Question

The PTI Company sells its product at $3.00 per unit. PTI uses a FIFO costing system, and a new burden rate for allocating overhead is determined each year by dividing the overhead by units produced. The following information pertains to the first two years of operations:

	Year 1	Year 2
Sales	1,000 units	1,200 units
Production	1,400 units	1,000 units
Costs
Direct manufacturing costs	$700	$500
Overhead (all fixed)	$700	$700
Variable SG&A	$1,000	$1,200
Fixed SG&A	$400	$400

1. For each year, calculate income using absorption costing.

2. Some firms use variable costing instead of absorption costing. Under variable costing, all fixed costs – both manufacturing and SG&A – are reported as expenses in the period in which they occur. For each year, calculate income using variable costing.

3. Compare your income calculations across the two costing approaches. Are they different? If so, why?

4. In class, we discussed why evaluating firm managers using absorption costing may encourage them to engage in dysfunctional behaviors. That said, are there circumstances in which you would recommend evaluating managers using absorption costing information? List and describe at least 2 such circumstances.

Answer 1

1) Under absorption costing, unit cost of goods manufactured shall consider both variable and fixed manufacturing costs incurred to produce the number goods. Therefore, Unit direct manufacturing cost Fixed mfg. overhead per unit Product cost per unit Year-1 $0.50 $0.50 $1.00 Year-2 $0.50 $0.70 $1.20 [Year-1 = $700 / 1400 units = $0.5; Year-2 = $500 / 1000 units = $0.5] [Year-1, $700 / 1400 units = $0.5; For Year-2, $700 / 1000 units = $0.7] PTI Company Absorption Costing Income Statement Year-1 Year-2 Sales Revenue $3,000 $3,600 [Year-1 = 1000 units x $3.00; Year-2 = 1200 units x $3.00] Less: Cost of Goods Sold $1,000 $1,360 [Year-1 = 1000 units x $1.00; Year-2= (400 units x $1.00) + (800 units x $1.20)] Gross Profit $2,000 $2,240 (Sales Revenue - Cost of Goods Sold] Less: Operating Expenses $1,400 $1,600 [Year-1 = $1000 + $400; Year-2 = $1200 + $400] Operating Income $600 $640

2) Under variable costing, unit product cost shall consider only variable mfg. costs incurred to produce the number of goods. Therefore, Year-2 $3,600 [Year-1 = 1000 units x $3.00; Year-2 = 1200 units x $3.00] PTI Company Variable Costing Income Statement Year-1 Sales Revenue $3,000 Variable Expenses: Variable Manufacturing costs $500 Variable Selling and Admin. Exps. $1,000 Total Variable Expenses $1,500 Contribution Margin $1,500 Fixed Expenses: Fixed Manufacturing costs $700 Fixed Selling and Admin. Exps. $400 Total Fixed Expenses $1,100 Net Operating Income $600 (1000 units x $0.5; 1200 units x $0.5] $1,200 [Given] $1,800 $1,800 (Sales Revenue - Total Variable Expenses] $700 (Fully charged as expense] $400 (Fully charged as expense) $1,100 $700 [Contribution margin - Total Fixed Expenses]

3) The only reason for the difference in net operating income (loss) between absorption costing and variable costing is the deferred fixed manufacturing overhead cost to next period through ending inventory under absorption costing. That is, under variable costing, entire fixed manufacturing overhead cost is considered as period cost and so charged to income statement. However, under the absorption costing, fixed mfg. overhead cost is considered as product cost and so a portion of it will be deferred to next reporting period through ending inventory. If number of units produced and sold are same, net operating income reported under both methods will be same. Reconciliation between net incomes reported under absorption versus variable costing: Year-1 Year-2 Variable costing income (loss) $400 $700 [As calculated in Part-2] Add: Fixed mfg. costs in ending inventory deferred $200 $140 [400 units x $0.5; 200 units x $0.7] Less: Fixed mfg. costs in beginning inventory released -$200 [Year-1's fixed mfg. costs in end. Inventory] Absorption costing income (loss) $600 $640 --> Matched with Part-1] There are many circumstances in which it will be recommend evaluating managers using absorption costing information. Two of such circumstances may include: $0 4) 1) Reports prepared for external reporting purpose because variable costing method is not allowed for external reporting purpose; 2) Fair pricing of the product to include applicable product costs incurred to produce the final product. That is, variable costing includes entire fixed manufacturing overhead costs as product costs in the year in which such costs are incurred though some of fixed mfg. overhead will be deferred to next reporting period via ending inventory of current period. Variable costing ignores fixed manufacturing costs released via beginning inventory also.