9-25 Variable versus absorption costing.
The Zeta Company manufactures trendy, good-
looking, moderately priced umbrellas. As Zeta’s senior financial analyst, you are asked to
recommend a method of inventory costing. The CFO will use your recommendation to prepare
Zeta’s 2017 income statement. The following data are for the year ended December 31, 2017:
Beginning inventory, January 1, 2017 100,000 units
Ending inventory, December 31, 2017 50,000 units
2017 sales 400,000 units
Selling price (to distributor) $25 per unit
Variable manufacturing cost per unit, including direct materials $6 per unit
Variable operating (marketing) cost per unit sold $2 per unit sold
Fixed manufacturing costs $1,625,000
Denominator-level machine-hours 6,500
Standard production rate 50 units per machine-hour
Fixed operating (marketing) costs $1,100,000
Required:
Assume standard costs per unit are the same for units in beginning inventory and units produced
during the year. Also, assume no price, spending, or efficiency variances. Any production-
volume variance is written off to cost of goods sold in the month in which it occurs.
1. Prepare income statements under variable and absorption costing for the year ended
December 31, 2017.
2. What is Zeta’s operating income as percentage of revenues under each costing method?
3. Explain the difference in operating income between the two methods.
4. Which costing method would you recommend to the CFO? Why?
SOLUTION
(40 min) Variable versus absorption costing.
1. Beginning Inventory + 2017 Production = 2017 Sales + Ending Inventory
100,000 units + 2017 Production = 400,000 units + 50,000 units
2017 Production = 350,000 units
Income Statement for the Zeta Company, Variable Costing
for the Year Ended December 31, 2017
Revenues: $25 × 400,000 $10,000,000
Variable costs
Beginning inventory: $6 × 100,000 $ 600,000
Variable manufacturing costs: $6 × 350,000 2,100,000
Cost of goods available for sale 2,700,000
Deduct ending inventory: $6 × 50,000 (300,000)
Variable cost of goods sold 2,400,000
Variable operating costs: $2 × 400,000 800,000
Adjustment for variances 0
Total variable costs 3,200,000
Contribution margin 6,800,000
Fixed costs
Fixed manufacturing overhead costs 1,625,000
Fixed operating costs 1,100,000
Total fixed costs 2,725,000
Operating income $4,075,000
Absorption Costing Data
Fixed manufacturing overhead allocation rate =
Fixed manufacturing overhead/Denominator level machine-hours = $1,625,000 6,500
= $250 per machine-hour
Fixed manufacturing overhead allocation rate per unit =
Fixed manufacturing overhead allocation rate/standard production rate = $250 50
= $5 per unit
Income Statement for the Zeta Company, Absorption Costing
for the Year Ended December 31, 2017
Revenues: $25 × 400,000 $10,000,000
Cost of goods sold
Beginning inventory ($6 + $5) × 100,000 $ 1,100,000
Variable manuf. costs: $6 × 350,000 2,100,000
Allocated fixed manuf. costs: $5 × 350,000 1,750,000
Cost of goods available for sale $4,950,000
Deduct ending inventory: ($6+ $5) × 50,000 (550,000)
Adjust for manuf. variances ($5 × 25,000)a (125,000)
Cost of goods sold 4,275,000
Gross margin 5,725,000
Operating costs
Variable operating costs: $2 × 400,000 $ 800,000
Fixed operating costs 1,100,000
Total operating costs 1,900,000
Operating income $3,825,000
a
Production volume variance = [(6,500 hours × 50) – 350,000] × $5
= (325,000 – 350,000) × $5
= $125,000
2. Zeta’s operating margins as a percentage of revenues are
Under variable costing:
Revenues $10,000,000
Operating income 4,075,000
Operating income as percentage of revenues 40.75%
Under absorption costing:
Revenues $10,000,000
Operating income 3,825,000
Operating income as percentage of revenues 38.25%
3. Operating income using variable costing is about 9.15 percent higher than operating income
calculated using absorption costing.
Variable costing operating income – Absorption costing operating income =
$4,075,000– $3,825,000= $250,000
Fixed manufacturing costs in beginning inventory under absorption costing –
Fixed manufacturing costs in ending inventory under absorption costing
= ($5 × 100,000) – ($5 × 50,000) = $250,000
4. The factors the CFO should consider include
(a) Effect on managerial behavior.
(b) Effect on external users of financial statements.
I would recommend absorption costing because it considers all the manufacturing resources
(whether variable or fixed) used to produce units of output. Absorption costing has many critics.
However, the dysfunctional aspects associated with absorption costing can be reduced by
Careful budgeting and inventory planning.
Adding a capital charge to reduce the incentives to build up inventory.
Monitoring nonfinancial performance measures.
