10 – 31

1. The profit change can be explained by the following analysis:

Increase in sales revenues $20,000

Increase in variable manufacturing costs ($3.90 × 2,000) (7,800)
Increase in variable selling costs ($0.50 × 2,000) (1,000)
Increase in fixed overhead:
Year 1—2,000 units × $2.90 (5,800)
Year 2—1,000 units × $3.00 (3,000)
Year 3 underapplied fixed OH (3,000)
Net change in income $ (600)

The problem is the increased fixed overhead. We expect variable costs to increase, but the
increase in fixed overhead expenses is notable, because the actual fixed overhead incurred for
Year 3 is the same as that of Year 2. This increase in fixed overhead recognized on the
income statement is explained by the fact that in Year 3, the division sold units from prior
years with fixed overhead attached to them, and by the fact that no fixed overhead was
inventoried (as was the case in Year 2).

2.
Year 1 Year 2 Year 3
Sales $ 80,000 $100,000 $120,000
Less variable expenses:
Cost of goods sold (31,200) (40,000) (47,800)
Selling expense (3,200) (5,000) (6,000)
Contribution margin $ 45,600 $ 55,000 $ 66,200
Less fixed expenses:
Fixed overhead (29,000) (30,000) (30,000)
Other fixed costs (9,000) (10,000) (10,000)
Net income $ 7,600 $ 15,000 $ 26,200

FOH, ending inventory $ 5,800a $ 8,800b $0

FOH, beginning inventory 0 5,800 8,800
Change in fixed overhead $ 5,800 $ 3,000 $ 8,800

a
$2.90 × 2,000 units
b
($3.00 × 1,000 units) + $5,800

The difference between the absorption- and variable-costing incomes is due to the change in
fixed overhead in the division’s inventories. In Year 1, $5,800 of the fixed overhead went into
inventory; so, absorption-costing income exceeds variable-costing income by $5,800. In Year
2, $3,000 more fixed overhead was inventoried, and absorption-costing income was $3,000
greater than variable-costing income. However, in Year 3, the inventory was sold, and
absorption-costing income now recognizes that additional $8,800 of fixed overhead ($5,800 +
$3,000), explaining why variable-costing income is greater by this amount.
3. Since variable-costing income provides an increase in income when sales increase and costs
do not change, the company vice president would have preferred variable costing. Variable
costing would have provided the expected bonus to the divisional manager and a consistent
signal of improved performance.