• Chapter 4Exercises 5, 8, 12, 17, and18
• Problem 12

172 iStockphoto Variable Costing In 2012, the all-tube amplifier p r o d u ce d b y C l a u s e n Tu b e r e ce i ve d rave reviews and the company was able to sell all 5,000 units it produced, generating company profit of $3,500,000. Based on these results, the company increased production to 6,000 units in the subsequent year but was able to sell only 4,800 units.This performance, however, was considered quite good given that the economy had slipped in the third and fourth quarters. In early January of 2014, Robert Clausen, company president and founder, reviewed financial performance for 2013. Surprisingly, profit had actually increased slightly to $3,528,000. Robert was confused and wasted no time calling Leslie Anders, the company controller. \"What's going on?\" Robert asked in a voice that hinted at his irritation. \"Sales are down, the production process and prices haven't changed, and yet profit is up! How confident are you in the income numbers? There must be a significant error somewhere.\" \"I know this result looks bizarre,\"Leslie replied.\"But it's not due to an error in the accounting department. It's due to the fact that our financial statements are prepared using what's called full, or absorption, costing. That's the method most companies use for external reporting to shareholders and creditors.If your schedule permits, let's meet this afternoon and I'll show you an analysis that explains what happened. There's a method called variable costing that we could use for internal reporting purposes which wouldn't produce such puzzling results. Maybe we should consider adopting it. I really think it can help us do a better job managing the business.\" In this chapter, we will discuss the differences between full costing and variable costing and gain an understanding of why profit is up at ClausenTube even though sales are down. We will also see how a variable costing income statement can support accurate planning and good decision making, two activities that are jeopardized if managers rely on full cost information. 1. Explain the difference between full (absorption) and variable costing. 2. Prepare an income statement using variable costing. 3. Discuss the effect of production on full and variable costing income. 4. Explain the impact of JIT (just-in-time) on the difference between full and variable costing income. 5. Discuss the benefits of variable costing for internal reporting purposes. iStockphoto iStockphoto iStockphoto 173 174 Chapter 5 Variable Costing LEARNING OBJECTIVE 1 FULL (ABSORPTION) AND VARIABLE COSTING Explain the difference between full (absorption) and variable costing. Income statements of manufacturing firms prepared for external purposes use full costing (also called absorption costing). In full costing, inventory costs include direct material, direct labor, and all manufacturing overhead. Direct material and direct labor are generally variable costs, but manufacturing overhead includes both variable and fixed cost elements.Thus, fixed and variable costs are commingled, or combined, and it is very difficult to untangle the costs to perform \"what if\" analysis that requires separating fixed and variable costs. An alternative to full costing for internal reporting purposes is variable costing.In variable costing, only variable production costs are included in inventory costs. All fixed production costs are treated as period costs and expensed in the period incurred. As shown in Illustration 5-1, the only difference between the two methods is their treatment of fixed manufacturing overhead. Under the full costing method, these costs are included in inventory. They enter into the determination of expense only when the inventory is sold.Under the variable costing method, fixed manufacturing costs enter into the determination of expense in the same way as other, nonmanufacturing period costs. Consider depreciation, which usually is a fixed cost component of manufacturing overhead. Under full Illustration 5-1 Comparison of full and variable costing Full Costing Product Costs Direct Material Direct Labor Period Costs Variable Manufacturing Overhead Fixed Manufacturing Overhead Cost of Goods Sold Inventory Selling Costs Administrative Costs Expense Variable Costing Product Costs Direct Material Direct Labor Inventory Period Costs Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Cost of Goods Sold Selling Costs Expense Administrative Costs Full (Absorption) and Variable Costing 175 costing, some portion of depreciation for the period remains in ending inventory when not all of the items produced are sold. Under the variable costing method, however, the total amount of depreciation is treated as an expense of the period. LEARNING OBJECTIVE 2 Prepare an income statement using variable costing. Variable Costing Income Statement If variable costing is used, an income statement can be prepared that classifies all expenses in terms of their cost behavior, either fixed or variable. With the variable expenses separated from the fixed expenses, a contribution margin can be presented. The contribution margin information will allow readers of the income statement to make reasonable estimates of how much profit will change with a change in sales. A comparison of a variable costing income statement and an income statement typical for a manufacturing firm using full costing is presented in Illustration 5-2. Suppose sales of Lee Dress Manufacturing Company are expected to increase by $10,000,000. What is the expected increase in profit? This can't be determined from the full costing income statement because we don't know which costs are fixed and which costs are variable. However, using the variable costing income statement, we can easily calculate the contribution margin ratio as the contribution margin divided by sales, which equals 65 percent. If sales increase by $10,000,000, profit is estimated to increase by $6,500,000: Contribution margin Contribution = margin ratio Sales Contribution $65,000 = = 0.65 margin ratio $100,000 Increase in sales Contribution margin ratio Increase in contribution margin $10,000,000 0.65 $ 6,500,000 Note that the full costing income statement at the top of Illustration 5-2 cannot be used to estimate the increase in profit due to a $10,000,000 increase in sales. The reason is that cost of goods sold includes both fixed and variable costs. Obviously, the fixed costs won't increase if sales increase, but the problem is that we don't know how much of cost of goods sold is fixedor variable, for that matterunder full costing. Also note that in the variable costing income statement, we assume that some of the Lee Dress Manufacturing Company's selling and administrative costs are fixed and some are variable. Given this, it is important that we break out the fixed and variable components of selling and administrative costs so that we can calculate the contribution margin ration. This ratio, as we just saw, allows us to do profit planning and answer questions like \"By how much will profit increase if sales increase by $10,000,000?\" LINK TO P R A C T I C E German Companies More Likely to Use Variable Costing In a survey yielding responses from 148 German companies and 130 U.S. rms, two accounting researchers found that German rms are much more likely to use variable costing (52% versus 21%). One German respondent stated that variable costing makes xed overhead more visible. And a U.S. respondent who uses variable costing stated that he prefers variable costing because, at his company, volumes vary a lot from period to period. If xed costs were allocated to products, unit costs would be distorted. Source: Kip Krumwiede and Augustin Suessmair, \"Getting Down to Specics on RCA,\" Strategic Finance, June 2007, pp. 50-55. 176 Chapter 5 Variable Costing Income Statement Prepared Using Full Costing Lee Dress Manufacturing Company Income Statement For the Year Ended December 31, 2014 Illustration 5-2 Comparison of income statements prepared using full and variable costing In Thousands Sales Less cost of goods sold Gross margin Less selling and administrative expense: Selling expense Administrative expense Net income $100,000 30,000 70,000 $18,000 12,000 30,000 $ 40,000 Income Statement Prepared Using Variable Costing Lee Dress Manufacturing Company Income Statement For the Year Ending December 31, 2014 In Thousands Sales Less variable costs: Variable cost of goods sold Variable selling expense Variable administrative expense Contribution margin Less fixed costs: Fixed manufacturing expense Fixed selling expense Fixed administrative expense $100,000 $20,000 10,000 5,000 10,000 8,000 7,000 Net income LEARNING OBJECTIVE 3 Discuss the effect of production on full and variable costing income. 35,000 65,000 25,000 $ 40,000 EFFECTS OF PRODUCTION ON INCOME FOR FULL VERSUS VARIABLE COSTING: THE CLAUSENTUBE EXAMPLE To examine in detail the differences between full and variable costing, let's consider the case of ClausenTube presented at the start of the chapter. The amplifiers produced by the company sell for $2,000 per unit. The variable production costs of each unit include the following: direct material (various tubes and other components), $600; direct labor, $225; and variable manufacturing overhead, $75. In addition, $1,200,000 of fixed manufacturing overhead is incurred each year. Selling expense is composed of $40 per unit sold of variable expense and $100,000 of fixed expense. Administrative expenses are all fixed and equal to $500,000: Selling price per unit Variable production costs per unit: Direct material Direct labor Variable overhead Variable selling expense per unit Contribution margin per unit Fixed manufacturing overhead Fixed selling expense Fixed administrative expense $2,000 $600 225 75 900 40 $1,060 $1,200,000 $100,000 $500,000 Effects of Production on Income for Full versus Variable Costing: The ClausenTube Example 177 LINK TO P R A C T I C E Manufacturing Firms May Have Higher Sales and Lower Gross Margins Due to Increases in the Cost of Oil-Based Materials An initially surprising result related to increases in the price of oil is that some manufacturers are seeing their sales increase while their gross margin ratios decrease. Since under GAAP, cost of goods sold for manufacturing rms is calculated using full costing, it includes xed costs. So if sales increase and xed costs don't change, we would expect the prot margin ratio (Gross margin Sales) to increase. But for some rms, just the opposite is happening. Consider Northeastern Plastics, a New Jersey manufacturer of ashlights, armrests, pool accessories, and ladder materials. A prime material in their company's products is engineering resins, which are made from oil. Suppliers are charging Northeastern more for the resins, and the company is able to pass along only part of the increased cost. So, the company's sales are increasing but not by enough to cover increased costs. Thus, the company's gross margin ratio is actually declining. Let's look at a simple example to illustrate this result. Suppose Northeastern has $20,000,000 in sale and that cost of sales is $15,000,000. Further, for simplicity's sake, let's assume that this cost is completely variable. In this case, the company's gross margin ratio is 25 percent: Sales Cost of goods sold Gross margin $20,000,000 15,000,000 $ 5,000,000 Gross margin ratio 25% Now suppose that the cost of raw materials related to this level of sales increases by $2,000,000, and the company is able to pass along only $1,800,000 to its customers. In this case, the contribution margin ratio will actually decrease to 22 percent: Sales ($20,000,000 + $1,800,000) Cost of goods sold ($15,000,000 + $2,000,000) Gross margin $21,800,000 17,000,000 $ 4,800,000 Gross Margin ratio 22% Source: James Haggerty, \"Skyrocketing Fuel, Raw Materials Costs Burden Business, Customers,\" http://thetimes-tribune .com, May 24, 2011. Quantity Produced Equals Quantity Sold In 2014, there is no beginning inventory of finished goods, 5,000 units are produced, and 5,000 units are sold. Illustration 5-3 provides a comparison of full costing and variable costing income statements for this situation. The full cost of production is $5,700,000. This includes $4,500,000 of variable production cost ($900 5,000 units) and $1,200,000 of fixed manufacturing overhead. With 5,000 units produced, this results in a unit cost of $1,140: Variable Fixed production production cost cost Units Produced Unit cost under full costing $4,500,000 + $1,200,000 = $1,140 per unit 5,000 Because 5,000 units are sold, cost of goods sold is $5,700,000 ($1,140 5,000 units). Selling expense is equal to $100,000 of fixed selling expense plus $40 per unit of variable selling expense for a total of $300,000: Variable selling expense ($40 5,000 units) Fixed selling expense Total selling expense $200,000 100,000 $300,000 178 Chapter 5 Variable Costing ClausenTube Income Statements For the Year Ended December 31, 2016 Illustration 5-3 Full versus variable costing when units produced equal units sold Full Costing Sales ($2,000 5,000 units) Cost of goods sold ($1,140 5,000 units) Gross margin Less selling and administrative expense: Selling expense Administrative expense $10,000,000 5,700,000 4,300,000 $ 300,000 500,000 Net income 800,000 $ 3,500,000 Notes: Units produced and sold both equal 5,000. Selling expense $100,000 ($40 5,000 units). Variable Costing Sales ($2,000 5,000 units) Less variable costs: Variable cost of goods sold ($900 5,000 units) Variable selling costs ($40 5,000 ) Contribution margin Less fixed costs: Fixed production costs Fixed selling costs Fixed administrative costs Net income $10,000,000 $4,500,000 200,000 1,200,000 100,000 500,000 4,700,000 5,300,000 1,800,000 $ 3,500,000 Note: Units produced and sold both equal 5,000. Decision Making / Incremental Analysis Taking into account fixed administrative expense of $500,000, net income is $3,500,000. Now let's consider the variable costing income statement in Illustration 5-3. The variable cost of production is only $900 per unit and variable selling expense is $40 per unit. With 5,000 units sold, variable expenses are $4,700,000. Thus, as indicated in the illustration, the contribution margin is $5,300,000. With fixed production cost of $1,200,000, fixed selling expense of $100,000, and fixed administrative expense of $500,000, net income is equal to $3,500,000, which is the same as net income calculated using full costing. As we've just seen, when the quantity produced equals the quantity sold, there is no difference between net income calculated using full versus variable costing. Since all units produced are sold, no fixed cost ends up in ending inventory. Thus, the only difference between the two methods in this situation is that variable costing breaks out total costs into both fixed and variable costs and provides a contribution margin.That, however, is not a trivial difference since the contribution margin can be very helpful in planning and decision making. Suppose, for example, that ClausenTube is considering an advertising campaign that will cost $100,000 and is expected to increase sales by $200,000. What will be the impact on income (a planning question), and should the company undertake the marketing plan (a decision question)? Using the variable costing income statement, we can easily calculate the contribution margin ratio to be 0.53: Contribution margin $5,300,000 = 0.53 = Sales $10,000,000 Effects of Production on Income for Full versus Variable Costing: The ClausenTube Example 179 With this information, we can estimate that if sales increase by $200,000, incremental profit will be $6,000: Increase in sales Contribution margin ratio Increase in contribution margin Less increased marketing costs Increase in profit $200,000 0.53 106,000 100,000 $ 6,000 Given that the impact on profit is positive, deciding to undertake the marketing plan is appropriate, and ClausenTube can update its financial plans accordingly. Now suppose that the variable costing income statement is not available and ClausenTube managers rely on the information in the full costing income statement. How will they calculate the impact of the marketing plan? There are two assumptions they might makeboth of which are wrong! First, they might assume that the cost of goods sold is entirely variable and, further, is the only variable cost. In this case, they will estimate that profit will increase by $0.43 for every dollar of sales, which, as we know, is too low: Gross margin $4,300,000 = 0.43 = Sales $10,000,000 Second, they might assume that all costs are variable, in which case net income is equivalent to the contribution margin. In this case, they will estimate that profit will increase by only $0.35 for every dollar of sales, which is also too low: Net income $3,500,000 = 0.35 = Sales $10,000,000 The point is that having a variable costing income statement can be very useful for planning and decision making. Not having one may lead managers to make assumptions that are incorrect, leading to poor plans and poor decisions. Quantity Produced Is Greater Than Quantity Sold In the previous section, we saw that when the quantity produced is equal to the quantity sold, there is no difference between income computed using full costing or using variable costing. Such is not the case if the quantity produced is greater than the quantity sold. In this case, income will be greater using full costing as opposed to variable costing. Let's see why this is the case. Recall that in 2013, ClausenTube increased production to 6,000 units but sold only 4,800 due to a weakening economy. Illustration 5-4 provides a comparison of full costing and variable costing income statements for this situation. The full cost of production is $6,600,000. This includes $5,400,000 of variable production cost ($900 6,000 units) and $1,200,000 of fixed manufacturing overhead. With 6,000 units produced, this results in a unit cost of $1,100: Variable Fixed production production cost cost Units produced Unit cost under full costing $5,400,000 + $1,200,000 = $1,100 per unit 6,000 180 Chapter 5 Variable Costing Any Questions? Q: If variable costing is so great for internal reporting purposes, why isn't it used for external reporting purposes? Don't external users want useful information? A: Generally accepted accounting principles (GAAP) imply that variable costing is not acceptable for external reporting purposes. Since it's not allowed, it isn't used! But that leads one to wonder why this is the case. Shouldn't GAAP be formulated to provide useful information? Perhaps a better answer is that company managers may be concerned that variable cost information will prove helpful to competitors who, with the variable cost information, will have better insight into a rival company's cost structure. Another reason is that separating costs into fixed and variable components may be quite subjective. As we saw in Chapter 4, the most common way of classifying costs as fixed and variable is account analysis. In that method, costs are simply classified using management's subjective judgment. In the previous year, the unit cost was $1,140. Unit costs have decreased because production has increased, spreading fixed costs out over more units. Because 4,800 units are sold, cost of goods sold is $5,280,000. Net income amounts to $3,528,000. Now let's consider the variable costing income statement in Illustration 5-4. The variable cost of production is only $900 per unit and variable selling costs are $40 per unit. With 4,800 units sold, variable expenses are $4,512,000. Thus, as indicated in the illustration, the contribution margin is $5,088,000. With fixed production costs of $1,200,000, fixed selling costs of $100,000, and fixed administrative costs of $500,000, net income is equal to $3,288,000, which is $240,000 less than the income computed using full costing. Illustration 5-4 Full versus variable costing when units produced are greater than units sold ClausenTube Income Statements For the Year Ended December 31, 2013 Full costing Sales ($2,000 4,800 units) Cost of goods sold ($1,100 4,800 units) Gross margin Less selling and administrative expense: Selling expense Administrative expense Net income $9,600,000 5,280,000 4,320,000 $ 292,000 500,000 792,000 $3,528,000 Notes: 6,000 units produced and 4,800 units sold. Selling expense $100,000 ($40 4,800 units). Variable Costing Sales ($2,000 4,800 units) Less variable costs: Variable cost of goods sold ($900 4,800 units) Variable selling costs ($40 4,800 ) Contribution margin Less fixed costs: Fixed production costs Fixed selling costs Fixed administrative costs Net income Note: 6,000 units produced and 4,800 units sold. $9,600,000 $4,320,000 192,000 1,200,000 100,000 500,000 4,512,000 5,088,000 1,800,000 $3,288,000 Effects of Production on Income for Full versus Variable Costing: The ClausenTube Example 181 Illustration 5-5 Inventory cost under full and variable costing Full Costing Inventory Value Cost per Unit Direct material per unit Direct labor per unit Variable manufacturing overhead Fixed manufacturing overhead ($1,200,000 6,000 units) Total Ending Inventory Value ($1,100 1,200 units) $ 600 225 75 200 $1,100 $1,320,000 Variable Costing Inventory Value Cost per Unit Direct material per unit Direct labor per unit Variable manufacturing overhead Total $ 600 225 75 $ 900 Difference of $240,000 due to $200 per unit of fixed manufacturing overhead in ending inventory under full costing ($200 1,200 units $240,000) Ending Inventory Value ($900 1,200 units) $1,080,000 Let's see why income is higher using full costing. Recall that the difference between full and variable costing is that under full costing,inventory cost includes fixed manufacturing overhead whereas under variable costing, fixed manufacturing overhead is expensed as a period cost.Illustration 5-5 presents a comparison.Note that the $240,000 difference in ending inventory values completely accounts for the difference in income under the two methods. Quantity Produced Is Less Than Quantity Sold We have just seen that if the quantity produced equals the quantity sold, then full and variable costing yield the same reported income (See Illustration 5-3). If the quantity produced is greater than the quantity sold, full costing yields a higher income, because some fixed manufacturing overhead is in ending inventory under full costing while the entire amount is treated as a period expense under variable costing (See Illustrations 5-4 and 5-5). Now, what is the case if the quantity produced is less than the quantity sold? To sell more than produced, a company must have some beginning inventory.The recorded value of that beginning inventory will be greater with full costing since full costing includes fixed manufacturing overhead and variable costing does not.Thus, when the beginning inventory is charged to cost of goods sold, the charge will be higher under full costing. The result: Income is lower under full costing when the quantity produced is less than the quantity sold. Suppose that in 2014, ClausenTube produces 6,000 units but sells 7,200 units. Recall that 1,200 units are left over from the prior year. Now cost of goods sold under full costing includes 1,200 units at $1,100 per unit from beginning inventory and 6,000 units at $1,100 from current-period production. As indicated in Illustration 5-6, total cost of goods sold is equal to $7,920,000 under full costing. The difference in incomes between full and variable costing is $240,000 ($5,832,000 under variable costing $5,592,000 under full costing). This, as we've already said, is due to the fact that beginning inventory includes fixed manufacturing overhead under full costing while beginning inventory under variable costing does not. 182 Chapter 5 Variable Costing Note that the difference between the beginning inventory values accounts for the $240,000 difference in incomes: Beginning inventory under full costing Beginning inventory under variable costing Difference $1,320,000 1,080,000 $ 240,000 To summarize, here are the comparative effects of production on income for the two methods: Condition Units produced equal units sold Units produced exceed units sold Units produced are less than units sold Result No difference in income Full costing yields higher income Variable costing yields higher income Explaining What Happened at ClausenTube Recall the scenario at the start of the chapter. Robert Clausen had just called his controller and asked her to explain why profit increased even though the company sold fewer units in 2014 compared to 2013 and had not changed its price or its production processes. It is hoped that the answer is now apparent. In 2014, the company produced a lot more units than it sold. The high level of production reduced cost per unit because fixed manufacturing overhead was spread out over more units. The low unit cost led to a low cost of goods sold value, but the company ended up with a substantial ending inventory balance. Illustration 5-6 Full versus variable costing when units produced are less than units sold ClausenTube Income Statements For the Year Ended December 31, 2014 Full Costing Sales ($2,000 7,200 units) Cost of goods sold 1,200 units $1,100 6,000 units $1,100 Gross margin Less selling and administrative expense: Selling expense Administrative expense Net income $14,400,000 $1,320,000 6,600,000 $ 388,000 500,000 7,920,000 6,480,000 888,000 $ 5,592,000 Notes: 6,000 units produced and 7,200 sold. Selling expense $100,000 ($40 7,200 units). Variable Costing Sales ($2,000 7,200 units) Less variable costs: Variable cost of goods sold 1,200 units $900 6,000 units $900 Variable selling costs ($40 7,200) Contribution margin Less fixed costs: Fixed production costs Fixed selling costs Fixed administrative costs Net income Note: 6,000 units produced and 7,200 sold. $14,400,000 $1,080,000 5,400,000 1,200,000 100,000 500,000 6,480,000 288,000 7,632,000 1,800,000 $ 5,832,000 Effects of Production on Income for Full versus Variable Costing: The ClausenTube Example 183 LINK TO P R A C T I C E Ford's Profit Margin Percent Hurt by Reduced Production In May 2008, Ford announced that it would cut vehicle production by an additional 20,000 units and that anticipated second-quarter production would be down 15 to 20 percent versus the second quarter of 2007. Much of the reduction would relate to trucks and SUVs, which have lost their appeal to consumers due to higher fuel prices. What happens to the cost per SUV when production is cut? Consider the fact that Ford has made huge investments in equipment. Thus, depreciation, which is a fixed cost, is high. The company also has large fixed costs due to depreciation of plant, insurance costs, and employee benefits. These costs remain relatively constant when production is cut. The upshot is that the cost per SUV increases substantially when there is a substantial cut in production. Since each SUV produced becomes more costly, the prot margin (selling price minus cost of unit sold) on each SUV drops. If the company had been using variable costing, Robert would have seen profit decline, just as he expected.Note that per Illustration 5-3, income under variable costing in 2012 when sales were 5,000 units was $3,500,000. Per Illustration 5-4, income under variable costing in 2013 when sales were only 4,800 units was only $3,288,000. That's because variable costing does not allow fixed manufacturing overhead to be \"buried\"in ending inventory. Rather, with variable costing, the entire amount is treated as a period expense. LEARNING OBJECTIVE 4 Impact of JIT on the Income Effects of Full versus Variable Costing Explain the impact of JIT on the difference between full and variable costing income. As discussed in Chapter 2, many companies have adopted just-in-time (JIT) inventory management systems. And companies that use JIT may have very low inventory levels since they don't produce until they are ready to sell their products.The result is that the units they produce are approximately equal to the units they sell.Thus, the difference between variable costing income and full costing income is likely to be very small for companies that use JIT. TEST YOUR KNOWLEDGE Kincade Faucets produces a variety of faucets for residential and commercial use. At the start of the year, the company had Finished Goods Inventory of $1,000,000. At the end of the year, the company had Finished Goods Inventory of $1,400,000. During the year, the company incurred $400,000 of depreciation expense on its manufacturing equipment. How much depreciation expense will be in Finished Goods Inventory under variable costing? a. $285,714. b. $0.00. c. Neither of the answer choices is correct. Correct answer is b. 184 Chapter 5 Variable Costing BENEFITS OF VARIABLE COSTING FOR INTERNAL REPORTING There are two primary benefits associated with using variable costing for internal reporting purposes. Both are discussed in this section. LEARNING OBJECTIVE 5 Discuss the benefits of variable costing for internal reporting purposes. You Get What You Measure Variable Costing Facilitates CVP Analysis Variable costing separates fixed and variable costs, a necessary step in performing costvolume-profit (CVP) analysis and, relatedly, planning and decision making.We discussed this point earlier, but it's worth repeating. Managers simply can't estimate accurately the impact of changes in volume on cost and profit unless they know which costs are fixed and which costs are variable. Consider the full costing income statement in Illustration 5-4 and ask yourself \"What would be the impact on profit of a $100,000 increase in sales?\" Unfortunately, the question cannot be answered with any assurance using the full cost information. We don't know which costs are fixed and which are variable so we don't know which ones will increase with the increase in sales. Now consider the variable costing income statement. We can easily see that the contribution margin ratio is .53 (i.e., $5,088,000 $9,600,000). Thus, we can easily estimate a $53,000 increase in profit with a $100,000 increase in sales. VARIABLE COSTING LIMITS MANAGEMENT OF EARNINGS VIA PRODUCTION VOLUME Because the performance of managers is often evaluated in relation to earnings, managers may have an incentive to artificially inflate profit by producing more units than they can sell. Using variable costing to calculate earnings, however, limits this option. Suppose a manager expects sales to be 1,000 units. The selling price is $100 per unit, variable production costs are $50 per unit, and fixed production costs are $45,000. If the manager produced 1,000 units, profit would be equal to $5,000 (i.e., 1,000 ($100 $50) $45,000) under both the full costing method and the variable costing method. The manager may realize, however, that if the full costing method is used, part of the fixed costs can be assigned to ending inventory, thereby transferring the expense to a future period.Thus, if the manager produces 2,000 units, profit will be $22,500 higher because half of the fixed costs will be included in the 1,000 units remaining in ending inventory. Of course, this is a short-run strategy, because eventually the inventory buildup will be noticed. However, the manager may hope to be working for a different company by that time with a great track record as a manager at the former company! Note that the strategy of producing more than you can sell will not increase income under the variable costing method, because under that method, none of the fixed costs can be included in ending inventory. Decision Making Insight A variable costing income statement facilitates decision making by breaking out the total contribution margin. If we divide the contribution margin by sales, we have the contribution margin ratio, and we can use it to analyze the impact of changes in sales on profit. Since many decisions affect sales, being able to estimate the impact of changes in sales on profit greatly facilitates decision making. Summary of Learning Objectives LEARNING OBJECTIVE 1 Explain the difference between full (absorption) and variable costing. In full costing, product cost includes direct material, direct labor,and variable and fixed manufacturing overhead.In variable costing, fixed manufacturing overhead is not included in product cost. Rather, it is treated as a period expense. LEARNING OBJECTIVE 2 Prepare an income statement using variable costing. In a variable costing income statement, variable and fixed costs are segregated. All variable expenses are deducted from sales to yield a contribution margin.Then fixed expenses are deducted from the contribution margin to yield net income. the quantity sold, full costing income is higher than variable costing income. If the quantity produced is less than the quantity sold, full costing income is less than variable costing income. LEARNING OBJECTIVE 4 Explain the impact of JIT on the difference between full and variable costing income. With a JIT system, there is often little difference between the quantity produced and the quantity sold.Thus, there is only a small difference between full and variable costing income. LEARNING OBJECTIVE 5 Discuss the benefits of variable costing for internal reporting purposes. LEARNING OBJECTIVE 3 Discuss the effect of production on full and variable costing income. If the quantity produced equals the quantity sold, there is no difference in income. If the quantity produced exceeds Variable costing results in a contribution margin, which is useful in planning and decision making. Also, variable costing income cannot be managed up by producing more units than needed. Review Problem 1 Albert Pernelli, a well-known consultant, was hired to \"turn around\" Inlet Steel Plate. In the year prior to his arrival, the company produced and sold 60,000 tons of steel plate for $800 per ton.The company has $20,000,000 of fixed manufacturing costs and $400 per ton of variable manufacturing costs. Selling and administrative costs are essentially fixed and amount to $9,000,000. At the end of the year, the company had a loss of $5,000,000, as follows: Sales (60,000 tons $800) Less cost of goods sold ($20,000,000 fixed ($400 60,000 tons)) Gross margin Less selling and administrative costs Net loss $48,000,000 44,000,000 4,000,000 9,000,000 ($ 5,000,000) Upon arriving at Inlet Steel Plate, Albert noted that the company was operating substantially below capacity due to a weak market for steel plate. He decided that the company had to take advantage of its capacity and ordered the company to increase production of steel plate to 90,000 tons. He also cut advertising and laid off white collar workers, saving the company $2,000,000. Although sales remained at 60,000 tons, profit went from a loss of $5 million to a gain of $3,666,667! Albert received a large fee and added to his reputation as a \"turnaround genius.\" Required a. Assuming no changes in price or the company's cost structure, show the calculation of income under Albert's \"leadership.\" b. How much fixed cost is buried in ending inventory? c. Did Albert really create value for the company? 185 Answer a. Calculation of unit cost of production Fixed cost Variable costs ($400 90,000 tons) Total Number of tons Cost per ton Calculation of net income: Sales (60,000 tons $800) Less cost of goods sold ($622.2222 60,000 tons) Gross margin Less selling and administrative costs Net income b. Fixed cost buried in ending inventory Amount of fixed cost Production (tons) Fixed cost per ton Tons in ending inventory (90,000 60,000) Fixed cost in ending inventory (30,000 $222.2222) $20,000,000 36,000,000 $56,000,000 90,000 $ 622.2222 per ton $48,000,000 37,333,333 10,666,667 7,000,000 $ 3,666,667 $20,000,000 90,000 $ 222.2222 30,000 $ 6,666,666 c. It's hard to see that Albert really created shareholder value. Most of the increase in profit is due to burying $6.7 million of fixed costs in ending inventory. Albert did increase profit by $2,000,000 due to cutting advertising and laying off white-collar workers, but this may be a short-run savings. Indeed, cutting advertising may actually hurt long-run profitability. Review Problem 2 Butler Manufacturing produces fireproof data storage containers that sell for $6,000 each.The company has the following cost structure: Manufacturing costs: Direct material per unit Direct labor per unit Variable manufacturing overhead per unit Total variable manufacturing costs per unit $ Fixed manufacturing overhead per year $2,000,000 Selling costs: Variable selling costs per dollar of sales Fixed selling costs per year $ 0.10 $ 600,000 Administrative costs: Fixed administrative costs per year $ 800,000 $ 1,000 2,000 500 3,500 At the start of 2014, there was no beginning inventory. During 2014, the company produced and sold 2,000 units. During 2015, the company produced 2,500 units but still sold only 2,000 units. 186 Required a. b. c. d. e. Calculate the full manufacturing cost per unit for 2014 and 2015. Prepare full costing income statements for 2014 and 2015. Calculate the variable manufacturing cost per unit for 2014 and 2015. Prepare variable costing income statements for 2014 and 2015. Reconcile the difference in net income for 2015 between the full costing and the variable costing approaches. Answer a. Full Manufacturing Cost per Unit in 2014 Direct material per unit Direct labor per unit Variable manufacturing overhead per unit Fixed manufacturing overhead per unit ($2,000,000 2,000 units) Total $1,000 2,000 500 1,000 $4,500 Full Manufacturing Cost per Unit in 2015 Direct material per unit Direct labor per unit Variable manufacturing overhead per unit Fixed manufacturing overhead per unit ($2,000,000 2,500 units) Total $1,000 2,000 500 800 $4,300 b. Income for 2014 Using Full Costing Sales ($6,000 2,000 units) Cost of goods sold ($4,500 2,000 units) Gross margin Less selling and administrative expense: Selling expense ($600,000 (.10 $12,000,000)) Administrative expense Net income $12,000,000 9,000,000 3,000,000 $1,800,000 800,000 $ 2,600,000 400,000 Note: Units produced and sold both equal 2,000. Income for 2015 Using Full Costing Sales ($6,000 2,000 units) Cost of goods sold ($4,300 2,000 units) Gross margin Less selling and administrative expense: Selling expense ($600,000 (.10 $12,000,000)) Administrative expense Net income $12,000,000 8,600,000 3,400,000 $1,800,000 800,000 $ 2,600,000 800,000 Note: 2,500 units produced and 2,000 units sold. c. Variable Manufacturing Cost per Unit in 2014 and 2015 Direct material per unit Direct labor per unit Variable manufacturing overhead per unit Total $1,000 2,000 500 $3,500 187 d. Income for 2014 and 2015 Using Variable Costing Sales ($6,000 2,000 units) Less variable costs: Variable cost of goods sold ($3,500 2,000 units) Variable selling costs (.10 $12,000,000) Contribution margin Less fixed costs: Fixed production costs Fixed selling costs Fixed administrative costs Net income $12,000,000 $7,000,000 1,200,000 8,200,000 3,800,000 2,000,000 600,000 800,000 $ 3,400,000 400,000 e. $800 of fixed manufacturing overhead per unit 500 units in ending inventory $400,000. Key Terms Absorption costing (174) Self-Assessment Full costing (174) Variable costing (174) (Answers Below) 1. Full costing differs from variable costing in that: a. Full costing excludes selling costs from consideration. b. Full costing excludes administrative costs from consideration. c. Full costing includes variable manufacturing overhead in inventory. d. Full costing includes fixed manufacturing overhead in inventory. 5. If units produced are less than units sold: a. Full costing yields a higher income than variable costing. b. Full costing yields a lower income than variable costing. c. Full costing and variable costing yield the same income. The following information applies to Questions 6-10. 2. If units produced exceed units sold: a. Full costing yields a higher income than variable costing. b. Full costing yields a lower income than variable costing. c. Full costing and variable costing yield the same income. Direct material Direct labor Variable manufacturing overhead Total variable manufacturing costs per unit 3. Use of a just-in-time inventory management system is likely to: a. Increase the difference between variable and full costing income. b. Decrease the difference between variable and full costing income. c. Have no effect on the difference between variable and full costing income. 4. A benefit of variable costing for internal reporting purposes is that it: a. Facilitates CVP analysis. b. Limits the ability to inflate income by producing more units than needed for current sales. c. Allows management to manage net income. d. Allows two of the answer choices. 188 Ajax Manufacturing has the following cost structure: $10 20 5 $35 Fixed manufacturing overhead per year $100,000 Fixed selling and administrative expense per year $200,000 6. Assume that Ajax produces 10,000 items and sells 8,000 items. In this case, the full costing value of ending inventory is: a. $70,000. b. $90,000. c. $130,000. d. $140,000. 7. Assume that Ajax produces 10,000 items and sells 8,000 items. In this case, the variable costing value of ending inventory is: a. $70,000. b. $90,000. c. $130,000. d. $140,000. 8. Assume that Ajax produces 10,000 items and sells 8,000 items. In this case, the full costing value of cost of goods sold is: a. $360,000. b. $350,000. c. $300,000. d. $280,000. 9. Assume that Ajax produces 10,000 items and sells 8,000 items. In this case, the variable cost of goods sold is: a. $360,000. b. $350,000. c. $300,000. d. $280,000. wo rl wide w eb d 10. Assume that Ajax produces 10,000 items and sells 8,000 items. The selling price of Ajax's product is $90 per unit. In this case, the contribution margin on the income statement prepared using variable costing is: a. $350,000. b. $440,000. c. $550,000. d. $700,000. Answers to Self-Assessment 1. d 2. a 3. b 4. d 5. b 7. a 8. a 9. d 10. b 6. b INTERACTIVELEARNING Enhance and test your knowledge of Chapter 5 using Wiley's online resources. Go to our dynamic Web site for more self-assessment,Web links, and additional information. QUESTIONS 1. Explain the difference between variable costing and full costing. 2. Explain why income computed under full costing will exceed income computed under variable costing if production exceeds sales. 3. What are the benefits of variable costing for internal reporting purposes? 4. Why would the difference between income computed under full costing and income computed under variable costing be relatively small if a company used a JIT inventory management system? 5. Explain why the ending inventory balance (assuming it is not zero) computed under full costing will always be greater than the ending inventory balance computed under variable costing. 6. If a company produces 50,000 units and sells 46,000 units during a period, which method of computing net income will result in the higher net income? Why? 7. If a company produces less than it sells (the extra units sold are from beginning inventory), which method of computing net income will result in the higher net income? Why? 8. Explain how fixed manufacturing costs are treated under variable costing. How are fixed manufacturing costs treated under full costing? 9. If the fixed manufacturing overhead per unit under full costing is multiplied by the change in inventory between the beginning of the period and the end of the period, what does the resulting number represent? 10. Explain how a manufacturing company can \"bury\" fixed production costs in ending inventory under full costing. Exercises EXERCISE 5-1. [LO 5] A key idea in this book is that decision making relies on incremental analysis. Required Explain how the use of variable costing can support appropriate decisions using incremental analysis. 189 EXERCISE 5-2. [LO 3, 5] In a normal year, Wilson Industries has $24,000,000 of fixed manufacturing costs and produces 60,000 units. In the current year, demand for its product has decreased, and it appears that the company will be able to sell only 50,000 units. Senior managers are concerned, in part because their bonuses are tied to reported profit. In light of this, they are considering keeping production at 60,000 units. Required Write a paragraph explaining why increasing production beyond the quantity needed for current sales will increase profit, and calculate the impact of producing 10,000 \"extra\" units. Is the managers' proposed action in the best interest of shareholders? EXERCISE 5-3. [LO 1] Mendel Manufacturing produces composite window frames for airline manufacturing companies. At the start of the year, the company had no beginning inventory. During the year, the company manufactured 5,000 units and sold 4,000. Direct material costs were $500,000, direct labor was $400,000, variable manufacturing overhead was $800,000, and fixed manufacturing overhead was $1,000,000. Required Calculate cost per unit under full costing and under variable costing. The following information relates to Exercises 5-4 through 5-10: Xenoc, Inc., produces stereo speakers. The selling price per pair of speakers is $1,800. There is no beginning inventory. Costs involved in production are: Direct material $ Direct labor 150 200 Variable manufacturing overhead 100 Total variable manufacturing costs per unit $ 450 Fixed manufacturing overhead per year $600,000 In addition, the company has fixed selling and administrative costs: Fixed selling costs per year Fixed administrative costs per year $210,000 $110,000 EXERCISE 5-4. [LO 1] During the year,Xenoc produces 1,500 pairs of speakers and sells 1,200 pairs. Required What is the value of ending inventory using full costing? EXERCISE 5-5. [LO 1] During the year, Xenoc produces 1,500 pairs of speakers and sells 1,200 pairs. Required What is the value of ending inventory using variable costing? EXERCISE 5-6. [LO 1] During the year,Xenoc produces 1,500 pairs of speakers and sells 1,200 pairs. Required What is cost of goods sold using full costing? EXERCISE 5-7. [LO 1] During the year, Xenoc produces 1,500 pairs of speakers and sells 1,200 pairs. Required What is variable cost of goods sold? EXERCISE 5-8. [LO 1] During the year,Xenoc produces 1,500 pairs of speakers and sells 1,200 pairs. Required What is net income using full costing? EXERCISE 5-9. [LO 1,2] During the year,Xenoc produces 1,500 pairs of speakers and sells 1,200 pairs. 190 Required What is net income using variable costing? EXERCISE 5-10. [LO 1,3] During the year,Xenoc produces 1,500 pairs of speakers and sells 1,200 pairs. Required How much fixed manufacturing overhead is in ending inventory under full costing? Compare this amount to the difference in the net incomes calculated in Exercises 5-8 and 5-9. The following information relates to Exercises 5-11 through 5-18: Summit Manufacturing, Inc., produces snow shovels.The selling price per snow shovel is $30.There is no beginning inventory. Costs involved in production are: Direct material Direct labor Variable manufacturing overhead Total variable manufacturing costs per unit $ Fixed manufacturing overhead per year $180,000 $ 5 4 3 12 In addition, the company has fixed selling and administrative costs of $160,000 per year. EXERCISE 5-11. [LO 1] During the year, Summit produces 50,000 snow shovels and sells 45,000 snow shovels. Required What is the value of ending inventory using full costing? EXERCISE 5-12. [LO 1, 2] 45,000 snow shovels. During the year, Summit produces 50,000 snow shovels and sells Required What is the value of ending inventory using variable costing? EXERCISE 5-13. [LO 1, 2, 3] During the year, Summit produces 50,000 snow shovels and sells 45,000 snow shovels. Required Calculate the difference in full costing net income and variable costing net income without preparing either income statement. EXERCISE 5-14. [LO 1] During the year, Summit produces 50,000 snow shovels and sells 45,000 snow shovels. Required What is cost of goods sold using full costing? EXERCISE 5-15. [LO 1, 2] During the year, Summit produces 50,000 snow shovels and sells 45,000 snow shovels. Required What is variable cost of goods sold? EXERCISE 5-16. [LO 1] During the year, Summit produces 50,000 snow shovels and sells 45,000 snow shovels. Required What is net income using full costing? EXERCISE 5-17. [LO 1, 2] 45,000 snow shovels. During the year, Summit produces 50,000 snow shovels and sells 191 Required What is net income using variable costing? EXERCISE 5-18. [LO 1, 2, 3] During the year, Summit produces 50,000 snow shovels and sells 45,000 snow shovels. Required How much fixed manufacturing overhead is in ending inventory under full costing? Compare this amount to the difference in the net incomes calculated in Exercise 5-13. Problems PROBLEM 5-1. Variable and Full Costing: Sales Constant but Production Fluctuates [LO 1, 2, 3, 5] Spencer Electronics produces a wireless home lighting device that allows consumers to turn on home lights from their cars and light a safe path into and through their homes. Information on the first three years of business is as follows: Units sold Units produced Fixed production costs Variable production costs per unit Selling price per unit Fixed selling and administrative expense 2014 2015 2016 Total 20,000 20,000 $750,000 $ 150 $ 250 20,000 25,000 $750,000 $ 150 $ 250 20,000 15,000 $750,000 $ 150 $ 250 60,000 60,000 $220,000 $220,000 $220,000 Required a. Calculate profit and the value of ending inventory for each year using full costing. b. Explain why profit fluctuates from year to year even though the number of units sold, the selling price, and the cost structure remain constant. c. Calculate profit and the value of ending inventory for each year using variable costing. d. Explain why, using variable costing, profit does not fluctuate from year to year. PROBLEM 5-2. Variable and Full Costing: Sales and Production Fluctuate [LO 1, 2, 3, 5] Hamilton Stage Supplies is a manufacturer of a specialized type of light used in theaters. Information on the first three years of business is as follows: 2014 Units sold Units produced Fixed production costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses 2015 2016 Total 15,000 15,000 5,000 5,000 $50,000 $ 75 $ 225 5,000 6,000 $50,000 $ 75 $ 225 5,000 4,000 $50,000 $ 75 $ 225 $ 5,000 $ 5,000 $ 5,000 Required a. Calculate profit and the value of ending inventory for each year using full costing. Round cost percent to two decimal places. b. Explain why profit fluctuates from year to year even though the number of units sold, the selling price, and the cost structure remain constant. c. Calculate profit and the value of ending inventory for each year using variable costing. d. Explain why, using variable costing, profit does not fluctuate from year to year. 192 PROBLEM 5-3. Variable and Full Costing: Earnings Management with Full Costing; Changes in Production and Sales [LO 1, 2, 3, 5] Firemaster BBQ produces stainless steel propane gas grills. The company has been in operation for three years, and sales have declined each year due to increased competition. The following information is available: Units sold Units produced Fixed production costs Variable production costs per unit Selling price per unit Fixed selling and administrative expense 2014 2015 2016 Total 30,000 30,000 $30,000,000 27,000 30,000 $30,000,000 25,000 22,000 $30,000,000 82,000 82,000 $ $ 1,000 2,500 $ $ 1,000 2,500 $ $ 1,000 2,500 $ 350,000 $ 350,000 $ 350,000 Required a. Calculate profit and the value of ending inventory for each year under full costing. b. Calculate profit and the value of ending inventory for each year under variable costing. c. Explain how management of Firemaster could manipulate earnings in 2015 by producing more units than are actually needed to meet demand. Could this approach to earnings management be repeated year after year? PROBLEM 5-4. Variable and Full Costing: Earnings Management with Full Costing; Changes in Production and Sales [LO 1, 2, 3, 5] Sampson Steel produces high-quality worktables. The company has been in operation for three years, and sales have declined each year due to increased competition. The following information is available: Units sold Units produced Fixed production costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses 2014 2015 2016 Total 10,000 10,000 $350,000 9,000 10,000 $350,000 8,000 7,000 $350,000 27,000 27,000 $ $ $ $ $ $ 100 350 $300,000 100 350 $300,000 100 350 $300,000 Required a. Calculate profit and the value of ending inventory for each year under full costing. b. Calculate profit and the value of ending inventory for each year under variable costing. c. Explain how management of Sampson could manipulate earnings in 2015 by producing more units than are actually needed to meet demand. Could this approach to earnings management be repeated year after year? 193 PROBLEM 5-5. Variable and Full Costing: Income Effect of Clearing Excess Inventory [LO 1, 2, 3, 5] The following information is available for Skipper Pools, a manufacturer of above-ground swimming pool kits: Units produced Units sold Selling price per unit Direct material per unit Direct labor per unit Variable manufacturing overhead per unit Fixed manufacturing overhead per year Fixed selling and administrative expense per year 2014 2015 Total 12,000 10,000 $ 4,000 $800 $ 1,500 $ 300 $2,400,000 8,000 10,000 $ 4,000 $800 $ 1,500 $ 300 $2,400,000 20,000 20,000 $1,500,000 $1,500,000 In its first year of operation, the company produced 12,000 units but was able to sell only 10,000 units. In its second year, the company needed to get rid of excess inventory (the extra 2,000 units produced but not sold in 2014), so it cut back production to 8,000 units. Required a. Calculate profit for both years using full costing. b. Note that profit has declined in 2015. Is company performance actually worse in 2015 compared to 2014? c. Calculate profit for both years using variable costing. d. Does variable costing profit present a more realistic view of firm performance in the two years? Explain. PROBLEM 5-6. Variable and Full Costing: Income Effect of Clearing Excess Inventory [LO 1, 2, 3, 5] The following information is available for Dunworth Canoes, a company that builds inexpensive aluminum canoes: Units produced Units sold Selling price per unit Variable production costs per unit Direct material per unit Direct labor per unit Variable manufacturing overhead per unit Fixed manufacturing overhead per year Fixed selling and administrative expense per year 2014 2015 Total $ $ $ $ 15,000 18,000 500 200 80 50 36,000 36,000 $ $ $ $ 21,000 18,000 500 200 80 50 $ 70 $ 70 $630,000 $630,000 $200,000 $200,000 In its first year of operation, the company produced 21,000 units but was able to sell only 18,000 units. In its second year, the company needed to get rid of excess inventory (the extra 3,000 units produced but not sold in 2014) so it cut back production to 15,000 units. 194 Required a. Calculate profit for both years using full costing. b. Note that profit has declined in 2015. Is company performance actually worse in 2015 compared to 2014? c. Calculate profit for both years using variable costing. d. Does variable costing profit present a more realistic view of firm performance in the two years? Explain. PROBLEM 5-7. Reconciling Variable and Full Costing Income [LO 1] Miller Heating Company is a small manufacturer of auxiliary heaters.The units sell for $300 each. In 2014, the company produced 1,000 units and sold 800 units.There was no beginning inventory. Below are variable and full costing income statements for 2014. Income Statement Prepared Using Variable Costing Miller Heating Company Income Statement For the Year Ending December 31, 2014 Sales Less variable costs: Variable cost of goods sold Variable selling expense Contribution margin Less fixed costs: Fixed manufacturing expense Fixed selling expense Fixed administrative expense Net income $240,000 $32,000 16,000 50,000 20,000 30,000 48,000 192,000 100,000 $ 92,000 Income Statement Prepared Using Full Costing Miller Heating Company Income Statement For the Year Ending December 31, 2014 Sales Less cost of goods sold Gross margin Less selling and administrative expenses: Selling expense Administrative expense Net income $240,000 72,000 168,000 $36,000 30,000 66,000 $ 102,000 Required Reconcile the difference in profit between the two income statements. PROBLEM 5-8. Reconciling Variable and Full Costing Income [LO 1] Octavius Company produces a 10-inch chef knife used by commercial chefs.The knives sell for $50 each. In 2014, the company produced 50,000 units and sold 45,000 units. There was no beginning inventory. Following are variable and full costing income statements for 2014. 195 Income Statement Prepared Using Variable Costing Octavius Company Income Statement For the Year Ending December 31, 2014 Sales Less variable costs: Variable cost of goods sold Variable selling expense Contribution margin Less fixed costs: Fixed manufacturing expense Fixed selling expense Fixed administrative expense Net income $2,250,000 $650,000 150,000 600,000 150,000 100,000 800,000 1,450,000 850,000 $ 600,000 Income Statement Prepared Using Full Costing Octavius Company Income Statement For the Year Ending December 31, 2014 Sales Less cost of goods sold Gross margin Less selling and administrative expenses: Selling expense Administrative expense Net income $2,250,000 1,190,000 1,060,000 $300,000 100,000 400,000 $ 660,000 Required Reconcile the difference in profit between the two income statements. PROBLEM 5-9. Using Information from a Variable Costing Income Statement to Make a Decision [LO 2, 5] Below is a variable costing income statement for Wilner Glass Company, a maker of bottles for the beverage industry. For the coming year, the company is considering hiring two additional sales representatives at $80,000 each for base salary plus 5 percent of their sales for commissions. The company anticipates that each sales representative will generate $900,000 of incremental sales. Wilner Glass Company Income Statement For the Year Ending December 31, 2014 Sales Less: Variable cost of goods sold Variable selling expense Contribution margin Less: Fixed production expense Fixed selling expense Fixed administrative expense Net income 196 $20,000,000 $8,000,000 4,000,000 2,600,000 1,800,000 3,000,000 12,000,000 8,000,000 7,400,000 $ 600,000 Required a. Calculate the impact on profit of the proposed hiring decision. Should the company hire the two additional sales representatives? b. Consider the analysis of the decision performed by the company's chief accountant and compare it to your analysis in part a. What is the fundamental flaw in the chief accountant's work? Analysis by Chief Accountant Incremental sales Income per dollar of sales in 2014 ($600,000 $20,000,000) Less increase in base salary Effect on profit $1,800,000 ($ 0.03 54,000 160,000 106,000) PROBLEM 5-10. Using Information from a Variable Costing Income Statement to Make a Decision [LO 2, 5] Below is a variable costing income statement for Trio Office Supplies, a company well known for its quality high-volume automatic staplers. For the coming year, the company is considering hiring three additional sales representatives at $75,000 each for base salary plus 5 percent of their sales for commissions (assume this is the only increase in variable selling expense). The company anticipates that each sales representative will generate $400,000 of incremental sales. Trio Office Supplies Income Statement For the Year Ending December 31, 2014 Sales Less: Variable cost of goods sold Variable selling expense Contribution margin Less: Fixed production expense Fixed selling expense Fixed administrative expense Net income $30,000,000 $15,000,000 3,000,000 2,000,000 1,500,000 3,000,000 18,000,000 12,000,000 6,500,000 $ 5,500,000 Required a. Calculate the impact on profit of the proposed hiring decision. Should the company hire the three additional sales representatives? b. Consider the analysis of the decision performed by the company's chief accountant and compare it to your analysis in part a. What is the fundamental flaw in the chief accountant's work? Analysis by Chief Accountant Incremental sales Income per dollar of sales in 2014: ($5,500,000 $30,000,000) Net increase in income from sales Less increase in base salary Effect on profit $1,200,000 .183 219,600 225,000 ($ 5,400) 197 PROBLEM 5-11. Variable versus Full Costing Income and Earnings Management [LO 1, 2, 3, 5] Renton Tractor Company was formed at the start of 2012 and produces a small garden tractor.The selling price is $4,800, variable production costs are $2,000 per unit, fixed production costs are $6,400,000 per year, and fixed selling and administrative costs are $3,600,000 per year. Data below indicate net income for 2012-2014 under full costing. In 2012 and 2013, Edward Vendon was the president of Renton Tractor. The board of directors was generally pleased with the company's performance under his leadershipthe company hit the break-even point in its first year of operation and had a modest profit in 2013. Edward quit at the end of 2013 and went on to start an e-commerce company selling used cars on the Internet. His replacement, Zac Dalton, was apparently not as successful as Ed.Zac argued that he was improving the company by getting rid of excess inventory, but the board noted that the company showed a $2,360,000 loss in the first year of his leadership. 2012 Production (units) Sales (units) Production cost per unit 4,000 3,000 3,600 $ Sales Less cost of goods sold Gross margin Less selling and administrative expense Net income (loss) $14,400,000 10,800,000 3,600,000 3,600,000 $ -0- 2013 $ 4,000 3,300 3,600 $15,840,000 11,880,000 3,960,000 3,600,000 $ 360,000 2014 $ 2,000 3,700 5,200 $17,760,000 16,520,000 1,240,000 3,600,000 ($ 2,360,000) Required a. Recalculate net income for all three years using variable costing. b. Based on the limited information available, comment on the relative job performance of Ed and Zac. c. Note that under full costing, the company is showing a substantial loss in 2014. Based on the limited information available, does it appear that the company should get out of the tractor business? PROBLEM 5-12. Variable versus Full Costing Income and Earnings Management [LO 1, 2, 3, 5] Hawthorne Golf, the maker of a sought-after set of golf clubs, was formed in 2012. The selling price for each golf club set is $1,700, variable production costs are $900 per unit, fixed production costs are $2,100,000 per year, and fixed selling and administrative costs are $2,250,000 per year. Data below indicate net income for 2012-2014 under full costing. In 2012 and 2013, Milo Hawthorne, Jr., was the president of Hawthorne Golf. The board of directors was generally pleased with the company's performance under his leadershipthe company hit the break-even point in its first year of operation and had a modest profit in 2013. Milo quit at the end of 2013 and went on to buy a golf course and open a pro shop. His replacement, Daryl Selmer, was apparently not as successful as Milo. Daryl argued that he was improving the company by getting rid of excess inventory, but the board noted that the company showed a $350,000 loss in the first year of his leadership. 198 2012 Production (units) Sales (units) Production cost per unit (full cost) 7,000 4,500 1,200 $ Sales Less cost of goods sold Gross margin Less selling and administrative expenses Net income (loss) $7,650,000 5,400,000 2,250,000 2,250,000 $ -0- 2013 $ 7,000 5,500 1,200 $9,350,000 6,600,000 2,750,000 2,250,000 $ 500,000 2014 $ 2,500 6,500 1,740 $11,050,000 9,150,000 1,900,000 2,250,000 ($ 350,000) Required a. Recalculate net income for all three years using variable costing. b. Based on the limited information available, comment on the relative job performance of Milo and Daryl. c. Note that under full costing, the company is showing a substantial loss in 2014. Based on the limited information available, does it appear that the company should get out of the golf club business? PROBLEM 5-13. Reconciling Variable and Full Costing Income [LO 1, 3] The following information relates to Jarden Industries for fiscal 2014, the company's first year of operation: Units produced Units sold Units in ending inventory Fixed manufacturing overhead 150,000 120,000 30,000 $900,000 Required a. Calculate the amount of fixed manufacturing overhead that would be expensed in 2014 using full costing. b. Calculate the amount of fixed manufacturing overhead that would be expensed in 2014 using variable costing. c. Calculate the amount of fixed manufacturing overhead that would be included in ending inventory under full costing and reconcile it to the difference between parts a a