Diego Company manufactures one product that is sold for $78 per unit in two geographic regions...

Question:

Diego Company manufactures one product that is sold for $78 per unit in two geographic regions the East and West regions. The following information pertains to the company's first year of operations in which it produced 49,000 units and sold 44,000 units.

Variable costs per unit
Manufacturing
Direct materials $28
Direct labor $14
Variable manufacturing overhead $4
Variable selling and administrative $6
Fixed costs per year
Fixed manufacturing overhead $686,000
Fixed selling and administrative expenses $510,000

The company sold 32,000 units in the East region and 12,000 units in the West region. It determined that $230,000 of its fixed selling and administrative expenses is traceable to the West region, $180,000 is traceable to the East region, and the remaining $100,000 is a common fixed cost. The company will continue to incur the total amount of its fixed manufacturing overhead costs as long as it continues to produce any amount of its only product.

1. What is the amount of the difference between the variable costing and absorption costing net operating incomes (losses)?

2. What is the company's break-even point in unit sales?

3. If the sales volumes in the East and West regions had been reversed, what would be the company's overall break-even point in unit sales?

4. What would have been the company's variable costing net operating income (loss) if it had produced and sold 44,000 units?

5. What would have been the company's absorption costing net operating income (loss) if it had produced and sold 44000 units?

6. If the company produces 5,000 fewer units than it sells in its second year of operations, will absorption costing net operating income be higher or lower than variable costing net operating income in Year 2?

7. Prepare a contribution format segmented income statement that includes a Total column and columns for the East and West regions.

8. Diego is considering eliminating the West region because an internally generated report suggests the region's total gross margin in the first year of operations was $14,000 less than its traceable fixed selling and administrative expenses. Diego believes that if it drops the West region, the East region's sales will grow by 5% in Year 2. Using the contribution approach for analyzing segment profitability and assuming all else remains constant in Year 2, what would be the profit impact of dropping the West region in Year 2?

9. Assume the West region invests $39,000 in a new advertising campaign in Year 2 that increases its unit sales by 20%. If all else remains constant, what would be the profit impact of pursuing the advertising campaign?

Variable Costing

Variable costing is a costing system whereby only variable manufacturing costs are classified as product costs. All other costs, including fixed manufacturing costs, selling and administrative costs are classified as period expenses and expensed in the income statement in the period they were incurred. One of the benefits of variable costing is that product costs reflect only variable costs which assists management in better understanding how costs will change with variations in production volume, thus it is consistent with cost volume profit analysis. The use of variable costing is also better aligned with organizational cash flows.

Answer and Explanation:

1.

Variable Costing Income Statement

Revenue 3,432,000 (44,000 x 78)
less Variable Costs
Direct materials 1,232,000 (44,000 x 28)
Direct labor 616,000 (44,000 x 14)
Variable manufacturing overhead 176,000 (44,000 x 4)
Variable selling and administrative 264,000 (44,000 x 6)
Contribution margin 1,144,000
less Fixed Costs
Fixed manufacturing overhead 686,000
Fixed selling and administrative expense 510,000
Operating income (52,000)

Absorption Costing Income Statement

Revenue 3,432,000 (44,000 x 78)
less Cost of goods sold
Direct materials 1,232,000 (44,000 x 28)
Direct labor 616,000 (44,000 x 14)
Variable manufacturing overhead 176,000 (44,000 x 4)
Fixed manufacturing overhead 616,000 (44,000 x 14)
Gross margin 792,000
less Expenses
Variable selling and administrative 264,000 (44,000 x 6)
Fixed selling and administrative expense 510,000
Operating income 18,000

The difference in income is $70,000 (52,000 + 18,000).

2.

Contribution margin per unit = 78 - 28 - 14 - 4 - 6 = $26

Total fixed costs = 686,000 + 510,000 = 1,196,000

Break-even in unit sales = 1,196,000 / 26 = 46,000 units

3.

There will be no change to company?s overall break-even if sales volumes are reversed between East and West regions.

4.

There will be no change to variable costing net income if it has produced and sold 44,000 units. The income will still incur a loss of $52,000.

5.

The income will be identical to variable costing income of a loss of $52,000 if it had produced and sold 44,000 units.

6.

Absorption costing will exhibit lower income as compared to variable costing in Year 2 since fixed overhead from ending inventory in Year 1 will be recognized in Year 2.

7.

East West Total
Revenue 2,496,000 936,000 3,432,000
less Variable Costs
Direct Materials 896,000 336,000 1,232,000
Direct Labor 448,000 168,000 616,000
Variable Manufacturing Overhead 128,000 48,000 176,000
Variable Selling and Admin 192,000 72,000 264,000
Contribution Margin 832,000 312,000 1,144,000
Fixed Selling and Admin 180,000 230,000 510,000
Fixed Manufacturing Overhead 686,000
Operating Income (Loss) (52,000)

8.

Revised Income of the East Division = Revised contribution margin - fixed selling and admin expenses ? fixed manufacturing overhead - common fixed selling and admin expenses = (832,000 x 1.05) - 180,000 - 686,000 - 100,000 = 873,600 - 180,000 - 686,000 - 100,000 = (92,400)

There will be a decrease in profit of $40,400 (92,400 - 52,000).

9.

Increase in profit = (832,000 x 20%) - 39,000 = $127,400


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