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SHORT ANSWER 1. What are three reasons that overhead must be allocated to products?

ANS: Overhead must be allocated because it is necessary to (1) determine fill cost, (2) it can motivate managers, and (3) it allows managers to compare alternative courses of action. DIF: Moderate OBJ: 3-1

2. Why should predetermined overhead rates be used? ANS: Predetermined overhead rates should be used for three reasons: (1) to assign overhead to Work in Process during the production cycle instead of at the end of the period; (2) to compensate for fluctuations in actual overhead costs that have no bearing on activity levels; and (3) to overcome problems of fluctuations in activity levels that have no impact on actual fixed overhead costs. DIF: Moderate OBJ: 3-1

3. What are the primary reasons for using a predetermined overhead rate? ANS: 1. A predetermined overhead rate allows overhead to be assigned during a period and therefore improves the timeliness of information. 2. A predetermined overhead rate adjusts for variations in actual overhead costs that are unrelated to activity. 3. A predetermined overhead rate overcomes the problem of fluctuations in activity levels that have no impact on actual fixed overhead costs. 4. Using a predetermined overhead rate often allows managers to be more aware of individual product or product line profitability as well as the profitability of doing business with a particular customer or vendor. DIF: Moderate OBJ: 3-1

4. Discuss underapplied and overapplied overhead and its disposition at the end of the period. ANS: During the course of the production cycle, actual overhead costs are incurred. When overhead is applied to Work in Process, it is commonly applied using a predetermined rate. Overhead application at a predetermined rate may cause overhead to be under- or overapplied. If actual overhead is greater than applied overhead, then underapplied overhead results and a debit balance exists in the overhead account. If applied overhead is greater than actual overhead, then overapplied overhead results and a credit balance exists in the overhead account. If the amount of under- or overapplied overhead is immaterial, it is closed directly to Cost of Goods Sold. If the amount is material, it must be allocated among Work in Process, Finished Goods, and Cost of Goods Sold. DIF: Moderate OBJ: 3-2

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5. List and explain the four alternative measures of capacity. ANS: Theoretical capacity--This is the estimated maximum potential activity for a specified time. It assumes that all production factors are operating perfectly. It disregards such factors as machinery breakdowns and reduced plant operations. Practical capacity--This measure reduces theoretical capacity by ongoing regular operating interruptions. It represents the capacity that could realistically be achieved during normal working hours. Normal capacity--This measure considers historical and estimated future production levels and cyclical fluctuations. Expected capacity--This is a short-run capacity measure that represents the firms anticipated activity level for the upcoming period based upon projected product demand. DIF: Difficult OBJ: 3-3

6. Discuss the high-low method. ANS: The high-low method is a technique for analyzing mixed costs. The high-low method analyzes changes at two levels of activity (the high end and the low end) within the relevant range. The changes in cost and activity are calculated for these two levels of activity. Dividing the change in cost by the change in activity determines the variable cost element portion of the mixed cost. Once this is determined, the fixed portion is computed by subtracting the variable element times either the high or low level of activity from respectively, total cost at either the high or low level of activity. DIF: Moderate OBJ: 3-4

7. Why do managers frequently prefer variable costing to absorption costing for internal use? ANS: Managers may prefer variable costing because it classifies costs both by their function and their behavior. When costs are classified by behavior, managers can more accurately predict how total costs will change when volume changes. With more accurate information, managers can make better production and pricing decisions. DIF: Moderate OBJ: 3-6

8. Why is variable costing not used extensively in external reporting? ANS: Variable costing is not used extensively outside of the firm because absorption costing is required by GAAP and the IRS. DIF: Moderate OBJ: 3-6

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9. How can a company produce both variable and absorption costing information from a single accounting system? ANS: Firms only have one accounting information system. This system will be based on either variable or absorption costing. If the system needs to provide information in both the variable and absorption formats, the system's accounting information can be converted from one format to the other. The conversion requires an adjustment to the product inventory accounts and the amount of product costs charged against the period's income. The conversion is typically easier if standard costing is employed. DIF: Moderate OBJ: 3-7

10. What are the major differences between variable and absorption costing? ANS: The major difference between variable costing and absorption costing is in the way each defines product cost. While absorption costing includes fixed manufacturing overhead as a product cost, variable costing treats it as a cost of the period. A secondary difference between the two methods is the format of the income statement. Absorption costing utilizes the traditional income statement format that categorizes costs by their function only. Variable costing uses an income statement format that categorizes costs by both their function and behavior. DIF: Moderate OBJ: 3-6

11. Why is absorption costing not used for CVP analysis? ANS: Absorption costing is not used in break-even analysis because it presents a classification of costs by function rather than by behavior. Without a behavioral classification of costs, it is impossible to predict how total costs change as volume changes. DIF: Moderate OBJ: 3-7

12. How do differences in sales and production level affect net income computed under absorption costing and variable costing? ANS: If production equals sales, absorption costing net income equals variable costing net income. If production exceeds sales, absorption costing net income exceeds variable costing net income, because some fixed manufacturing overhead is deferred as inventory cost on the balance sheet. If production is less than sales, absorption costing net income is less than variable costing net income, because some fixed manufacturing overhead that had been deferred as inventory cost is now expensed. DIF: Moderate OBJ: 3-7

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PROBLEM 1. Hume Corporation has the following data for the current year: Direct Labor Direct Material Actual Overhead Applied Overhead Raw Material Work in Process Finished Goods Cost of Goods Sold
$220,000 137,800 320,000 395,000 51,394 101,926 111,192 250,182

What is the amount of under- or overapplied overhead? Prepare the necessary journal entry to dispose of under- or overapplied overhead. ANS: Applied Overhead Actual Overhead
$395,000 320,000 $ 75,000

overapplied

WIP $101,926/$463,300=.22 FG $111,192/$463,300=.24 CGS $250,182/$463,300=.54 Manufacturing Overhead Work in Process Finished Goods Cost of Goods Sold DIF: Moderate OBJ: 3-2

x x x

$75,000 = $16,500 $75,000 = $18,000 $75,000 = $40,500


$75,000 $16,500 18,000 40,500

2. Leon Corporation has the following data relating to its power usage for the first six months of the current year. Month Jan. Feb. Mar. Apr. May June Usage 500 550 475 425 450 725 (Kw)Cost $450 455 395 310 380 484

Assume usage is within the relevant range of activity. Required: a. Using the high-low method, compute the cost formula.

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b. Leon Corporation estimates its power usage for July at 660 watts. Compute the total power cost for July. ANS: Usage High Low
725 425 300

Cost
$484 310 $174

$174/300 = $.58 x 425 = $246.50 Total variable cost $310 (TC) - $246.50 (TVC) = $63.50 Fixed cost TC = $63.50 + $0.58(VC) At 660 kw, the total cost would be TC = $63.50 + $0.58(660 kwh) TC = $446.30 DIF: Moderate OBJ: 3-4

3. Miller Corporation applies overhead at the rate of 70 percent of direct labor. Miller incurred $450,000 of direct labor during the current year. Miller incurred actual overhead of $367,000. (a) Compute the amount of under- or overapplied overhead for Miller Corporation for the current year (b) Prepare the necessary journal entry to dispose of the under- or overapplied overhead (assuming that the amount is immaterial). ANS: a. $450,000 x 70% = $315,000 applied overhead 367,000 actual overhead $ 52,000 underapplied overhead
$52,000 $52,000

b.

Cost of Goods Sold Manufacturing Overhead OBJ: 3-2

DIF: Easy

4. Action Trainers provides a personalized training program that is popular with many companies. The number of programs offered over the last five months, and the costs of offering these programs are as follows: Programs Offered Jan Feb Mar April
55 45 60 50

Costs Incurred
$15,400 14,050 18,000 14,700

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May a. b.

75

19,000

Using the high-low method, compute the variable cost per program and the total fixed cost per month. Using the least squares regression method, compute the variable cost per program and the total fixed cost per month.

ANS: a. Variable cost per program:

Change in costs $19,000 - $14,050 = $165 per program Change in activity 75 - 45 Fixed cost: At high activity = $19,000 - (75 x $165) = $6,625 per month At low activity = $14,050 - (45 x $165) = $6,625 per month b. x
55 45 60 50 75 285

y
$15,400 14,050 18,000 14,700 19,000 $81,150

xy
$ 847,000 632,250 1,080,000 735,000 1,425,000 $4,719,250

x2
3,025 2,025 3,600 2,500 5,625 16,775

= 57 = 16,230 b = 4,719,250 - (5 57 16,230) b = 176.79 a = 16,230 - (176.79 57) a = 6,152.97 DIF: Moderate OBJ: 3-4 (16,775 - (5 57 )

5. The facility manager of Bello Corporation asked the systems analyst for information to help in forecasting handling costs. The following printout was generated using the least squares regression method. Fixed cost Variable cost per unit Activity variable a. b. $2550 1.85 units of production volume

Using the information from the printout, develop a cost function that can be used to estimate handling costs at different volume levels. Estimate handling costs if expected production for next month is 20,000 units.

ANS:

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a. b.

Total handling costs = $2,550 + $1.85 (unit production) Total handling costs = $2,550 + ($1.85 x 20,000) = $39,550 OBJ: 3-4

DIF: Moderate

6. The McAlister Co. has the following information available regarding costs and revenues for two recent months. Selling price is $20. March Sales revenue Cost of goods sold Gross profit Less other expenses: Advertising Utilities Salaries and commissions Supplies (bags, cleaning supplies etc.) Depreciation Administrative costs Total Net income Required: a. b. c. d. Identify each of the company's expenses (including cost of goods sold) as being either variable, fixed, or mixed. By use of the high-low method, separate each mixed expense into variable and fixed elements. State the cost formula for each mixed expense. What is the total cost equation? Estimate total cost if sales = $75,000.
$60,000 -36,000 $24,000 $ 600 4,200 3,200 320 2,300 1,900 -12,520 $11,480

April
$100,000 - 60,000 $ 40,000 $ 600 5,600 4,000 400 2,300 1,900 -14,800 $25,200

ANS: a. Cost COGS Advertising Utilities Salaries, Etc. 3,200/60,000=5.3% Supplies Depreciation Administration Utilities $1,400 $40,000 April
36,000/60,000=60% 600 4,200/60,000= 7% 4,000/100,000=4% 320/60,000 .53% 2,300 1,900

May
60,000/100,000=60% 600 5,600/100,000=5.6% M 400/100,000=.4% 2,300 1,900

Behavior
V F M

M F F

b.

= 3.5% Sales

FC = $4,200 - (3.5% x 60,000) = $2,100 Salaries $800/$40,000 = 2% Sales

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FC = $3,200 - (2% x 60,000) = $2,000 Supplies $80/$40,000 = .2% sales

FC = $320 - (.2% x $60,000) = $200 c. Total FC = $600 + $2,300 + $1,900 + $2,100 + $2,000 + $200 = $9,100 Total VC = 60% + 3.5% + 2% + .2% = 65.7% sales TC = $9,100 + 65.7% sales TC = $9100 + (65.7% x $75,000) = $58,375 OBJ: 3-4

d.

DIF: Moderate

7. Browning Company owns two luxury automobiles that are used by employees on company business. Mileage and expenses, excluding depreciation, by quarters for the most recent year are presented below: Quarter First Second Third Fourth Mileage
3,000 3,500 2,000 3,500 12,000

Expenses
$ 550 560 450 600 $2,160

Required: Determine the variable cost per mile (nearest tenth of a cent) and the fixed costs per quarter, using the method of least squares. ANS: X 1ST 2ND 3RD 4TH
3,000 3,500 2,000 3,500 12,000

Y
$550 560 450 600 $2,160

XY
$1,650,000 1,960,000 900,000 2,100,000 $6,610,000

X2
9,000,000 12,250,000 4,000,000 12,250,000 37,500,000

_ X = 12,000/4 = 3,000/miles per quarter _ Y = $2,160/4 = $540 b = $6,610,000 - 4 (3,000) ($540) = $130,000 = $.087/mile $37,500,000 - 4 (3,000) (3,000) $1,500,000 a = $540 - ($.087) (3,000) = $279 TC = $279 + .087/mile DIF: Moderate OBJ: 3-4

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8. On December 30, a fire destroyed most of the accounting records of the Adams Division, a small oneproduct manufacturing division that uses standard costs and flexible budgets. All variances are written off as additions to (or deductions from) income; none are pro-rated to inventories. You have the task of reconstructing the records for the year. The general manager informs you that the accountant has been experimenting with both absorption costing and variable costing. The following information is available for the current year: a. b. c. d. e. f. g. h. i. j. k. l. m. n. o. Cash on hand, December 31 Sales Actual fixed indirect manufacturing costs Accounts receivable, December 31 Standard variable manufacturing costs per unit Variances from standard of all variable manufacturing costs Operating income, absorption-costing basis Accounts payable, December 31 Gross profit, absorption costing at standard (before deducting variances) Total liabilities Unfavorable budget variance, fixed manufacturing costs Notes receivable from chief accountant Contribution margin, at standard (before deducting variances) Direct-material purchases, at standard prices Actual selling and administrative costs (all fixed)
$10 $128,000 21,000 20,000 1 $5,000 $14,400 18,000 22,400 100,000 1,000 4,000 48,000 50,000 6,000

Required: Compute the following items (ignore income tax effects). 1. 2. 3. 4. 5. 6. 7. 8. Operating income on a variable-costing basis. Number of units sold. Number of units produced. Number of units used as the denominator to obtain fixed indirect cost application rate per unit on absorption-costing basis. Did inventory (in units) increase or decrease? Explain. By how much in dollars did the inventory level change (a) under absorption costing, (b) under variable costing? Variable manufacturing cost of goods sold, at standard prices. Manufacturing cost of goods sold at standard prices, absorption costing.

ANS: 1. CM - FC Operating Income (STD) - unfavorable variances Operating Income (actual) Sales - CM = VC Sales
48,000 (26,000) $22,000 (6,000) $16,000

Actual fix mfg - unfavorable VAR fix cost @STD

$21,000 (1,000) $20,000

2.

$128,000 (48,000) $ 80,000 /$1 UNIT = 80,000 units sold $128,000

3.

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- GM COGS

(22,400) $105,600 /80,000 = $1.32

Difference in OI = (P - S) fix mfg/unit $(1,600) = (P - 80,000) $.32 P = 75,000 4. OI - absorption cost = $22,400 - $6,000 = variances - other VAR VOL VAR $4,000 F = (75,000 - X) $.32 X = 62,500 units produced 5. 6. Inventory decreased. OI absorption is less than OI variable. Absorption cost 5,000 units $1.32 = $6,600 Variable cost 5,000 units $1 = $5,000 80,000 units $1 = $80,000 80,000 $1.32 = $105,600 OBJ: 3-7
$ 16,400 (14,400) $ 2,000 6,000 $ 4,000

OI STD OI ACT UNF UNF FAV

7. 8.

DIF: Difficult

9. Sports Innovators has developed a new design to produce hurdles that are used in track and field competition. The company's hurdle design is innovative in that the hurdle yields when hit by a runner and its height is extraordinarily easy to adjust. Management estimates expected annual capacity to be 90,000 units; overhead is applied using expected annual capacity. The company's cost accountant predicts the following 2001 activities and related costs: Standard unit variable manufacturing costs Variable unit selling expense Fixed manufacturing overhead Fixed selling and administrative expenses Selling price per unit Units of sales Units of production Units in beginning inventory $12 $5 $480,000 $136,000 $35 80,000 85,000 10,000

Other than any possible under- or overapplied fixed overhead, management expects no variances from the previous manufacturing costs. Under- or overapplied fixed overhead is to be written off to Cost of Goods Sold. Required: 1. Determine the amount of under- or overapplied fixed overhead using (a) variable costing and (b) absorption costing. 2. 3. Prepare projected income statements using (a) variable costing and (b) absorption costing. Reconcile the incomes derived in part 2.

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ANS: 1. a. b. 2. a. $0 (90,000 - 85,000) $5.33 = $26,650 U Sales (80,000 $35) = - VC (80,000 $17) = CM - FC Income before income taxes Sales (80,000 $35) - COGS ($17.33 80,000) GM - S&A Income before income (STD) - VOL VAR Income before income taxes
$2,800,000 (1,360,000) $1,440,000 (616,000) $ 824,000 $2,800,000 (1,386,400) $1,413,600 (536,000) $ 877,600 (26,650) $ 850,950

b.

3.

5,000 $5.33 = $26,650. OBJ: 3-7

DIF: Moderate

10. Sherrill Corporation produces a single product. The following is a cost structure applied to its first year of operations. Sales price Variable costs: SG&A Production Fixed costs (total cost incurred for the year): SG&A Production $15 per unit $2 per unit $4 per unit $14,000 $20,000

During the first year, Sherrill Corporation manufactured 5,000 units and sold 3,800. There was no beginning or ending work-in-process inventory. a. b. c. How much income before income taxes would be reported if Stanley uses absorption costing? How much income before income taxes would be reported if variable costing was used? Show why the two costing methods give different income amounts.

ANS: a. Income under absorption costing is: Sales $15 3,800 = COGS 3,800 ($4 + $20,000/5,000) GM Oper. Exp.
$57,000 30,400 $26,600

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VSE $2 3,800 = FSE Absorption income before income taxes b. Income under variable costing: CMU = SP - VProd.Cost - VSGA = $15 - $4 - $2 = $9 Vol. sold 3,800 CM Less: FC - Production SG&A Variable costing income before income taxes Reason for difference in income: Fixed costs expensed under absorp. costing COGS 3,800 $20,000/5,000 units Fixed SG&A Total Fixed costs expensed under variable costing Fixed SG&A Fixed Production Total FC Difference in FC expensed under two methods

$ 7,600 14,000

(21,600) $ 5,000

$34,200 (20,000) (14,000) $ 200

c.

$15,200 14,000 $29,200 $14,000 20,000 $34,000 $ 4,800

This is also the difference in income amounts. DIF: Moderate OBJ: 3-7

11. Trent Johnson Company used least squares regression analysis to obtain the following

output: Personnel Department Cost Explained by Number of Employees Constant Standard error of Y estimate R - squared No. of observations Degrees of freedom X coefficient(s) Standard error of coefficient(s) a. What is the total fixed cost? b. What is the variable cost per employee? c. Prepare the linear cost function. d. What is the coefficient of determination? Comment on the goodness of fit. 56 $5,800 $630 0.8924 20 18 1.902 0.0966

ANS:

a. The constant or intercept is the total fixed cost of $5,800. b. The variable cost per employee is the X coefficient of $1.902. c. Personnel department cost = $5,800 + $1.902 * (number of employees). d. The coefficient of determination is the R - squared of 0.8924. This represents a very high goodness of fit. The closer to 1.0, the better the cost driver explains the dependent variable. Therefore, the conclusion can be drawn that there is a significant relationship between the cost of the personnel department and the number of employees.
DIF: Difficult OBJ: 3-7

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