CH 8 (Answers)

The Miller Company had the following results for its first two years of operation:
Year 1 Year 2
Sales $1,200,000 $1,200,000
Cost of goods sold 800,000 800,000
Gross margin 400,000 400,000
Selling and administrative 300,000 300,000
expense
Operating income $100,000 $100,000

In Year 1, the company produced and sold 40,000 units of its only product; in Year 2, the company again sold
40,000 units, but increased production to 50,000 units. The company's variable production cost is $5 per unit, and its
fixed manufacturing overhead cost is $600,000 a year. Fixed manufacturing overhead costs are applied to the
product on the basis of each year's unit production (i.e., a new fixed overhead rate is computed each year). Variable
selling and administrative expenses are $2 per unit sold.

Required:

a) Compute the unit product cost for each year under absorption costing and under variable costing.
b) Prepare an income statement for each year, using the contribution format with variable costing.
c) Reconcile the variable costing and absorption costing income figures for each year.
d) Explain why the operating income for Year 2 under absorption costing was higher than the operating income for
Year 1, although the same number of units were sold in each year.

Answers:

a) Cost per unit under absorption costing:

Year 1 Year 2
Variable production cost per unit $5 $5
Fixed manufacturing overhead cost:
($600,000/40,000) $15
($600,000/50,000) $12
Unit product cost $20 $17

Cost per unit under variable costing:

Year 1 Year 2
Variable production cost per $5 $5
unit
b) Income statements for each year under variable costing:
Year 1 Year 2
Sales $1,200,000 $1,200,000
Cost of goods sold ($5 x 200,000 200,000
40,000)
Variable selling and 80,000 80,000
administrative expense ($2 x
40,000)
Contribution margin 920,000 920,000
Fixed expense:
Fixed manufacturing overhead
600,000 600,000
Fixed selling and 150,000 150,000
administrative expense
Operating income $100,000 $100,000

c) Reconciliation of absorption costing and variable costing net incomes

Year 1 Year 2
Net income under variable costing $100,000 $100,000
Fixed manufacturing overhead deferred in
(released from) inventory:
Year 1 0
Year 2 (10,000 units x $12 per unit) 120,000
Net income under absorption costing $100,000 $220,000

d. The increase in production in Year 2, in the face of level sales, caused a buildup of inventory and a deferral of a
portion of the overhead costs of Year 2 to the next year. This deferral of cost relieved Year 2 of $120,000 of fixed
manufacturing overhead. Income for Year 2 was $120,000 higher than income of Year 1, even though the same
number of units was sold each year. By increasing production and building up inventory, the company was able to
increase profits without increasing sales. This is a major criticism of the absorption costing approach.