Question

1. 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 1,000 units 1,400 units Year 2 1,200 units 1,000 units Sales Production Costs Direct manufacturing costs Overhead (all fixed) Variable SG&A Fixed SG&A $700 $700 $1,000 $400 $500 $700 $1,200 $400 a. For each year, calculate income using absorption costing. b. 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. c. Compare your income calculations across the two costing approaches. Are they different? If So, why? d. 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

a) Income statement under absorption costing

particulars	year 1 ($)	year 2 ($)
Sales unit	1000	1200
production unit	1400	1000
sales price	3	3
total sales	3000	3600
costs:
direct manufacturing cost	700	500
overhead	700	700
total manufacturing cost	1400	1200
+ opening stock	0	400
(-) closing stock	-400	-240
cost of production	1000	1360
variable SG&A	1000	1200
Fixed SG&A	400	400
cost of goods sold	2400	2960
profit	600	640

b) Income statement under variable costing

particulars	year 1 ($)	year 2 ($)
Sales unit	1000	1200
production unit	1400	1000
sales price	3	3
total sales	3000	3600
costs:
direct manufacturing cost	700	500
+ opening stock	0	200
(-) closing stock	-200	-100
	500	600
variable SG&A	1000	1200
total variable cost	1500	1800
contribution	1500	1800
overhead (fixed cost)	700	700
Fixed SG&A	400	400
total fixed cost	1100	1100
profit	400	700

c) Income under both approaches are different. In absorption costing closing stock is calculated on total manufacturing cost whereas in variable costing, closing stock is valued on variable manufacturing cost only. And thus closing stock is less in variable costing as well profit is also lower (if production is more than sales). And vice versa.

All costs are same in both cases except closing stock value, which is more in variable costing in year 2 and thus profit is also more in yr 2. And vice versa in year 1.

d) Managers uses absorption costing information as

- managers wishes to put fixed cost as production cost and thus increases production cost and avail tax benefiits

- It compliance with GAAP and calculates more accurate profit amount.