Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 41

Profit Centers: Comparison of Variable and Full Costing (Underapplied Overhead) Mark Hancock, Inc. manufactures a specialized surgical instrument called the HAN-20. The firm has grown rapidly in recent years because of the product’s low price and high quality. However, sales have declined this year due primarily to increased competition and a decrease in the surgical procedures for which the HAN-20 is used. The firm is concerned about the decline in sales, and has hired a consultant to analyze the firm’s profitability. The consultant has provided the following information:

	2009	2010
Sales (units)	3,200	2,800
Production	3,800	2,300
Budgeted production and sales	4,000	3,400
Beginning inventory	800	1,400
Data per unit (all variable)
Price	$2,095	$1,995
Direct materials and labor	1,200	1,200
Selling costs	1 25	1 25
Period cost (all fixed)
Manufacturing overhead	$700,000	$595,000
Selling and administrative	120,000	120,000

Hancock explained to the consultant that the unfavorable economic climate in 2009 and 2010 had caused the firm to reduce its price and production levels and reduce its fixed manufacturing costs in response to the decline in sales. Even with the price reduction there was a decline in sales in both

2009 and 2010. This led to an increase in inventory in 2009, which the firm was able to reduce in

2010 by further reducing the level of production. In both years Hancock’s actual production was less than the budgeted level so that the overhead rate for fixed overhead, calculated from budgeted production levels, was too low and a production volume variance was calculated to adjust cost of goods sold for the underapplied fixed overhead (the calculation of the production-volume variance is explained fully in Chapter 15, and reviewed briefly below).

The production-volume variance for 2009 was determined from the fixed overhead rate of $175 per unit ($700,000/4,000 budgeted units). Since the actual production level was 200 units short of the budgeted level in 2009 (4,000-3,800), the amount of the production-volume variance in 2009 was 200 X $175 = $35,000. The production-volume variance is underapplied (since actual production level is less than budgeted) and is therefore added back to cost of goods sold to determine the

amount of cost of goods sold in the full-cost income statement. The full-cost income statement for 2009 is shown below:

Sales		$6,704,000
Cost of goods sold:
Beginning inventory	$1,100,000
Cost of goods produced	5,225,000
Cost of goods available for sale	$6,325,000
Less ending inventory	1,925,000
Cost of goods sold:		$4,400,000
Plus underapplied production-
volume variance		35,000
Adjusted cost of goods sold		$4,435,000
Gross margin		$2,269,000
Less selling and administrative costs
Variable	$ 400,000
Fixed	120,000	520,000
Net income		$1,749,000

Required

1. Using the full-cost method, prepare the income statements for 2010.

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2. Using variable costing, prepare an income statement for each period, and explain the difference in income from that obtained in requirement 1.

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3. Write a brief memo to the firm to explain the difference in operating income between variable costing and full costing.

Step 1 of 4

Fixed cost is the portion of total cost which does not changes with change in level of production. Variable cost is the portion of total cost which changes with change in level of production.