The Zwatch Company manufactures trendy, high quality, moderately watches. As Zwatch's senior...

Question:

The Zwatch Company manufactures trendy, high quality, moderately watches.

As Zwatch's senior financial analyst, you are asked to recommend another way to prepare Zwatch's of inventory costing.

The CFO will use your recommendation to prepare the income statement.

The following data are for the year ended December 31, 2014:

Beginning inventory, January 1, 2014 100,000 units
Ending inventory, December 31, 2014 50,000 units
2014 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

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.

Required:

1. Prepare income statements under variable and absorption costing for the year ended December 31, 2014.

2. What is Zwatch'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?

Variable Costing

Variable costing is a costing method whereby only variable costs are included as product costs. These costs include direct materials, direct labor and variable manufacturing overhead. Other product costs, namely fixed manufacturing overhead are treated as period costs which will be expensed in the period incurred. Variable costing is used internally for managerial decision making since GAAP prescribes only the use of absorption costing for external financial reporting. The use of variable costing allows management to clearly determine costs from changes in activity and it is an effective tool used in cost-volume-profit analysis.

Answer and Explanation:

1.

Variable Costing Income Statement

Sales Revenue 10,000,000 (400,000 x 25)
less Variable Costs
Variable Manufacturing Costs 2,400,000 (400,000 x 6)
Variable Operating Costs 800,000 (400,000 x 2)
Contribution Margin 6,800,000
less Fixed Costs
Fixed Manufacturing Costs 1,625,000
Fixed Operating Costs 1,100,000
Operating Income 4,075,000

Units Produced = 400,000 + 50,000 - 100,000 = 350,000 units

Fixed manufacturing cost per unit = 1,625,000 / 350,000 = $4.64 per unit

Absorption Costing Income Statement

Sales Revenue 10,000,000 (400,000 x 25)
less COGS
Variable Manufacturing Costs 2,400,000 (400,000 x 6)
Fixed Manufacturing Costs 1,856,000 (400,000 x 4.64)
Gross Profit 5,744,000
less Expenses
Variable Operating Costs 800,000 (400,000 x 2)
Fixed Operating Costs 1,100,000
Operating Income 3,844,000

2.

Operating income as a percentage of revenue under variable costing = 4,075,000 / 10,000,000 = 40.75%

Operating income as a percentage of revenue under absorption costing = 3,844,000 / 10,000,000 = 38.44%

3.

The company manufactured 350,000 units this year but sold 400,000 units as the company had sufficient ending inventory from the previous year. The absorption costing method will thus produce lower income as fixed manufacturing costs from the additional 50,000 units in the previous year?s ending inventory will be recognized this year. Hence, absorption costing has a lower percentage of operating income to revenue ratio. Variable costing on the other hand, recognizes all fixed manufacturing costs in the period they are incurred.

4.

It depends on what the CFO will require information for. Variable costing assists in cost-volume-profit analysis since variable costs and fixed are clearly presented. However, variable costing is not acceptable under GAAP for external reporting. Absorption costing is the correct cost method for preparation of external reports but the calculation of fixed manufacturing overhead on a per-unit cost might result in the misunderstanding of these costs as being variable.


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Variable Costing: Method, Formula & Advantages

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Chapter 13 / Lesson 5
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