Question

Exercise #2: Townsley Records Townley Records produces music CDs. The company plans to produce and sell 12,000 CDs each quarter and have an inventory of 2,000 CDs at the start of Q1. The selling price of each CD is $6 and the variable cost is $1. The production and non-production overheads are estimated at $24,000 and $30,000 a quarter, respectively. The results for the year, expressed in the number of CDs, are as follows: Q1 Q2 Q3 Q4 Total Sales 9,000 16,000 6,000 13,000 44,000 Production 14,000 12,000 11,000 10,000 47,000 Calculate the Q1 profits (a) using absorption costing, and (b) using variable costing. (c) Explain why the profits differ. (Assume the total of actual overhead incurred was as forecast) [NOTE: You may find this a difficult problem. I want you to use logic and the class material to figure out how you might approach the problem and make a stab at the solution. We'll work through in the next class.)

Answer 1

1) Under variable costing, unit product cost shall consider only variable mfg. costs incurred to to produce the number goods. Therefore, Townsley Records Variable Costing Income Statement (For Q1) Sales Revenue $54,000.00 [9000 units x $6] Variable Expenses: Manufacturing costs $9,000.00 [9000 units x $1] Non-production expenses $0.00 [9000 units x $0] Total Variable Expenses $9,000.00 Contribution Margin $45,000.00 [Sales Revenue - Total Variable Expenses] Fixed Expenses: Manufacturing costs $24,000.00 Non-production expenses $30,000.00 Total Fixed Expenses $54,000.00 Net Operating Income (Loss) -$9,000.00 [Contribution margin - Total Fixed Expenses]

2) Under absorption costing, unit cost of goods manufactured shall consider both variable and fixed manufacturing costs incurred to produce the number goods. Therefore, Variable mfg. overhead per unit Fixed mfg. overhead per unit Product cost per unit $1.0000 $1.7143 $2.7143 [$24000 / 14000 units produced] Townsley Records Absorption Costing Income Statement (For Q1) Sales Revenue $54,000.00 [9000 units x $6] Cost of Goods Sold $24,428.57 [9000 units x $2.7143] Gross Profit $29,571.43 [Sales Revenue - Cost of Goods Sold] Non-production expenses $30,000.00 [(9000 units x $0) + $30000] Net Operating Income (Loss) ($428.57)

3) The only reason for the difference in net operating income (loss) between absorption costing and variable costing is the deferred fixed manufacturing overhead cost to next period through ending inventory under absorption costing. That is, under variable costing, entire fixed manufacturing overhead cost is considered as period cost and so charged to income statement. However, under the absorption costing, fixed mfg. overhead cost is considered as product cost and so a portion of it will be deferred to next reporting period through ending inventory. If number of units produced and sold are same, net operating income reported under both methods will be same. Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes (Losses) Variable costing net operating income (loss) ($9,000.00) [Ref: Part-1] Add: Fixed costs deferred to next period in ending inventory $8,571.43 [(14000 - 9000) units x $1.7143 = 5000 units x $1.7143 = $8571.43] Absorption costing net operating income (loss) ($428.57) --> Matched with Part-2's result