Question

Horace Company manufacturers a professional-grade vacuum cleaner and began operations in 2017. For 2017​, Horace budgeted to produce and sell 25,000 units. The company had no​ price, spending, or efficiency variances and writes off​ production-volume variance to cost of goods sold. Actual data for 2017 are given as​ follows: Data: Units produced 21,000 Units sold 18,500 Selling price $432 Variable cost: Manufacturing cost per unit produced: Direct materials $33 Direct manufacturing labor $23 Manufacturing Overhead $62 Marketing cost per unit sold $46 Fixed cost: Manufacturing costs $1,550,000 Administrative costs $906,000 Marketing costs $1,479,000 Requirements: 1. Prepare a 2017 income statement for Horace Company using variable costing. 2. Prepare a 2017 income statement for Horace Company using absorption costing. 3. Explain the differences in operating incomes obtained in requirements 1 and 2. 4. Horace​'s management is considering implementing a bonus for the supervisors based on gross margin under absorption costing. What incentives will this bonus plan create for the​ supervisors? What modifications could Horace management make to improve such a​ plan? Explain briefly.

Answer 1

1. Variable manufacturing cost per unit = $ ( 33 + 23 + 62) = $ 118

Horace Company Variable Costing Income Statement For the year 2017
Sales Revenue ( 18,500 x $ 432)			$ 7,992,000
Less: Variable Cost of Goods Sold
Beginning Inventory	0
Variable Manufacturing Costs ( 21,000 x $ 118 )	2,478,000
Less: Ending Inventory ( 2,500 x $ 118)	(295,000)	2,183,000
Variable Marketing Costs ( 18,500 x $ 46)		851,000
Total Variable Costs			3,034,000
Contribution Margin			4,958,000
Fixed Costs
Fixed Manufacturing Costs		1,550,000
Fixed Administrative Costs		906,000
Fixed Marketing Costs		1,479,000
Total Fixed Costs			3,935,000
Net Operating Income			1,023,000

2. Fixed manufacturing overhead rate = $ 1,550,000 / 25,000 units = $ 62.

Total product cost per unit = $ 118 + $ 62 = $ 180.

Horace Company Absorption Costing Income Statement For the year 2017
Sales Revenue			$ 7,992,000
Less: Cost of Goods Sold
Beginning Inventory	0
Add: Cost of Goods Manufactured ( 21,000 x $ 180)	3,780,000
Less: Ending Inventory ( 2,500 x $ 180)	(450,000)	3,330,000
Add: Unfavorable Volume Variance ( 25,000 - 21,000) x $ 62		248,000
Adjusted Cost of Goods Sold			3,578,000
Gross Profit			4,414,000
Selling and Administrative Expenses
Variable Marketing Costs		851,000
Fixed Marketing Costs		1,479,000
Fixed Administrative Costs		906,000
Total Selling and Administrative Costs			3,236,000
Net Operating Income			$ 1,178,000

3. The difference in operating income = $ 1,178,000 - $ 1,023,000 = $ 155,000.

This difference is because of fixed manufacturing cost being included in product cost in absorption costing, and consequently in ending finished goods inventory. Effectively speaking, cost of 2,500 x $ 62 = $ 155,000 has been deferred to the next accounting period. That explains why absorption costing net operating income exceeds variable costing net operating income by $ 155,000.

4. The managers might attempt to set lower production targets, so as to increase the fixed manufacturing overhead rate per unit. That would lead to an overstatement of ending inventories, and consequent overstatement of gross margin.