CHAPTER 9

INVENTORY COSTING AND CAPACITY ANALYSIS

9-16 In comparing the absorption and variable cost methods, each of the following statements is
true except:
a. SG&A fixed expenses are not included in inventory in either method.
b. Only the absorption method may be used for external financial reporting.
c. Variable costing charges fixed overhead costs to the period they are incurred.
d. When inventory increases over the period, variable net income will exceed absorption net
income.

SOLUTION

Choice "d" is correct. Inventory under the absorption method includes fixed overhead costs,
while the variable cost method includes fixed overhead costs as period costs. Fixed overhead
costs will hit the income statement under variable costing in the period they are incurred, while
under the absorption method, an increase in inventory results in more costs (fixed overhead)
remaining on the balance sheet. These costs will not hit the income statement (and therefore net
income) until the inventory is sold, which implies the absorption method will produce a higher
net income in this situation.

The other choices are incorrect as the statements contained in them are accurate.

The statement in "a" is accurate, as all SG&A expenses, fixed and variable, will be period costs
(not included in inventory) under either method.

The statement in "b" is accurate, as the absorption method should be used for financial reporting.
The variable cost method is used internally, but does not fit under GAAP and is therefore not
reported externally.

The statement in "c" is accurate, as fixed overhead costs under variable costing will hit the
income statement as an expense in the period they are incurred.

9-17 Queen Sales, Inc. has just completed its first year of operations. The company has not had
any sales to date. Queen has incurred the following costs associated with its production as of
December 31, Year 1:

Direct materials $45,000

Production labor 35,000
Bookkeeper salary 28,000
Factory utilities 18,500
Office rent 12,000
Factory supervisor salary 9,600
Machine maintenance contract 7,500

9-1
Under absorption costing, what is the inventory amount shown on the balance sheet at December
31, Year 1?
a. $155,600
b. $115,600
c. $98,500
d. $80,000

SOLUTION

Choice "b" is correct. Absorption costing, which is required under U.S. GAAP, requires all
product costs to be included in inventory. No segregation is made between fixed and variable
costs, and the costs are expensed when the product is sold. All of the costs listed, except for the
bookkeeper salary and the office rent, are product costs.

Choice "a" is incorrect. Period costs, in this case, the bookkeeper salary and the office rent, are
expensed immediately. They are not included in inventory and are expensed even if the company
has no sales.

Choice "c" is incorrect. Indirect and fixed costs related to production are included in the cost of
the product under absorption costing. The factory supervisor and the maintenance contract costs
are product costs that are considered to be inventoriable.

Choice "d" is incorrect. Production costs in addition to the prime costs of direct material
($45,000) and direct labor ($35,000) are included in the inventory under absorption costing until
such time that the goods are sold.

9-18 King Tooling has produced and sold the following number of units of their only product
during their first two years in business:

Produced Sold
Year ended December 31, Year 1 50,000 40,000
Year ended December 31, Year 2 50,000 55,000

Production costs per unit have not changed over the two-year period. Under variable costing,
what is the amount of cost of sales relative to the cost of sales shown on the GAAP income
statement of the company?

Year 1 Year 2
a. Higher Higher
b. Higher Lower
c. Lower Higher
d. Lower Lower

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SOLUTION

Choice "b" is correct. When more units are produced in a period than sold, a portion of the fixed
manufacturing overhead is included in the ending inventory under absorption costing (GAAP).
Under variable costing, all fixed manufacturing overhead is an immediate expense. As a result,
the ending inventory is lower under variable costing and the cost of sales is higher. The opposite
effect is present when the number of units sold exceeds the number of units produced.

Choice "a" is incorrect. The cost of sales under variable costing is less than the cost of sales
under GAAP when the number of units sold exceeds the number of units produced for a period.

Choice "c" is incorrect. If units produced in any period exceed the units sold during that period,
the GAAP cost of sales is lower than the cost of sales under variable costing since the fixed costs
of production are immediately expensed under the variable costing method. The opposite is true
when the units sold exceed the units produced during the period.

Choice "d" is incorrect. The cost of sales under variable costing is more than the cost of sales
under GAAP when the number of units produced exceeds the number of units sold for a period.

9-19 The following information relates to Drexler Inc.’s Year 3 financials:

Direct labor $420,000

Direct materials 210,000
Variable overhead 205,000
Fixed overhead 355,000
Variable SG&A expenses 150,000
Fixed SG&A expenses 195,000

Year 3 period costs for Drexler, under both the absorption and variable cost methods, will be

Absorption Cost Method Variable Cost Method

a. $345,000 $700,000
b. $345,000 $905,000
c. $550,000 $700,000
d. $550,000 $905,000

SOLUTION

Choice "a" is correct. Under the absorption method, only variable and fixed SG&A expenses are
period costs. Direct labor, direct materials, variable, and fixed overhead are product costs. Under
the variable cost method, variable SG&A expenses, fixed SG&A expenses, and fixed overhead
are all period costs, while direct labor, direct materials, and variable overhead are product costs.

Choice "b" is incorrect. This answer choice incorrectly adds variable overhead as a period cost
under the variable cost method.

9-3
Choice "c" is incorrect. This answer choice incorrectly adds variable overhead as a period cost
under the absorption method.

Choice "d" is incorrect. This answer choice incorrectly adds variable overhead as a period cost
under both methods.

9-20 Which of the following statements is not true regarding the use of variable and absorption
costing for performance measurement?
a. The net income reported under the absorption method is less reliable for use in performance
evaluations because the cost of the product includes fixed costs, which means the level of
inventory affects net income.
b. The net income reported under the contribution income statement is more reliable for use in
performance evaluations because the product cost does not include fixed costs.
c. Variable costing isolates contribution margins to aid in decision making.
d. The Internal Revenue Service allows either absorption or variable costing as long as the
method is not changed from year to year, while U.S. GAAP only allows absorption costing.

SOLUTION

The answer is choice "d". This is not a true statement. The I.R.S. only allows absorption costing
for financial statements, which is the same method required for U.S. GAAP.
Choices “b” and “c” are factually accurate. Variable costing is useful for decision making
because it segregates costs based on behavior, identifies the contribution margin, and expenses
fixed costs rather than unitizing them into the cost of products.

Choice “a” is again a true statement. Under absorption costing, the choice of output and
inventory affects the realized level of net income, making it more susceptible to manipulation
and a less reliable measure of managerial performance.

9-21 Variable and absorption costing, explaining operating-income differences. Nascar

Motors assembles and sells motor vehicles and uses standard costing. Actual data relating to
April and May 2017 are as follows:

The selling price per vehicle is $24,000. The budgeted level of production used to calculate the
budgeted fixed manufacturing cost per unit is 500 units. There are no price, efficiency, or
spending variances. Any production-volume variance is written off to cost of goods sold in the
9-4
month in which it occurs.

Required:
1. Prepare April and May 2017 income statements for Nascar Motors under (a) variable costing
and (b) absorption costing.
2. Prepare a numerical reconciliation and explanation of the difference between operating
income for each month under variable costing and absorption costing.

SOLUTION

(30 min.) Variable and absorption costing, explaining operating-income differences.

1. Key inputs for income statement computations are

April May
Beginning inventory 0 150
Production 500 400
Goods available for sale 500 550
Units sold 350 520
Ending inventory 150 30

The budgeted fixed cost per unit and budgeted total manufacturing cost per unit under absorption
costing are

April May
(a) Budgeted fixed manufacturing costs $2,000,000 $2,000,000
(b) Budgeted production 500 500
(c)=(a)÷(b) Budgeted fixed manufacturing cost per unit $4,000 $4,000
(d) Budgeted variable manufacturing cost per unit $10,000 $10,000
(e)=(c)+(d) Budgeted total manufacturing cost per unit $14,000 $14,000

(a) Variable costing

April 2017 May 2017

Revenuesa $8,400,000 $12,480,000
Variable costs
Beginning inventory $ 0 $1,500,000
Variable manufacturing costsb 5,000,000 4,000,000
Cost of goods available for sale 5,000,000 5,500,000
Deduct ending inventoryc (1,500,000) (300,000)
Variable cost of goods sold 3,500,000 5,200,000
Variable operating costsd 1,050,000 1,560,000
Total variable costs 4,550,000 6,760,000
Contribution margin 3,850,000 5,720,000
Fixed costs
Fixed manufacturing costs 2,000,000 2,000,000
Fixed operating costs 600,000 600,000
Total fixed costs 2,600,000 2,600,000

9-5
 Operating income $1,250,000 $3,120,000
a $24,000 × 350; $24,000 × 520 c $10,000 × 150; $10,000 × 30
b $10,000 × 500; $10,000 × 400 d $3,000 × 350; $3,000 × 520

(b) Absorption costing

April 2017 May 2017

Revenues a
$8,400,000 $12,480,000
Cost of goods sold
Beginning inventory $ 0 $2,100,000
Variable manufacturing costsb 5,000,000 4,000,000
Allocated fixed manufacturing costsc 2,000,000 1,600,000
Cost of goods available for sale 7,000,000 7,700,000
Deduct ending inventoryd (2,100,000) (420,000)
Adjustment for prod.-vol. variancee 0 400,000 U
Cost of goods sold 4,900,000 7,680,000
Gross margin 3,500,000 4,800,000
Operating costs
Variable operating costsf 1,050,000 1,560,000
Fixed operating costs 600,000 600,000
Total operating costs 1,650,000 2,160,000
Operating income $1,850,000 $ 2,640,000
a d
$24,000 × 350; $24,000 × 520 $14,000 × 150; $14,000 × 30
b e
$10,000 × 500; $10,000 × 400 $2,000,000 – $2,000,000; $2,000,000 – $1,600,000
c f
$4,000 × 500; $4,000 × 400 $3,000 × 350; $3,000 × 520

2.

– = –

April:
$1,850,000 – $1,250,000 = ($4,000 × 150) – ($0)
$600,000 = $600,000
May:
$2,640,000 – $3,120,000 = ($4,000 × 30) – ($4,000 × 150)
– $480,000 = $120,000 – $600,000
– $480,000 = – $480,000

The difference between absorption and variable costing is due solely to moving fixed
manufacturing costs into inventories as inventories increase (as in April) and out of inventories
as they decrease (as in May).

9-23 Variable and absorption costing, explaining operating-income

differences. EntertainMe Corporation manufactures and sells 50-inch television sets and
uses standard costing. Actual data relating to January, February, and March 2017 are as follows:

9-6
 January February March
Unit data:
Beginning inventory 0 150 150
Production 1,500 1,400 1,520
Sales 1,350 1,400 1,530
Variable costs:
Manufacturing cost per unit produced $ $ 1,000 $
1,000 1,00
0
Operating (marketing) cost per unit $ $ 800 $
sold 800 800
Fixed costs:
Manufacturing costs $525,00 $525,000 $525,0
0 00
Operating (marketing) costs $130,00 $130,000 $130,0
0 00

The selling price per unit is $3,300. The budgeted level of production used to calculate the
budgeted fixed manufacturing cost per unit is 1,500 units. There are no price, efficiency, or
spending variances. Any production-volume variance is written off to cost of goods sold in the
month in which it occurs.

1. Prepare income statements for EntertainMe in January, February, and March 2017 under (a)
variable costing and (b) absorption costing.
2. Explain the difference in operating income for January, February, and March under variable
costing and absorption costing.

SOLUTION

(40 min.) Variable and absorption costing, explaining operating-income differences.

1. Key inputs for income statement computations are:

January February March

Beginning inventory 0 150 150
Production 1,500 1,400 1,520
Goods available for sale 1,500 1,550 1,670
Units sold 1,350 1,400 1,530
Ending inventory 150 150 140

The budgeted fixed manufacturing cost per unit and budgeted total manufacturing cost
per unit under absorption costing are:

January February March

9-7
(a) Budgeted fixed manufacturing costs $525,000 $525,000 $525,000
(b) Budgeted production 1,500 1,500 1,500
(c)=(a)÷(b) Budgeted fixed manufacturing cost per unit $350 $350 $350
(d) Budgeted variable manufacturing cost per unit $1,000 $1,000 $1,000
(e)=(c)+(d) Budgeted total manufacturing cost per unit $1,350 $1,350 $1,350

9-8
(a) Variable Costing
January 2017 February 2017 March 2017
Revenues a
$4,455,000 $4,620,000 $5,049,000
Variable costs
Beginning inventoryb $ 0 $ 150,000 $ 150,000
Variable manufacturing costsc 1,500,000 1,400,000 1,520,000
Cost of goods available for sale 1,500,000 1,550,000 1,670,000
Deduct ending inventoryd (150,000) (150,000) (140,000)
Variable cost of goods sold 1,350,000 1,400,000 1,530,000
Variable operating costse 1,080,000 1,120,000 1,224,000
Total variable costs 2,430,000 2,520,000 2,754,000
Contribution margin 2,025,000 2,100,000 2,295,000
Fixed costs
Fixed manufacturing costs 525,000 525,000 525,000
Fixed operating costs 130,000 130,000 130,000
Total fixed costs 655,000 655,000 655,000
Operating income $1,370,000 $1,445,000 $1,640,000

a $3,300 × 1,350; $3,300 × 1,400; $3,300 × 1,530

b $? × 0; $1,000 × 150; $1,000 × 150
c $1,000 × 1,500; $1,000 × 1,400; $1,000 × 1,520
d $1,000 × 150; $1,000 × 150; $1,000 × 140
e $800 × 1,350; $800 × 1,400; $800 × 1,530

9-9
(b) Absorption Costing

January 2017 February 2017 March 2017

Revenuesa $4,455,000 $4,620,000 $5,049,000
Cost of goods sold
Beginning inventoryb $ 0 $ 202,500 $ 202,500
Variable manufacturing costsc 1,500,000 1,400,000 1,520,000
Allocated fixed manufacturing
costsd 525,000 490,000 532,000
Cost of goods available for sale 2,025,000 2,092,500 2,254,500
Deduct ending inventorye (202,500) (202,500) (189,000)
Adjustment for prod. vol. var.f 0 35,000 U (7,000) F

Cost of goods sold 1,822,500 1,925,000 2,058,500

Gross margin 2,632,500 2,695,000 2,990,500
Operating costs
Variable operating costsg 1,080,000 1,120,000 1,224,000
Fixed operating costs 130,000 130,000 130,000

Total operating costs 1,210,000 1,250,000 1,354,000

Operating income $1,422,500 $1,445,000 $1,636,500

a $3,300 × 1,350; $3,300 × 1,400; $3,300 × 1,530

b
$? × 0; $1,350 × 150; $1,350 × 150
c
$1,000 × 1,500; $1,000 × 1,400; $1,000 × 1,520
d
$350 × 1,500; $350 × 1,400; $350 × 1,520
e
$1,350 × 150; $1,350 × 150; $1,350 × 140
f
$525,000 – $525,000; $525,000 – $490,000; $525,000 – $532,000
g
$800 × 1,350; $800 × 1,400; $800 × 1,530

9-10
9-11
2. – = –

January: $1,422,500 – $1,370,000 = ($350 × 150) – $0

$52,500 = $52,500
February: $1,445,000 – $1,445,000 = ($350 × 150) – ($350 × 150)
$0 = $0

March: $1,636,500 – $1,640,000 = ($350 × 140) – ($350 × 150)

– $3,500 = – $3,500

The difference between absorption and variable costing is due solely to moving fixed
manufacturing costs into inventories as inventories increase (as in January) and out of
inventories as they decrease (as in March).

9-25 Variable versus absorption costing. The Tomlinson Company manufactures trendy, high-
quality, moderately priced watches. As Tomlinson’s senior financial analyst, you are asked to
recommend a method of inventory costing. The CFO will use your recommendation to prepare
Tomlinson’s 2017 income statement. The following data are for the year ended December 31,
2017:

Beginning inventory, January 1, 2017 90,000 units

Ending inventory, December 31, 2017 34,000 units
2017 sales 433,000 units
Selling price (to distributor) $24.00 per unit
Variable manufacturing cost per unit, including $5.40 per unit
direct materials
Variable operating (marketing) cost per unit sold $1.20 per unit sold
Fixed manufacturing costs $1,852,200
Denominator-level machine-hours 6,300
Standard production rate 60 units per machine-hour
Fixed operating (marketing) costs $1,130,000

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.

1. Prepare income statements under variable and absorption costing for the year ended
December 31, 2017.
2. What is Tomlinson’s operating income as percentage of revenues under each costing

9-12
 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

90,000 units + 2017 Production = 433,000 units + 34,000 units

2017 Production = 377,000 units

Income Statement for the Tomlinson Company, Variable Costing

for the Year Ended December 31, 2017

Revenues: $24 × 433,000 $10,392,000

Variable costs
Beginning inventory: $5.40 × 90,000 $ 486,000
Variable manufacturing costs: $5.40 × 377,000 2,035,800
Cost of goods available for sale 2,521,800
Deduct ending inventory: $5.40 × 34,000 (183,600)
Variable cost of goods sold 2,338,200
Variable operating costs: $1.20 × 433,000 519,600
Adjustment for variances 0
Total variable costs 2,857,800
Contribution margin 7,534,200
Fixed costs
Fixed manufacturing overhead costs 1,852,200
Fixed operating costs 1,130,000
Total fixed costs 2,982,200
Operating income $4,552,000

Absorption Costing Data

Fixed manufacturing overhead allocation rate =

Fixed manufacturing overhead/Denominator level machine-hours = $1,852,200 6,300
= $294 per machine-hour

Fixed manufacturing overhead allocation rate per unit =

Fixed manufacturing overhead allocation rate/standard production rate = $294 60

9-13
 = $4.90 per unit

Income Statement for the Tomlinson Company, Absorption Costing

for the Year Ended December 31, 2017

Revenues: $24 × 433,000 $10,392,000

Cost of goods sold
Beginning inventory ($5.40 + $4.90) × 90,000 $ 927,000
Variable manuf. costs: $5.40 × 377,000 2,035,800
Allocated fixed manuf. costs: $4.90 × 377,000 1,847,300
Cost of goods available for sale $4,810,100
Deduct ending inventory: ($5.40 + $4.90) × 34,000 (350,200)
Adjust for manuf. variances ($4.90 × 1,000)a 4,900 U
Cost of goods sold 4,464,800
Gross margin 5,927,200
Operating costs
Variable operating costs: $1.20 × 433,000 $ 519,600
Fixed operating costs 1,130,000
Total operating costs 1,649,600
Operating income $4,277,600
a
Production volume variance = [(6,300 hours × 60) – 377,000] × $4.90
= (378,000 – 377,000) × $4.90
= $4,900

2. Tomlinson’s operating margins as a percentage of revenues are

Under variable costing:

Revenues $10,392,000
Operating income 4,552,000
Operating income as percentage of revenues 43.8%

Under absorption costing:

Revenues $10,392,000
Operating income 4,277,600
Operating income as percentage of revenues 41.2%

3. Operating income using variable costing is 6.4% higher than operating income calculated
using absorption costing. The difference is entirely due to the way fixed manufacturing costs are
accounted for under the two costing systems.

Variable costing operating income – Absorption costing operating income =

$4,552,000 – $4,277,600 = $274,400

Fixed manufacturing costs in beginning inventory under absorption costing –

Fixed manufacturing costs in ending inventory under absorption costing

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 = ($4.90 × 90,000) – ($4.90 × 34,000) = $274,400

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.

9-15