CHAPTER 20
DISCUSSION QUESTIONS
Q20-1. Direct costs are direct materials, direct labor,
and other costs directly assignable to a product.
Direct costing is a procedure by which only
prime costs plus variable factory overhead
are assigned to a product or inventory; all
fixed costs are considered period costs.
Q20-2. Product costs are associated with the manu-
facture of a product and include direct materi-
als, direct labor, and factory overhead. These
costs are charged against revenue as cost of
goods sold, or shown on the balance sheet as
inventories of work in process and finished
goods. Period costs are associated with the
passage of time and are included as expenses
in the income statement. Under direct costing,
fixed factory overhead is treated as a period
cost rather than as a product cost.
Q20-3. Under direct costing, only variable manufactur-
ing costs are included in inventory. Under
absorption costing (the current, generally
accepted method of costing inventory for exter-
nal reporting), all manufacturing costs, both
variable and fixed, are included in inventory.
Q20-4. It is argued that fixed manufacturing costs are
the expenses of maintaining productive
capacity. Such expenses are more closely
associated with the passage of time than with
production activity and should, therefore, be
charged to period expense rather than to the
product.
Q20-5. The direct costing method is useful for inter-
nal reporting because it focuses attention on
the fixed-variable cost relationship and the
contribution margin concept. It facilitates man-
agerial decision making, product pricing, and
cost control. It allows certain calculations to
be readily made, such as break-even points
and contribution margins of products, sales
territories, operating divisions, etc. The focus
on the contribution margin (sales revenue
less variable costs) enables management to
emphasize profitability in making short-run
business decisions. Fixed costs are not easily
controllable in the short run and hence may
not be particularly relevant for short-run busi-
ness decisions.
20-1
Q20-6. Arguments for the use of direct costing
include the following:
(a) For profit-planning and decision-making
purposes, management requires cost-
volume-profit relationship data that are
more readily available from direct cost
statements than from absorption cost
statements.
(b) Since fixed factory overhead is absorbed
as a period cost, fluctuations in produc-
tion and differences between the number
of units produced and the number sold do
not affect the per unit product cost.
(c) Direct costing reports are more easily
understood by management because the
statements follow management’s deci-
sion-making processes more closely than
do absorption cost statements.
(d) Reporting the total fixed cost for the
period in the income statement directs
management’s attention to the relation-
ship of such cost to profits.
(e) The elimination of allocated joint fixed cost
permits a more objective appraisal of
income contributions according to prod-
ucts, sales areas, kinds of customers, etc.
Cost-volume relationships are highlighted.
(f) The similarity of the underlying concepts
of direct costing and flexible budgets facil-
itates the adoption and use of these
methods for reporting and cost control.
(g) Direct costing provides a means of costing
inventory that is similar to management’s
concept of inventory cost as the current
out-of-pocket expenditures necessary to
produce or replace the inventory.
(h) Clerical costs are lower under direct cost-
ing because the method is simpler and
does not require involved allocations of
fixed costs or special analyses of absorp-
tion data.
(i) The computation of product costs is sim-
pler and more reliable under direct costing
because a basis for allocating the fixed
costs, which involves estimates and per-
sonal judgment, is eliminated.
20-2
Q20-7. Arguments against the use of direct costing
include the following:
(a) Separation of costs into fixed and variable
might be difficult, especially when such
costs are semivariable in nature.
Moreover, all costs—including fixed
costs—are variable at some level of pro-
duction and in the long run.
(b) Long-range pricing of products and other
long-range policy decisions require a
knowledge of complete manufacturing
cost, which would require additional sep-
arate computations to allocate fixed over-
head.
(c) The pricing of inventories by the direct
costing method is not acceptable for
income tax computation purposes.
(d) Direct costing has not been recognized
as conforming with generally accepted
accounting principles applied in the
preparation of financial statements for
stockholders and the general public.
(e) Profits determined by direct costing are not
“true and proper” because of the exclusion
of fixed production costs that are part of
total production costs and inventory.
Production would not be possible without
plant facilities, equipment, etc. To disregard
these fixed costs violates the general prin-
ciple of matching costs with revenue.
(f) The elimination of fixed costs from inven-
tory results in a lower figure and conse-
quent reduction of reported working
capital for financial analysis purposes.
Q20-8. Assuming that the quantity of ending inven-
tory is larger than the quantity of beginning
inventory and the lifo method is used, operat-
ing income using direct costing would be
smaller than operating income using absorp-
tion costing. Direct costing excludes fixed fac-
tory overhead from inventories because such
costs are considered to be period costs which
are expensed when incurred. In contrast,
absorption costing includes fixed factory over-
head in inventories because such costs are
considered to be product costs, which are
expensed only when the products are sold.
When the quantity of inventory increases dur-
ing a period, direct costing produces a lower
dollar increase in inventory than absorption
costing, because fixed costs are expensed
rather than charged to inventory. Since a
smaller amount of current period cost is
Chapter 20
charged against income under the absorption
costing method when inventories increase,
absorption costing income would be larger
than direct costing income.
Q20-9. The break-even point is the point at which
costs and revenue are in equilibrium, showing
neither profit nor loss for the business.
Q20-10. The contribution margin is the result of sub-
tracting variable cost from the sales figure. The
contribution margin indicates the amount avail-
able for the recovery of fixed cost and for profit.
Q20-11.(a) R(BE) = F
1–V
or (in words):
Revenue at the = Total fixed cost
break-even point Contribution margin
per dollar of sales
(b) Q(BE) = F
P–C
or (in words):
Units of sales at = Total fixed cost
break-even point Contribution margin
per unit of sales
Q20-12. (1) Dollars of revenue and costs.
(2) Volume of output, expressed in units, per-
cent of capacity, sales, or some other
measure.
(3) Total cost line.
(4) Variable cost area.
(5) Fixed cost area.
(6) Break-even point.
(7) Loss area.
(8) Profit area.
(9) Sales line.
Q20-13. An analysis of the expected behavior of a
firm’s expenses and revenue for the purpose
of constructing a break-even chart is usually
restricted to the output levels at which the firm
is likely to operate. Assumptions about the
level of fixed cost, the rate of variable cost,
and sales prices are based on the operating
conditions and managerial policies that will be
in effect over the expected output levels.
These expected output levels represent the
firm’s relevant range, and the cost-volume-
profit relationships shown in a break-even
chart are applicable only to output levels
within this range. The behavior of fixed cost,
variable cost, and sales prices at levels of out-
put below or above the relevant range are
likely to result in an entirely different set of
cost-volume-profit relationships because of
Chapter 20
changed operating conditions or managerial
policies. The fact that the cost and revenue
lines on a break-even chart are typically
extended past the upper and lower limits of
the relevant range should not, therefore, be
interpreted to mean that they are valid for
these levels of output.
A break-oven chart showing cost-volume-
profit relationships for all levels of output could
be developed. The shapes of the cost and rev-
enue lines in such a chart could not, however,
be expected to approximate straight-line (lin-
ear) patterns. By restricting the underlying cost
and revenue behavior assumptions in break-
even analyses to a relatively narrow output
range (the range over which the firm is likely to
operate), it is usually possible to assume linear
behavior patterns without any significant distor-
tions in cost-volume-profit relationships,
thereby simplifying the analysis.
If the range over which a firm is likely to
operate is quite wide, curvilinear functions
may be employed; or it may be desirable to
develop a number of break-even charts, each
having its own relevant range, for which the
underlying cost and revenue behavior
assumptions are valid.
Q20-14. Weaknesses inherent in the preparation and
use of break-even analysis are:
(a) When more than one product is pro-
duced, the contribution margin of each
product will probably differ. Accordingly, a
break-even analysis for the whole opera-
tion will not indicate the contribution of
each product to fixed cost and the volume
required for each product.
(b) Some costs are almost impossible to
classify conclusively as being either fixed
or variable.
(c) General economic conditions and other
external factors may affect the data used
in the analysis.
(d) In the final analysis, fixed cost is related to
production and sales and, therefore, may
decrease somewhat due to decreased
production and sales—and vice versa.
(e) Quite often costs increase sharply at cer-
tain points in production and sales levels
and then level out until a certain greater
stage of production and/or sales is
reached, at which time the phenomenon
is repeated as production and/or sales
are again increased.
20-3
(f) Performance must be constantly com-
pared to the break-even analysis in order
to determine whether the conditions that
existed at the time of the calculations
have held true, and whether any changes
have been considered.
Q20-15. (a) With sales price per unit and total fixed
cost remaining constant, the break-even
point moves up rapidly as unit variable
cost is increased; at the same time, the
break-even point moves down as unit
variable cost is decreased.
(b) A decrease in fixed cost lowers the break-
even point. An increase in fixed cost
moves the break-even point higher.
Q20-16. The margin of safety is a selected sales figure
less break-even sales. The margin of safety is
a cushion against sales decreases. The
greater the margin, the greater the cushion
against suffering a loss.
Q20-17. Cost-volume-profit relationship is the relation-
ship of profit to sales volume. This relationship
is important to management because man-
agement tries at all times to keep volume,
cost, price, and product mix in a ratio that will
achieve a desired level of profit.
Q20-18. The Theory of Constraints is a specialized
version of direct costing for use in short-run
optimization decisions. A distinction between
TOC and direct costing is that TOC focuses
on only the purely variable costs and does not
consider direct labor to be purely variable.
Q20-19. Most companies that classify costs into fixed
and variable categories treat direct labor as
variable, so in direct costing, direct labor is
assigned to products as a variable or incre-
mental cost of production. In the Theory of
Constraints, direct labor is stipulated to be not
purely variable and therefore is not treated as
an incremental cost of output.
The difference between the contribution
margin measure in direct costing and the
throughput measure in TOC is that direct
labor is one of the costs deducted from sales
to calculate contribution margin, but direct
labor is not a cost to be deducted from sales
in calculating throughput.
There are many differences in emphasis
between direct costing and the Theory of
Constraints. For example, while direct cost-
ing is widely used as an accounting
approach for internal reporting of income
and product cost, TOC deals heavily with the
20-4
improvement of constraints or bottlenecks in a
production system.
Q20-20. Throughput is the rate at which a system gen-
erates money through sales. It is calculated
as sales minus the purely variable costs, and
often the only purely variable cost is the cost
of materials.
Q20-21. Elevating a constraint means improving the
constraint—improving the conditions at a bot-
tleneck in the system. Its significance is great-
est if the constraint is the tightest one in the
Chapter 20
system; there, any improvement will increase
the total throughput of the entire system.
An improvement in product quality can help
elevate a constraint because it can reduce the
workload on a bottleneck resource. For exam-
ple, removing defective units before rather
than after they reach the bottleneck means
there will be fewer units passing through the
bottleneck. This has approximately the same
effect on the bottleneck as increasing its
capacity.
Chapter 20 20-5

EXERCISES

E20-1

Operating income for 20A using direct costing:

Sales (90,000 × $12) .................................................................. $1,080,000
Variable cost of goods sold (90,000 × $4) .............................. 360,000
Gross contribution margin ....................................................... $ 720,000
Variable marketing and administrative expenses
(90,000 × $20) ................................................................ 18,000
Contribution margin.................................................................. $ 702,000
Less fixed expenses:
Factory overhead........................................ $200,000
Marketing and administrative expenses .. 90,000 290,000
Operating income...................................................................... $ 412,000

E20-2

(1) Variable cost per unit:

$7,000,000 total variable cost
60% manufacturing cost portion
$4,200,000 total variable manufacturing cost

$4,200,000 total variable manufacturing cost = $30 per unit

140,000 units actually produced
Fixed cost per unit:
$11,200,000 total fixed cost
50% manufacturing cost portion
$5,600,000 total fixed factory overhead

$5,600,000 total fixed factory overhead = 35 per unit

160,000 units normal production volume
Full cost per unit at standard $65
Number of units sold during the year × 100,000
Cost of goods sold at standard under
absorption costing $6,500,000

(2) Units actually produced during the year.................... 140,000

Units sold during the year ........................................... 100,000
Unit increase in inventory ........................................... 40,000
Standard variable manufacturing cost per unit......... × 30
Ending inventory at standard direct cost .................. $1,200,000
20-6 Chapter 20

E20-2 (Concluded)

(3) Normal production volume..................................................... 160,000

Units actually produced during the year .............................. 140,000
Excess of budget over actual production............................. 20,000
Fixed factory overhead per unit............................................. × $35
Factory overhead volume variance ....................................... $ 700,000
(4) Sales (100,000 units × $180)................................................... $18,000,000
Standard variable cost of goods sold (100,000 units × $30
unit variable cost)........................................................... 3,000,000
Gross contribution margin ..................................................... $15,000,000
Variable selling expense ($7,000,000 variable cost × 40%). 2,800,000
Contribution margin ................................................................ $12,200,000
Less fixed costs ...................................................................... 11,200,000
Operating income under direct costing ................................ $1,000,000

E20-3

(1) Income statement using absorption costing:

Sales (9,000 × $30) .................................................................. $270,000
Cost of goods sold (9,000 × ($10 + $5)) ................................ 135,000
Gross profit .............................................................................. $135,000
Less commercial expenses.................................................... 44,000
Operating income.................................................................... $ 91,000
(2) Income statement using direct costing:
Sales (9,000 × $30) .................................................................. $270,000
Variable cost of goods sold (9,000 × $10)............................. 90,000
Contribution margin ................................................................ $180,000
Less fixed expenses:
Factory overhead .................................. $40,000
Commercial expenses .......................... 44,000 84,000
Operating income.................................................................... $ 96,000
(3) Computations explaining the difference in operating income:
Absorption costing operating income .................................. $ 91,000
Direct costing operating income ........................................... 96,000
Difference ................................................................................. $ (5,000)
Units produced during the period ......................................... 8,000
Units sold during the period .................................................. 9,000
Unit decrease in finished goods inventory ......................... (1,000)
Fixed factory overhead charged to each unit of product
under absorption costing .............................................. × $5
Difference ................................................................................. $ (5,000)
Chapter 20 20-7

E20-4
$6, 000 $6, 000 $6, 000
= = = $10, 000 break-even po
oint in dollars
1− $ .80 1− .40 .60
$2.00

$10,000 ÷ $2 = 5,000 break-even point in units

(or)
$6, 000 $6, 000
= = 5, 000 break-even point in units
$2, 00 − $.80 $1.20

000 units × $2 = $10,000 break-even point in dollars

5,0

E20-5

Materials ................................................................................... $ 1.00

Direct labor .............................................................................. 1.20
Variable factory overhead....................................................... .50
Variable marketing expense ................................................... .30
Total variable cost per unit..................................................... $ 3.00
Sales price per unit ................................................................. $ 5.00
Variable cost per unit.............................................................. 3.00
Contribution margin per unit.................................................. $ 2.00
Fixed factory overhead ........................................................... $15,000
Fixed marketing expense ....................................................... 5,000
Fixed administrative expense ................................................ 6,000
Total fixed expense ................................................................. $26,000

(1) $26,000 total fixed cost = 13,000 units of sales to break even
$2 contribution margin

(2) 13,000 units × $5 per unit = $65,000 sales to break even

(3) $26,000 fixed cost + $10,000 profit = 18,000 units

$2 contribution margin

(4) 18,000 units × $5 per unit = $90,000 sales

E20-6

Planned sales .......................................................................... $2,000,000

Break-even sales ..................................................................... 1,500,000
Margin of safety....................................................................... $ 500,000
20-8 Chapter 20

E20-6 (Continued)

$500,000 Margin of safety = 25% Margin of safety ratio

$2,000,000 Planned sales

E20-7

(1) $9, 300

= $15, 000 break-even point sales
.62
(2) $15, 000 $15, 000
= = $20, 000 actual sales
1− .25 .75
(3) PR = C/M × M/S; PR = .62 × .25 = .155
$20,000 × .155 = $3,100 profit for the month

E20-8

(1) $30, 000

= $50, 000 break-even sales
.60
(2) $50, 000 $50, 000
= = $62, 500 sales for the year
1− .20 .80
PR = C/M × M/S; PR = .20 × .60 = .12
$62,500 × .12 = $7,500 profit for the year

(3) Sales ......................................................................................... $62,500

Variable cost ($62,500 × (1 – .60)).......................................... 25,000
Contribution margin ($62,500 × .60) ...................................... $37,500

E20-9

Chip A Chip B Total

Sales:
(100,000 × $8)....................................... $800,000
(200,000 × $6)....................................... $1,200,000 $2,000,000
Variable cost:
($800,000 × 30%).................................. 240,000
($1,200,000 × 25%)............................... 300,000 540,000
Contribution margin......................................... $560,000 $ 900,000 $1,460,000
Planned operating profit ................................. 270,000
Fixed cost ......................................................... $1,190,000
Chapter 20 20-9

E20-10

Tables Chairs
Sales price per unit ...................................................... $110 $35
Variable cost per unit ................................................... 50 20
Contribution margin per unit....................................... $ 60 $15

$720, 000 fixed cost

= $1, 500, 000 sales to break even
1− ((($50 + (4 × $20)) ÷ ($110 + (4 × $35)))

or alternatively:
$720, 000 fixed cost
= $1, 500, 000 sales to break even
($60 + (4 × $15)) ÷ ($110 + (4 × $35))

$1, 500, 000 sales

= 6, 000 hypothetical packages
$110 + (4 × $35)
or alternatively:

$720, 000 fixed cost

= 6, 000 hypothetical packages
$60 + (4 × $15) CM

6,000 packages × 1 table per package = 6,000 tables to break even

6,000 packages × 4 chairs per package = 24,000 chairs to break even
6,000 tables × $110 per table.............. = $ 660,000
24,000 chairs × $ 35 per chair ............ = 840,000
Total sales to break even.................... $1,500,000

E20-11

Product L Product M
Sales price per unit ............................. $20 $15
Variable cost per unit.......................... 12 10
Unit contribution margin .................... $ 8 $ 5
Expected sales mix ............................. × 2 × 3
Contribution margin per
hypothetical package ................. $16 + $15 = $31
20-10 Chapter 20

E20-11 (Concluded)

(1) $372,000 fixed cost = 12,000 packages to break even

$31 contribution margin
12,000 packages × 2 units of L = 24,000 units of L
12,000 packages × 3 units of M = 36,000 units of M
24,000 units of L × $20 = $ 480,000 sales of L
36,000 units of M × $15 = 540,000 sales of M
Break-even sales....................................................... $1,020,000

(2) $372,000 fixed cost + $93,000 profit = 15,000 packages to achieve profit
$31 contribution margin
15,000 packages × 2 units of L = 30,000 units of L
15,000 packages × 3 units of M = 45,000 units of M
30,000 units of L × $20 = $600,000 sales of L
45,000 units of M × $15 = 675,000 sales of M
Sales to achieve profit.............................................. $1,275,000

E20-12

(1) Variable manufacturing cost............................................................... $210,000

Fixed manufacturing cost ................................................................... 80,000
Variable marketing expense................................................................ 105,000
Fixed marketing and administrative expenses ................................. 60,000
Total costs to produce and sell 70,000 units .................................... $455,000
$455,000 total cost = $6.50 sales price per unit to break even
70,000 units

(2) ($80,000 + $60,000) fixed cost = 51,852 units

$8 – $4.50 – (10% × $8)

(3) ($147,000 + $60,000) fixed cost = 90,000 units

$8 – $4.50 – (15% × $8)

CGA-Canada (adapted). Reprint with permission.

E20-13 Break-even chart: Alternative break-even chart:
Chapter 20

Costs Costs
$200,000 $200,000

$190,000 $190,000
Sales Revenue Line Sales Revenue Line
$180,000 $180,000
Profit Profit
$170,000 Area $170,000 Area

$160,000 Break-Even Point $160,000 Break-Even Point

$150,000 $150,000

$140,000 $140,000
Variable Fixed
$130,000 Cost $130,000 Cost
Total Cost Line Total Cost Line
$120,000 $120,000

$110,000 $110,000

$100,000 $100,000

$90,000 Loss Area $90,000 Loss Area

$80,000 $80,000

$70,000 $70,000

$60,000 $60,000
Fixed Cost Line Variable
$50,000 $50,000
Cost
$40,000 $40,000
Fixed
$30,000 Cost $30,000

$20,000 $20,000 Variable Cost Line

$10,000 $10,000

0 0
1,000 3,000 5,000 7,000 9,000 1,000 3,000 5,000 7,000 9,000
Units of Sales Units of Sales
2,000 4,000 6,000 8,000 10,000 2,000 4,000 6,000 8,000 10,000

$20,000 $60,000 $100,000 $140,000 $180,000 $20,000 $60,000 $100,000 $140,000 $180,000
Sales Revenue Sales Revenue
$40,000 $80,000 $120,000 $160,000 $200,000 $40,000 $80,000 $120,000 $160,000 $200,000
20-11
20-12 Chapter 20

E20-14

(1) throughput/unit = sales – materials cost = $45 – ($14 + $1) = $30

(2) Maximum throughput per month is $144,000. Total throughput for a period is the
$30/unit (from requirement 1) multiplied by the number of units shipped; units
are limited by the lowest-capacity operation, which is Surface Prep’s 4,800 units
per month: 4,800 units/month × $30/unit = $144,000/month.
(3) Surface Prep is the tightest constraint, with a 4,800-unit capacity.

E20-15

(1) No, they should not acquire the equipment. Gloss Coat is not the tightest con-
straint, so increasing its capacity will not help.
(2) Zero. Maximum monthly throughput will not increase.
(3) Yes, an additional Surface Prep (SP) crew should be hired. The increase in over-
all throughput more than justifies the cost.
(4) Maximum throughput will increase by about $15,000 per month (500 units/month
× $30/unit). SP is the tightest constraint, so increasing its capacity will increase
throughput of the entire system until SP’s improvement causes another con-
straint to become the tightest. Gloss Coat, the second-tightest constraint,
presently has capacity 500 units higher than SP’s.

E20-16

(1) Yes, an inspection should be created just prior to Surface Prep (SP). For each
1,000 shipped, 50 defectives enter SP—26, 14, and 10 arising in the three preced-
ing operations, respectively. SP is the tightest constraint, so removing defec-
tives prior to SP will increase total system throughput. At $30 throughput per
unit, the 50 added units (per thousand shipped) do justify the added inspection.
(2) Removing all defectives just prior to SP will increase the number of good units
entering SP by 50/1,000 or about 5%. With SP presently handling 4,800 units per
month, a 5% increase in units shipped is .05 × 4,800 = 240. Additional through-
put will be 240 units/month × $30/unit = $7,200 per month. Because the inspec-
tion will cost $1,800 per month, the monthly advantage of the added inspection
operation will be $7,200 minus $1,800, or $5,400 per month.
Chapter 20 20-13

PROBLEMS

P20-1
TAYLOR TOOL CORPORATION
Product-Line Income Statement
(Contribution Margin Approach)

Electronic Pneumatic Hand

Total Tools Tools Tools
Sales ....................................................... $3,000,000 $1,500,000 $1,000,000 $500,000
Less variable cost of goods sold ........ 1,400,000 700,000 500,000 200,000
Gross contribution margin ................... $1,600,000 $ 800,000 $ 500,000 $300,000
Less variable marketing expenses
(packing and shipping) .................... 250,000 100,000 100,000 50,000
Contribution margin.............................. $1,350,000 $ 700,000 $ 400,000 $250,000
Less traceable fixed expenses:
Manufacturing................................... $ 250,000 $ 100,000 $ 100,000 $ 50,000
Marketing (advertising).................... 450,000 200,000 200,000 50,000
Total traceable fixed expense...... $ 700,000 $ 300,000 $ 300,000 $100,000
Product contribution............................. $ 650,000 $ 400,000 $ 100,000 $150,000
Less common fixed expenses:
Manufacturing1 ................................. $ 300,000
Marketing2 ......................................... 100,000
Administration .................................. 150,000
Total common fixed expenses .... $ 550,000
Operating income.................................. $ 100,000

1 $1,950,000 absorption cost of goods sold – $1,400,000 variable costs – $250,000 traceable fixed cost
2 $800,000 total marketing costs – $250,000 variable expense – $450,000 advertising expense
20-14 Chapter 20

P20-2
(1) ROBERTS CORPORATION
Income Statement
For Year Ended 12-31-20–
Sales (52,000 × $25)...................................................................... $1,300,000
Cost of goods sold:
Standard full cost (52,000 × $15) ......................... $780,000
Net unfavorable variable cost variances ............. 2,000
Unfavorable volume variance* ............................. 5,000 787,000
Gross profit ................................................................................... $ 513,000
Less commercial expenses:
Variable expenses (52,000 × $1)........................... $ 52,000
Fixed expenses ...................................................... 180,000 232,000
Operating income under absorption costing ............ $ 281,000
*Units budgeted for production during the year......................... 50,000
Units actually produced during the year.................................... 49,000
1,000
Fixed factory overhead charged to each unit............................ $ × 5
Unfavorable volume variance ...................................................... $ 5,000

(2) ROBERTS CORPORATION

Income Statement
For Year Ended 12-31-20–
Sales (52,000 × $25)...................................................................... $1,300,000
Cost of goods sold:
Standard variable cost (52,000 × $10) ................. $520,000
Net unfavorable variable cost variances ............. 2,000 522,000
Gross contribution margin .......................................... $ 778,000
Variable commercial expenses (52,000 × $1)............................. 52,000
Contribution margin ..................................................................... $ 726,000
Less fixed costs:
Factory overhead
(50,000 units budgeted × $5) .......................... $250,000
Commercial expenses........................................... 180,000 430,000
Operating income under direct costing ..................................... $ 296,000
(3) Operating income under absorption costing............................. $ 281,000
Operating income under direct costing ..................................... 296,000
Difference ...................................................................................... $ (15,000)
Units produced during the year .................................................. 49,000
Units sold during the year ........................................................... 52,000
Unit decrease in finished goods inventory ................................ (3,000)
Fixed factory overhead charged to each unit under
absorption costing .................................................................... $ × 5
Difference ...................................................................................... $ (15,000)
Chapter 20 20-15

P20-3
(1) PLACID CORPORATION
Income Statement
For Year Ended 12-31-20–
Sales (48,000 × $16)...................................................................... $768,000
Cost of goods sold:
Standard full cost (48,000 × $9) ........................... $432,000
Net unfavorable variable cost variances ............. 1,000
Favorable volume variance* ................................. (3,000) 430,000
Gross profit ................................................................................... $338,000
Less commercial expenses:
Variable expenses (48,000 × $1)........................... $48,000
Fixed expenses ...................................................... 99,000 147,000
Operating income under absorption costing............................. $191,000
*Units budgeted for production during the year......................... 50,000
Units actually produced during the year.................................... 51,000
(1,000)
Fixed factory overhead charged to each unit............................ × $3
Favorable volume variance .......................................................... $ (3,000)

(2) PLACID CORPORATION

Income Statement
For Year Ended 12-31-20–
Sales (48,000 × $16)...................................................................... $768,000
Cost of goods sold:
Standard variable cost (48,000 × $6) ................... $288,000
Net unfavorable variable cost variances ............. 1,000 289,000
Gross contribution margin .......................................................... $479,000
Variable commercial expenses (48,000 × $1)............................. 48,000
Contribution margin ..................................................................... $431,000
Less fixed costs:
Factory overhead
(50,000 units budgeted × $3) ............................ $150,000
Commercial expenses........................................... 99,000 249,000
Operating income under direct costing ..................................... $182,000
(3) Operating income under absorption costing ............ $191,000
Operating income under direct costing ..................... 182,000
Difference ...................................................................... $ 9,000
Units produced during the year .................................. 51,000
Units sold during the year ........................................... 48,000
Unit increase in finished goods inventory................. 3,000
Fixed factory overhead charged to each unit under
absorption costing.................................................... × $3
Difference ...................................................................... $ 9,000
20-16 Chapter 20

P20-4

(1) Absorption costing: Quarter

First Second
Sales ................................................................ $200,000 $260,000
Direct materials .............................................. $ 30,000 $ 20,000
Direct labor ..................................................... 60,000 40,000
Variable factory overhead ............................. 45,000 30,000
Fixed factory overhead.................................. 62,400 62,400
Cost of goods manufactured ........................ $197,400 $152,400
Beginning inventory....................................... 65,800
Cost of goods available for sale................... $197,400 $218,200
Ending inventory ............................................ 65,800 1 30,480 2
Cost of goods sold ........................................ $131,600 $187,720
Gross profit..................................................... $68,400 $72,280
Marketing and administrative expenses...... 25,000 28,000
Operating income........................................... $ 43,400 $ 44,280

1 $1 + $2 + $1.50 + ($62,400 ÷ 30,000) = $6.58

$6.58 × 10,000 units = $65,800
2 $1 + $2 + $1.50 + ($62,400 ÷ 20,000) = $7.62
$7.62 × 4,000 units = $30,480

(2) Direct Costing: Quarter

First Second
Sales ................................................................ $200,000 $260,000
Direct materials .............................................. $ 30,000 $ 20,000
Direct labor ..................................................... 60,000 40,000
Variable factory overhead ............................. 45,000 30,000
Variable cost of goods manufactured.......... $135,000 $ 90,000
Beginning inventory....................................... 45,000
Variable cost of goods available for sale..... $135,000 $135,000
Ending inventory ............................................ 45,000 18,000
Variable cost of goods sold .......................... $90,000 $117,000
Gross contribution margin ............................ $110,000 $143,000
Variable marketing and administrative
expenses ................................................ 10,000 13,000
Contribution margin....................................... $100,000 $130,000
Less fixed expenses:
Factory overhead .................................. $ 62,400 $ 62,400
Marketing and administrative .............. 15,000 15,000
Total fixed expense ........................................ $ 77,400 $ 77,400
Operating income........................................... $ 22,600 $ 52,600
Chapter 20 20-17

P20-4 (Concluded)
Quarter
(3) First Second
Operating income under absorption costing $43,400 $ 44,280
Operating income under direct costing....... 22,600 52,600
Difference........................................................ $20,800 $ (8,320)
Change in inventory under absorption costing:
Ending inventory ................................... $65,800 $ 30,480
Beginning inventory.............................. 0 65,800
Increase (decrease) in inventory ......... $65,800 $(35,320)
Change in inventory under direct costing:
Ending inventory ................................... $45,000 $18,000
Beginning inventory.............................. 0 45,000
Increase (decrease) in inventory ......... $45,000 $(27,000)
Difference between absorption and
direct costing......................................... $20,800 $ (8,320)

P20-5

Capital Labor
Intensive Intensive
Sales price ...................................................... $30.00 $30.00
Variable costs:
Materials................................................. $5.00 $5.60
Direct labor ............................................ 6.00 7.20
Variable factory overhead .................... 3.00 4.80
Variable marketing expenses............... 2.00 16.00 2.00 19.60
Contribution margin per unit ........................ $14.00 $10.40
(a) Capital-intensive manufacturing method:
Fixed factory overhead .................................................. $2,440,000
Fixed marketing expenses ............................................ 500,000
Total fixed cost ............................................................... $2,940,000
$2,940,000 fixed cost = 210,000 units of sales to break even
$14 contribution margin per unit
(b) Labor-intensive manufacturing method:
Fixed factory overhead .................................................. $1,320,000
Fixed marketing expenses ............................................ 500,000
Total fixed cost ............................................................... $1,820,000
$1,820,000 fixed cost = 175,000 units of sales to break even
$10.40 contribution margin per unit
20-18 Chapter 20

P20-5 (Concluded)

(2) Kimbrell Company would be indifferent between the two alternative manufactur-
ing methods at the volume of sales for which total cost was equal under both
alternatives. Let Q equal the quantity of units of product manufactured and sold.

($16 × Q) + $2,940,000 = ($19.80 × Q) + $1,820,000

$2,940,000 – $1,820,000 = ($19.60 × Q) – ($16 × Q)
$1,120,000 = $ 3.60 × Q
311,111 = Q

Total cost will be the same for both manufacturing methods at 311,111 units of
sales.

P20-6

(1) The number of units to break even at a per unit sales price of $38.50:

Variable costs:
Direct materials...................................................................... $ 60,000
Direct labor............................................................................. 40,000
Variable factory overhead..................................................... 20,000
Variable marketing and administrative expenses .............. 10,000
$130,000
$30, 000 + $15, 000 $45, 000
= = 3, 600 break-even
n units
$38.50 − $26.00 * $12.50
*$130,000 ÷ 5,000 units = $26 variable cost per unit

(2) Units that must be sold to produce an $18,000 profit, at a $40 per unit sales price:
$45, 000 + $18, 000 $63, 000
= = 4, 500 units
$40 − $26 $14
(3) The price Castleton must charge at a 5,000-unit sales level, in order to produce
a profit equal to 20% of sales:
Let x = sales price per unit
5,000x = 5,000($26) + $45,000 + 5,000 (.2x)
4,000x = $175,000
x = $43.75 sales price per unit

CGA-Canada (adapted). Reprint with permission.

Chapter 20 20-19

P20-7
B2 B4
Sales price per unit........................................ $180.00 $176.00*
Less:
Variable manufacturing cost per unit . $121.00 $ 96.00
Variable selling expense per unit
(5% of sales price) .......................... 9.00 8.80
Total variable cost per unit .................. $130.00 $104.80
Contribution margin per unit ........................ $ 50.00 $ 71.20

*$160 sales price per unit in 20A + ($160 × 10% increase in 20B)

Total fixed factory overhead

((20,000 B2’s + 40,000 B4’s) × $25 per unit)................. $1,500,000
Total fixed selling and administrative expenses.................. 207,330
Total fixed costs ...................................................................... $1,707,330

$1,707,330 fixed cost + ($135,000 profit ÷ (1 – .4)) =

(2 B2’s × $50 CM each) + (3 B4’s × $71.20 CM each)
$1,707,330 fixed cost + $225,000 pretax profit =
$313.60 CM per package

$1,932,330 = 6,162 packages

$313.60

6,162 packages × 2 units of B2 = 12,324 units of B2

6,162 packages × 3 units of B4 = 18,486 units of B4
20-20 Chapter 20

P20-8

(1) The 20A sales mix in units is 1:2 (70,000 tape recorders; 140,000 electronic cal-
culators).
Let x = Number of tape recorders to break even
2x = Number of electronic calculators to break even
At break even:
Sales = Variable cost + Fixed cost
$15x + 2 ($22.50x) = $8x + 2 ($9.50x) + $1,320,0001
$15x + $45x = $8x + $19x + $1,320,000
$60x = $27x + $1,320,000
$33x = $1,320,000
x = 40,000 tape recorders
2x = 80,000 electronic calculators
1Fixed costs:

Factory overhead ..................................... $ 280,000

Marketing and administrative ................. 1,040,000
Total........................................................ $1,320,000
Chapter 20 20-21

P20-8 (Continued)

(2) The following formula can be used to calculate the sales dollars required to earn
an aftertax profit of 9% on sales, using 20B estimates:
S = VC(S) + FC + P(S)
1 –T
Where: S =Necessary sales dollars
VC =Variable cost stated as a percentage of sales dollars (S)
FC =Fixed costs
P =Desired profit stated as a percentage of sales dollars (S)
T =Income tax rate
.09(S)
S = .46S1 + $1,377,0002 +
(1 – .55)

S = .46S + $1,377,000 + .2S

.34S = $1,377,000
S = $4,050,000
1Variable cost rate for tape recorders and electronic calculators:
Tape Electronic
Recorders Calculators
Per Per
Unit % Unit %
Sales price ......................................................$15.00 100% $20.00 100.0%
Variable costs:
Materials................................................. $3.80 $ 3.60
Direct labor ............................................ 2.20 3.30
Factory overhead .................................. 2.00 2.00
Total variable cost ............................. $7.80 52% $ 8.90 44.5%

Contribution margin....................................... $7.20 48% $11.10 55.5%

Composite variable cost rate per dollar of sales:

(.20 × Tape recorder variable cost rate) + (.80 × Calculator variable cost rate) =
.20 (.52) + .80 (.445) = .104 + .356 = .46
2Fixed costs:

Factory overhead ........................................................... $ 280,000

Marketing and administrative ....................................... 1,040,000
Additional advertising.................................................... 57,000
Total ............................................................................. $1,377,000
20-22 Chapter 20

P20-8 (Concluded)

(3) Let: x = Number of tape recorders to break even

3x = Number of electronic calculators to break even
At break even:
Sales = Variable cost + Fixed cost
$15x + 3($20x) = $7.80x + 3($8.90x) + $1,377,000
$15x + $60x = 7.80x + $26.70x + $1,377,000
$75x = $34.50x + $1,377,000
$40.50x = $1,377,000
x= 34,000 tape recorders
3x = 102,000 electronic calculators

P20-9

(1) (a) In order to break even, Almo must sell 500 units determined as follows:

F $100, 000
Q(BE) = = = 500 units
P − C $400 − $200
where F = fixed cost, P = sales price per unit, and C = variable cost per
unit.

(b) To achieve an after-tax profit of $240,000, Almo must sell 2,500 units
determined as follows:

F+π $100, 000 + ($240, 000 ÷ (1− .40)) $100, 000 + $400
0, 000
Q= = =
P−C $400 − $200 $200
$500, 000
=
$200
= 2, 500 units
where P, F, and C are defined the same as in (1)(a), and π is the after-tax
profit objective.
Chapter 20 20-23

P20-9 (Concluded)

(2) Almo Company should choose alternative (a) because it will result in the largest
after tax profit.
Alternative (a):
Revenue = ($400 unit sales price × 350 units) + (($400 – $40 price reduction) × 2,700 units)
= $140,000 + $972,000
= $1,112,000

Variable Cost = $200 per unit × (350 units sold + 2,700 units to be sold)
= $610,000

After-tax Profit = (Revenue – Variable Cost – Fixed Cost) × (1 – Tax Rate)

= ($1,112,000 – $610,000 – $100,000) × (1 – .4)
= $402,000 × .6
= $241,200
Alternative (b):
Revenue = ($400 unit sales price × 350 units) + (($400 – $30 price reduction) × 2,200 units
= $140,000 + $814,000
= $954,000

Variable Cost = ($200 per unit × 350 units) + (($200 – $25 cost reduction) × 2,200 units)
= $70,000 + $385,000
= $455,000

After-tax Profit = (Revenue – Variable Cost – Fixed Cost) × (1 – Tax Rate)

= ($954,000 – $455,000 – $100,000) × (1 –.4)
= $399,000 × .6
= $239,400
Alternative (c):
Revenue = ($400 unit sales price × 350 units) + ($400 × (1 – 5% price reduction) × 2,000 units)
= $140,000 + $760,000
= $900,000

Variable Cost = $200 per unit × (350 units sold + 2,000 units to be sold)
= $470,000

After-tax Profit = (Revenue – Variable Cost – Fixed Cost) × (1 – Tax Rate)

= ($900,000 – $470,000 – ($100,000 – $10,000 cost reduction)) × (1 – .4)
= $340,000 × .6
= $204,000
20-24 Chapter 20

P20-10

(1) Estimated break-even point based on pro forma income statement:

Sales ......................................................................................... $10,000,000

Variable costs:
Cost of goods sold ............................... $6,000,000
Commissions paid to agents............... 2,000,000 8,000,000
Contribution margin ................................................................ $2,000,000

Contribution margin ratio = $2,000,000 = 20% C/M

$10,000,000
$100,000 fixed cost = $500,000 break-even point
20% C/M
(2) Estimated break-even point with the company employing its own salespersons:

Variable cost ratios:

Cost of goods sold to sales ($6,000,000 ÷ $10,000,000) 60%
Commissions on sales .................................................. 5%
Total variable cost ratio ............................................. 65%

Contribution margin ratio = 1 – 65% variable cost ratio = 35%

Fixed costs:
Administrative ................................................................ $100,000
Sales manager................................................................ 160,000
Salaries of salespersons (3 × $30,000) ........................ 90,000
Total fixed costs ......................................................... $350,000

$350,000 fixed cost = $1,000,000 break-even point

35% C/M
Chapter 20 20-25

P20-10 (Concluded)

(3) Estimated sales volume to yield net income projected in pro forma income state-
ment with independent sales agents receiving 25% commission:

Total income before income tax ............................................ $1,900,000

Fixed cost................................................................................. 100,000
Total fixed cost and profit ...................................................... $2,000,000
Variable cost ratios:
Cost of goods sold to sales..................................................... 60%
Commissions on sales............................................................. 25%
Total variable cost ratio.................................................... 85%

Contribution margin ratio = 1 – 85% variable cost ratio = 15%

$2,000,000 fixed cost and profit = $13,333,333 sales

15% C/M

(4) Estimated sales volume to yield an identical income regardless of whether the
company employs its own salespersons or continues with independent sales
agents and pays them a 25% commission:

Total cost with agents = Total cost with company’s

receiving 25% commission own sales force

(85% variable cost × sales) = (65% variable cost × sales)

+ $100,000 fixed cost + $350,000 fixed cost

20% × sales = $250,000

sales = $1,250,000
20-26 Chapter 20

CASES

C20-1

(1) Because Star Company uses absorption costing, income from operations is
influenced by both sales volume and production volume. Sales volume was
increased in the November 30 forecast, and at standard gross profit rates this
would increase income from operations by $5,600. However, during this same
period, production volume was below the January 1 forecast, causing an
unplanned volume variance of $6,000. The volume variance and the increased
marketing expenses (due to the 10% increase in sales) overshadowed the added
profits from sales, as follows:

Increased sales ................................................ $ 26,800

Increased cost of goods sold at standard .... 21,200
Increased gross profit at standard ................ $ 5,600
Less:
Volume variance......................................... $6,000
Increased marketing expense .................. 1,340 7,340
Decrease in income from operations ............ $(1,740)
Chapter 20 20-27

C20-1 (Concluded)

(2) Star Company could adopt direct costing. Under direct costing, fixed manufac-
turing costs would be treated as period costs and would not be assigned to pro-
duction. Consequently, earnings would not be affected by production volume,
but only by sales volume. Statements prepared on a direct-costing basis are as
follows:
STAR COMPANY
Forecasts of Operating Results for 20—
Forecasts as of
January 1 November 30
Sales ................................................................ $268,000 $294,800
Variable costs:
Manufacturing........................................... $182,000 $200,200*
Marketing .................................................. 13,400 14,740
Total variable cost .............................. $195,400 $214,940
Contribution margin....................................... $ 72,600 $ 79,860
Fixed costs:
Manufacturing........................................... $ 30,000 $ 30,000
Administrative .......................................... 26,800 26,800
Total fixed cost ................................... $ 56,800 $ 56,800
Income from operations ................................ $ 15,800 $ 23,060

*$182,000 × 110% = $200,200

Reconciliation of differences in income from operations:

January 1: No difference in absorption vs. direct costing because $30,000 fixed
factory overhead was expensed in both cases.

November 30: Income from

Operations
Direct costing ................................................. $23,060
Absorption costing ........................................ 14,060
Difference........................................................ $ 9,000

Fixed factory overhead included in cost of goods sold at standard:

November 30 forecast ($30,000 in January 1 forecast
+ 10% sales volume increase) .................... $33,000
January 1 forecast ......................................... 30,000
$ 3,000
Underapplied fixed factory overhead........... 6,000
Difference........................................................ $ 9,000
20-28 Chapter 20

C20-2

(1) In absorption costing, as currently employed by RGS Corporation, fixed factory

overhead is considered a product cost rather than a period cost. Fixed factory
overhead is applied to production based on a normal capacity of 1,000,000 units.
Thus, the fixed factory overhead is applied to products in the same manner as
variable costs, even though it does not vary with production. In addition, if pro-
duction and sales are not equal during the year, fixed factory overhead is
deferred as part of inventory costs (when production exceeds sales) or released
upon sales of the inventory (when sales exceed production).
During 20A, production exceeded sales, resulting in a portion of the fixed fac-
tory overhead being inventoried in finished goods rather than being expensed in
20A. This resulted in 20A operating income being larger than it would have been
if all fixed factory overhead had been charged against 20A sales revenue. Then
in 20B, sales exceeded production, resulting In more fixed factory overhead
being charged against 20B sales revenue than was incurred in 20B. First, fin-
ished goods were sold out of inventory, which meant that the part of fixed fac-
tory overhead that was incurred in 20A and inventoried in 20A was charged
against 20B sales revenue. Second, fixed factory overhead was underapplied in
20B because only 850,000 units were produced (150,000 units less than normal
capacity used in determining the factory overhead rate). This resulted in an unfa-
vorable volume variance that was charged to the cost of goods sold in 20B. Both
of these occurrences increased the cost of goods sold and resulted in a reduc-
tion of gross profit and operating income in 20B.
Chapter 20 20-29

C20-2 (Continued)

(2)
(a) RGB CORPORATION
Operating Income Statement
For the Years Ended November 30, 20A and 20B
(in thousands)
20A 20B

Sales ....................................................... $9,000 $11,200

Variable cost of goods sold:
900,000 units at $5.00 .................... 4,500
300,000 units at $5.00 .................... $1,500
700,000 units at $5.50 .................... 3,850 5,350
Contribution margin.............................. $4,500 $ 5,850
Fixed expenses:
Fixed factory overhead.................. $3,000 $3,300
Selling and administrative ............ 1,500 4,500 1,500 4,800
Operating income.................................. 0 $ 1,050

(b) Reconciliation:
20A 20B
Operating income—
absorption costing......................... $ 900 $ 645
Operating income—
direct costing ................................. 0 1,050
Difference............................................... $ 900 $ (405)
Difference accounted for as follows:
Inventory change under
absorption costing:
Ending inventory:
300,000 units at $8.00 ............ $2,400
150,000 units at $8.80 ............ $1,320
Beginning inventory: ................. 0 $2,400
300,000 units at $8.00 ............ 2,400 $(1,080)
Inventory change under direct costing:
Ending inventory:
300,000 units at $5.00 ............ $1,500
150,000 units at $5.50 ............ $ 825
Beginning inventory .................. 0 1,500
300,000 units at $5.00 ............ 1,500 (675)
Difference .............................................. $ 900 $ (405)
20-30 Chapter 20

C20-2 (Concluded)

(3) The advantages of direct costing for internal reporting include the following:
(a) Direct costing aids in forecasting and in evaluating reported income for
internal management decision-making purposes, because fixed costs are
not arbitrarily allocated between accounting periods (or among different
products, sales territories, operating divisions, etc.).
(b) Fixed costs are reported at incurred values (and not absorbed values),
increasing opportunity for more effective control of these costs.
(c) Profits vary directly with sales volume and are unaffected by changes in
inventory levels.
(d) Analysis of the cost-volume-profit relationship is facilitated, and manage-
ment is able to determine the break-even point and total profit for a given
volume of production and sales.
The disadvantages of direct costing for internal reporting include the following:
(a) Management may fail to consider properly the fixed cost element in long-
range pricing decisions.
(b) Direct costing lacks acceptability for external financial reporting or as a
basis for computing taxable income. As a consequence, additional record-
keeping costs must be incurred to use direct costing.
(c) The separation of costs into fixed and variable elements is a costly process.
In addition, the distinction between fixed and variable cost is not precise and
not reliable at all levels of activity.

C20-3
(1) Daly would determine the number of units of Product Y that it would have to sell
to attain a 20% profit on sales, by dividing total fixed costs plus desired profit
(i.e., 20% of sales price per unit multiplied by the units to attain a 20% profit) by
unit contribution margin (i.e., sales price per unit less variable cost per unit).
(2) If variable cost per unit increases as a percentage of the sales price, Daly would
have to sell more units of Product Y to break even. Because the unit contribution
margin (i.e., sales price per unit less variable cost per unit) would be lower, Daly
would have to sell more units to cover the fixed cost in order to break even.
Chapter 20 20-31

C20-3 (Concluded)

(3) The limitations of break-even and cost-volume-profit analysis in managerial

decision making follow:
(a) The analysis is fundamentally a static analysis, and, in most cases, changes
can be determined only by recomputing results. If a break-even chart is
used, changes can be shown only by drawing a new chart or series of
charts.
(b) The amount of fixed and variable cost, as well as the slope of the sales line,
is meaningful in a defined range of activity and must be redefined for activ-
ity outside the relevant range.
(c) The analysis is highly dependent upon a meaningful separation of fixed and
variable costs, which may be difficult to obtain in actual practice.
(d) The analysis is based on a single mix of products. If the mix is expected to
change, the results must be recomputed.
(e) The analysis assumes that production technology (i.e., labor productivity,
level of automation, and product specifications) will be unchanged. If
changes in production technology are expected to occur, the analyst must
consider the expected effects on costs.
(f) The analysis assumes that selling prices, input prices, and other market
conditions will not change. Expected changes must be incorporated into the
analysis. If a range of possible changes can occur, a different result must be
determined for each possible combination.