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1. Absorption costing is required under generally accepted accounting principles. Under this approach, the fixed manufacturing costs are allocated to sold and inventoried units. Thus, if production exceeds sales, a portion of the fixed
manufacturing cost is included in the ending inventory balance and not matched against current period sales. This has the effect of reducing cost of goods sold by the amount of fixed costs allocated to the inventory. Thus, net income is improved by increasing inventory. Likewise, when sales exceed production and the inventory is liquidated, the fixed manufacturing cost in the beginning
goods sold by the amount of fixed costs included in the beginning inventory. Therefore, net income is reduced when inventory is liquidated.
2. Gordon is incorrect in implying that nothing can be done because of generally accepted accounting principles (GAAP). GAAP is required for external financial reporting. However, the income reports used to guide management may be developed under the variable costing concept. Under variable costing, the fixed manufacturing cost is not allocated to sold goods and inventory. Rather, fixed manufacturing cost is allocated to the period in which it is incurred. Treating fixed manufacturing cost in this way causes net income to be unaffected by either inventory building or reduction. Changes in net income under variable costing only occur from business events such as changes in volume, price, or cost. Reporting under variable costing would address Matt’s concern by tying profit more directly to profit-changing business events rather than inventory decisions.
CP 20–3 (FIN MAN); CP 5–3 (MAN)
Martin is earning more contribution margin than Dean; however, both salespersons are earning the same contribution margin ratio. Dean’s total sales are less than Martin’s. However, the manufacturing margin ratio is much different between the two salespersons. Dean is selling products with a much higher manufacturing margin than is Martin. This indicates that Dean is selling a more attractive product mix than is Martin. Unfortunately, Dean’s very attractive manufacturing margin is offset by very high promotional costs (as a percent of sales). As a result, Dean’s final contribution margin ratio is no better than Martin’s. Both employees apparently earn the same commission rate of 14% of sales. Thus, the promotion expenses as a percent of sales for Dean (18%) are much greater than for Martin (9%). In summary, Martin should be encouraged to sell products with higher manufacturing margins, while Dean should be encouraged to trim promotional costs. Both salespersons should be encouraged to improve total sales volume (with a little more
encouragement going to Dean).
As a final point, it may be the case that the high manufacturing margin product mix sold by Dean requires extensive promotional support. For example, maybe Dean is selling newly introduced products that have high margins but require extensive launch-related promotional expenses. In this case, there may be little opportunity for Dean to improve profitability, except by increasing total sales.
CP 20–4 (FIN MAN); CP 5–4 (MAN)
1. Danica Kyle Richard Tom
Manufacturing margin as a percent of sales 65% 50% 50% 50%
Contribution margin ratio 32% 22% 22% 22%
2. Danica has the highest contribution margin and contribution margin ratio of the four salespersons, even though Danica’s sales level is ranked third. There are two reasons for Danica’s superior performance. First, Danica sells products that have the highest manufacturing margin (65% vs. 50% for the others). This means that Danica is selling a more profitable mix of products than the other three salespersons. However, Danica spends more on variable selling expenses as a percent of sales than do the other three salespersons (33% vs. 28% for the others). Together these two explanations cause Danica to have a contribution margin ratio that is 10 percentage points higher than the other three salespersons. As a result, Danica is able to contribute more profit than either Kyle or Richard, both of whom have higher sales.
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1.
Florida Georgia Tennessee
Revenue $1,125,000 $1,000,000 $1,181,250
Variable cost of goods sold 450,000 310,000 436,000
Manufacturing margin $ 675,000 $ 690,000 $ 745,250
Variable operating expenses 281,225 202,500 306,375
Contribution margin $ 393,775 $ 487,500 $ 438,875
Contribution margin ratio 35.0% 48.8% 37.2%
Note: The variable cost of goods sold and variable selling expenses are determined
by subtracting the respective fixed costs from the cost of goods sold and selling expenses found on the income statement.
2. Florida Georgia Tennessee
Increase in contribution margin $78,755 $97,500 $87,775
Less additional advertising 42,200 42,200 42,200
Additional profit $36,555 $55,300 $45,575
Note: The increase in contribution margin is determined by multiplying the
contribution margin in (1) by 20%.
3. Georgia will generate the greatest profit increase for an additional $42,200 in advertising. This may seem surprising, because the profit report indicates that Georgia is the least profitable on an absorption costing basis. However, Georgia also has the largest fixed costs. These costs will not change with a change in sales volume. Thus, the contribution margin and contribution margin ratio for Georgia are actually higher than the other two states [from (1)].
Increasing sales volume by 20% will produce the greatest increase in contribution margin in Georgia. Increases in contribution margin translate directly into
increases in income from operations because the fixed costs are not expected to change beyond the increase in advertising.
TRANS SPORT COMPANY Contribution Margin by State
CP 20–6 (FIN MAN); CP 5–6 (MAN) 1.
Sales (44,000 × $106) $4,664,000
Cost of goods sold (44,000 × $61) 2,684,000
Gross profit $1,980,000
Selling and administrative expenses ($1,050,000 + $330,000) 1,380,000
Income from operations $ 600,000
Sales (44,000 × $106) $4,664,000
Cost of goods sold:
Cost of goods manufactured (55,000 × $58.8) $3,234,000 Less inventory, December 31 (11,000 × $58.8) 646,800
Cost of goods sold 2,587,200
Gross profit $2,076,800
Selling and administrative expenses
($1,050,000 + $330,000) 1,380,000
Income from operations $ 696,800
2. The $96,800 difference in the amount of income from operations ($696,800 – $600,000) is due to the allocation of fixed manufacturing costs to ending inventory. The entire amount of the $484,000 of fixed manufacturing costs is included in the cost of goods sold when 44,000 units are manufactured. When 55,000 units are manufactured, $96,800 (11,000 units × $8.8) of the fixed manufacturing costs are included in ending inventory and are thus excluded from the cost of goods sold.
3. a. Base salary……… $140,000 Bonus ($600,000 – $670,000) × 10%……… — Total salary……… $140,000 b. Base salary……… $140,000 Bonus ($696,800 – $670,000) × 10%……… 2,680 Total salary……… $142,680 4. By manufacturing 55,000 units, Pinder increased his salary by $2,680.
Note: Instructors may also point out that by increasing the ending inventory by
11,000 units, Craig Company will risk higher obsolescence and incur additional costs of carrying and storing inventory, and these costs will reduce future income of Craig Company.
CRAIG COMPANY
Absorption Costing Income Statement—55,000 units manufactured For the Year Ended December 31, 2014
CRAIG COMPANY
Absorption Costing Income Statement—44,000 units manufactured For the Year Ended December 31, 2014
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5. If Pinder’s salary were $140,000 (plus a bonus based on income from operations) and the variable costing method had been used, income from operations would have been $600,000, regardless of how many units were manufactured. Thus, Pinder would not have been able to increase his salary simply by manufacturing more units.
Note: Instructors may ask students to verify that income from operations, using
the variable costing method, would be $600,000 regardless of whether 44,000 or 55,000 units are manufactured. The variable costing income statements are as follows:
Sales (44,000 × $106) $4,664,000
Cost of goods sold (44,000 × $50) 2,200,000
Manufacturing margin $2,464,000
Variable selling and administrative expenses 1,050,000
Contribution margin $1,414,000
Fixed costs:
Fixed manufacturing costs $484,000
Fixed selling and administrative expenses 330,000 814,000
Income from operations $ 600,000
Sales (44,000 × $106) $4,664,000
Variable cost of goods sold:
Variable cost of goods manufactured
(55,000 × $50) $2,750,000
Less inventory, December 31 (11,000 × $50) 550,000
Variable cost of goods sold 2,200,000
Manufacturing margin $2,464,000
CRAIG COMPANY
Variable Costing Income Statement—55,000 units manufactured For the Year Ended December 31, 2014
CRAIG COMPANY
Variable Costing Income Statement—44,000 Units Manufactured For the Year Ended December 31, 2014