the fixed capacity costs being spread over fewer and fewer units,
increasing reported costs, resulting in rising intention to raise prices.