Question

The Daniels Tool & Die Corporation has been in existence for a little over three years. The company's sales have been increasing each year as it builds a reputation. The company manufactures dies to its customers' specifications and therefore uses a job-order cost system. Factory overhead is applied to the jobs based on direct labour hours—the absorption-costing (full) method. Over-applied or under-applied overhead is treated as an adjustment to cost of goods sold. The company's income statements and other data for the past two years are as follows:

DANIELS TOOL & DIE CORPORATION 2019-2020 Comparative Income Statements
	2019	2020
Sales	$840,000	$1,015,000
Cost of goods sold
Finished goods, January 1	25,000	18,000
Cost of goods manufactured	548,000	657,600
Total available	573,000	675,600
Finished goods, December 31	18,000	14,000
Cost of goods sold before overhead adjustment	555,000	661,600
Under-applied factory overhead	36,000	14,400
Cost of goods sold	591,000	676,000
Gross profit	249,000	339,000
Selling expenses	82,000	95,000
Administrative expenses	70,000	75,000
Total operating expenses	152,000	170,000
Operating income	$ 97,000	$  169,000

	Daniels Tool & Die Corporation Inventory Balances
	January 1, 2018	December 31, 2019	December 31, 2020
Raw material	$22,000	$30,000	$10,000
Work in process	$40,000	$48,000	$64,000
Direct labour hours (used in WIP)	1,335	1,600	2,100
Finished goods	$25,000	$18,000	$14,000
Direct labour hours (used in FG)	1,450	1,050	820

Daniels used the same predetermined overhead rate in applying overhead to its production orders in both 2019 and 2020. The rate was based on the following estimates:

Fixed factory overhead	$ 25,000
Variable factory overhead	$155,000
Direct labour hours	25,000
Direct labour costs	$150,000

In 2019 and 2020, the actual direct labour hours used were 20,000 and 23,000, respectively. Raw materials put into production were $292,000 in 2019 and $370,000 in 2020. The actual fixed overhead was $42,300 for 2019 and $37,400 for 2020, and the planned direct labour rate was the direct labour achieved.

For both years, all of the administrative costs were fixed. The variable portion of the selling expenses results from a 5% commission that is paid as a percentage of the sales revenue.

Instructions

a.  

For the year ended December 31, 2020, prepare a revised income statement for Daniels Tool & Die Corporation using the variable-costing method.

Operating income $168,730

b.  

Reconcile the difference in operating income between Daniels Tool & Die Corporation's 2020 absorption-costing income statement and the revised 2020 income statement prepared under variable costing.

c.  

Describe both the advantages and disadvantages of using variable costing.

Answer 1

(a)      In order to apply variable costing to the Daniels Tool & Die operations, it is necessary to first remove fixed manufacturing costs from the inventory values and the cost of goods sold.

            Fixed MOH per unit = $25,000 ÷ 25,000 DLH = $1.00 per DLH

	Beginning finished goods inventory:
	Using absorption costing			$18,000
	Less:  Fixed MOH included
		1,050 hours × $1.00		1,050
	Using variable costing			$16,950
	Ending finished goods inventory
	Using absorption costing			$14,000
	Less:  Fixed MOH included
		820 hours × $1.00			820
	Using variable costing			$13,180
	Beginning work in process inventory:
	Using absorption costing			$48,000
	Less:  Fixed MOH included
		1,600 hours × $1.00			1,600
	Using variable costing			$46,400

	Ending work in process inventory
	Using absorption costing			$64,000
	Less:  Fixed MOH included
		2,100 hours × $1.00			2,100
	Using variable costing			$61,900

	Variable cost of goods manufactured:
	Raw materials put into production		$370,000
	Direct labour [23,000 × ($150,000 ÷ 25,000)]	138,000
	Variable overhead [23,000 × ($155,000 ÷ 25,000)]	142,600
		Total variable manufacturing costs		650,600
	Plus:  Variable beginning work in process	46,400
						697,000
	Less:  Variable ending work in process		61,900
		Variable cost of goods manufactured		$635,100
	Variable cost of goods sold:
	Variable beginning finished goods inventory	$16,950
	Plus:  Variable cost of goods manufactured	635,100
		Variable cost of goods available for sale	$652,050
	Less:  Variable ending finished goods inventory	13,180
		Variable cost of goods sold		$638,870

Daniels Tools & Die Corporation
Variable Costing Income Statement
For the year ended December 31, 2020
	Sales				$1,015,000
	Less:  Variable costs
		Cost of goods sold	$638,870
		Sales commissions (5% × Sales)	50,750		689,620
	Contribution margin			325,380
	Less:  Fixed manufacturing overhead	37,400
		Selling & Admin ($95,000 – $50,750 + $75,000)	119,250		156,650
	Operating income			$168,730

(b)      The difference in the operating income of $270 is caused by the different treatment of fixed manufacturing overhead. Under absorption costing, fixed overhead costs are assigned to inventory and are not expensed until the goods are sold. Under variable costing, these costs are treated as expenses in the period incurred. Since the direct labour hours in the work in process and finished goods inventories had a net increase of 270 hours, the absorption costing operating profit is higher because the fixed factory overhead associated with the increased labour hours in inventory is not expensed when absorption costing is used.

	Variable costing operating income	$168,730
	Plus: FMOH deferred in work in process
	Inventory [$1.00 × (2,100 – 1,600)]	500
		169,230
	Less: FMOH released from finished goods
	inventory [$1.00 × (1,050 – 820)]	230
	Absorption costing operating income	$169,000

(c)       The advantages of using variable costing follow.

·The fixed manufacturing costs are reported at incurred values, not at absorbed values, which increases the likelihood of better control over fixed costs.

·Profits are directly influenced by changes in sales volume and not by changes in inventory levels.

·Contribution margin by product line, territory, department, or division is emphasized and more readily ascertainable.

The disadvantages of using variable costing follow.

·Variable costing is not recommended for tax reporting, for external financial reporting; therefore, companies need to adjust variable costing amounts for these purposes.

·Costs other than variable costs (i.e., fixed costs and total production costs) may be ignored when making decisions, especially long-term decisions.

·With the advancement of factory technology and the movement toward a fully automated factory, the fixed factory overhead may be a significant portion of the production costs. To ignore these significant costs in inventory valuation may not be acceptable.