# Accounting for Decision Making Study Set 5

## Quiz 10 :Criticisms of Absorption Cost Systems: Incentives to Overproduce

Question Type
Varilux Varilux manufactures a single product and sells it for $10 per unit. At the beginning of the year, there were 1,000 units in inventory. Upon further investigation, you discover that units produced last year had$3 of fixed manufacturing costs and $2 of variable manufacturing costs. During the year, Varilux produced 10,000 units of product. Each unit produced generated$3 of variable manufacturing cost. Total fixed manufacturing cost for the current year was $40,000. Selling and administrative costs consisted of$12,000 of variable costs and $18,000 of fixed costs. There were no inventories at the end of the year. Required : Prepare two income statements for the current year: one on a variable cost basis and the other on an absorption cost basis. Explain any difference between the two net income numbers and provide calculations supporting your explanation of the difference. Free Essay Answer: Answer: Inventory It is defined as the items or the products in which any company or any organization deals that is the company or the organization purchases the items or manufactures them while selling such items. Inventory can be bifurcated into two parts, opening inventory and closing inventory. Fixed Costs These costs remain fixed irrespective of the level of output. It is immaterial that the company produces any product or not or it generates any income or not, these costs have to be paid by the company due to their fixed obligation. Fixed costs are irrelevant in relevant costing. In the present case, the information regarding the selling price, the inventory value, fixed and manufacturing costs per unit and in total are also provided. Prepare the income statements under both the methods with the help of MS-Excel as follows: The result of the above calculations is as follows: Explanations: As per the calculations are done above, it is clear that the income of the company is less under the absorption costing method as compared with the variable costing method. The reason behind such results is the fixed costs because in variable costing the fixed costs of current year only are considered. But in the absorption costing the fixed costs of current as well as a previous year are taken for the computation of net income. Tags Choose question tag Alliance Tooling Alliance Tooling produces a single product in its plant. At the beginning of the year, there were no units in inventory. During the year, Alliance produced 120,000 units and sold 100,000 units at$26.75 per unit. Variable manufacturing costs are $13.50 per unit. Alliance pays$2.70 per unit for sales commissions and shipping. It has fixed costs of $720,000 for selling and administration. Its tax rate is 40 percent. Required: a. Prepare an income statement for Alliance Tooling using absorption costing. b. Prepare an income statement for Alliance Tooling using variable costing. c. Explain why the net income figures computed in parts (a) and (b) differ. Free Essay Answer: Answer: Income Statement: It is a part of the books of a company and is a most important element as it shows the performance of a company. It shows the net profit by subtracting all the expenses from the income that incurred during the fiscal year. In the present case, the information regarding the number of units sold, the variable costs and other costs incurred for the manufacturing is provided. Prepare the Income Statement by using Absorption Costing Method as follows: The result of the above calculations is as follows: Therefore the Net Income comes out to be$201,000.
b.Prepare the Income Statement using the Variable Costing Method as follows:
The result of the above calculations is as follows:
Therefore the net Income of the company comes out to be $201,000. c.As per the calculations are done both the parts above, there is no difference in the Net Income of the company because the company has not incurred any amount of cost that relates to the fixed manufacturing overheads. Tags Choose question tag TransPacific Bank You are working as a loan officer at TransPacific Bank and are analyzing a loan request for a client when you come across the following footnote in the client's annual report: Inventories are priced at the lower of cost or market of materials plus other direct (variable) costs. Fixed overheads of$4.2 million this year and $3.0 million last year are excluded from inventories. Omitting such overhead resulted in a reduction in net income (after taxes) of$720,000 for this year. Our tax rate is 40 percent. In preparing to present the loan application to the bank's loan committee, write a brief paragraph in nontechnical terms describing what this footnote means and how it affects the bank's evaluation of the financial condition of the borrower.
Free
Essay

Fixed Costs:
These costs remains fixed irrespective of the level of output. It is immaterial that the company produces any product or not or it generates any income or not, these costs have to be paid by the company due to their fixed obligation. Fixed costs are irrelevant in relevant costing.
Variable Costs:
These costs changes with the level of output. Variable costs are considered relevant under relevant costing.
In the present case, the income of the year reported by the client and such income is computed after providing for all the taxes. Such income is computed by using variable costing method but if the client has used the absorption costing method then the income would have been more than by $720,000. This is because under that method, all the overheads incurred during the process of manufacturing are being charged into the products by the management. As per the data provided, the amount of overheads as written by the company has rapidly gone up and thus decreasing the amount of taxes and finally increasing the amount of net income in the hands of the company. In other terms, the experts can a raise a query on the sudden increase of fixed overheads by that much rate. But due to such increase the firm is able to generate more capacity and hence the profits are increased. Tags Choose question tag Zipp Cards Zipp Cards buys baseball cards in bulk from the companies that produce them. Zipp buys sheets of 48 cards, then cuts the sheets into individual cards, and sorts and packages them, usually by team. Zipp then sells the packages to large discount stores. The accompanying table provides information regarding operations for 2016 and 2017. Volume is measured in terms of 48-card sheets processed. Budgeted production and actual production in 2016 were both 50,000 units. There were no beginning inventories on January 1, 2016. In 2017, budgeted and actual production rose to 75,000 units. At the beginning of 2017, the president of Zipp was pleasantly surprised when the accountant showed her the income statement for the year 2016. The president remarked, "I'm surprised we made more money in 2017 than 2016. We had to cut prices and we didn't sell as many units, yet we still made more money. Well, you're the accountant and these numbers don't lie." Required : a. Prepare income statements for 2016 and 2017 using absorption costing. b. Prepare a statement reconciling the change in net income from 2016 to 2017. Explain to the president why the firm made more money in 2017 than in 2016. Essay Answer: Tags Choose question tag Kothari Inc The telecom division of Kothari Inc. produces and sells 100,000 line modulators. Half of the modulators are sold externally at$150 per unit, and the other half are sold internally at variable manufacturing costs plus 10 percent. Kothari uses variable costing to evaluate the telecom division. The following summarizes the cost structure of the telecom division. Required: a. Calculate the net income of the telecom division (before taxes) using variable costing. b. Telecom can outsource the final assembly of all 100,000 modulators for $9.00 per modulator. If it does this, it can reduce variable manufacturing cost by$1.00 per unit and fixed manufacturing overhead by $700,000. If the managers of the telecom unit are compensated based on telecom's net income before taxes, do you expect them to outsource the final assembly of the modulators? Show calculations. c. What happens to the net cash flows of Kothari Inc. if the final assembly of the modulators is outsourced? Essay Answer: Tags Choose question tag Joon manufactures and sells to retailers a variety of home care and personal care products. Joon has a single plant that produces all four of its product lines: Stick Goods (brooms and mops), Floor Care (strippers, soaps, and waxes), Brushes (hair brushes and shoe brushes), and Aerosols (room deodorizers, bug spray, furniture wax). The following statement summarizes Joon's financial performance for the most recent fiscal year. Since organic growth (i.e., growth from existing products) is difficult due to a very competitive marketplace, management proposes to the board of directors the purchase of Snuffy as a way to drive additional volume into the plant. With volume of 60,000 cases and 1.9 direct labor hours per case, Snuffy's car care product line will add 114,000 direct labor hours to the plant and increase volume about 80 percent (114,000/143,000). This additional volume will significantly reduce the overhead the existing products must absorb and allow the product managers to lower prices. To incorporate Snuffy's manufacturing and distribution into Joon's current operations, Joon will have to incur additional fixed manufacturing overhead of$450,000 per year for new equipment and $400,000 per year for additional SG A expenses. Required: a. Prepare a pro forma financial statement that shows Joon's financial performance (net income) for the most recent fiscal year assuming that Joon has already acquired Snuffy's car care products and has incorporated them into Joon's manufacturing and SG A processes. In preparing your analysis, make the following assumptions: i. Snuffy's products have the same fixed and variable cost structure as Joon's existing lines (i.e., variable overhead is$3.50 per direct labor hour, and variable SG A is 20 percent of revenues). ii. The addition of Snuffy products does not change the demand for Joon's existing products. iii. There are no positive or negative externalities in manufacturing from having the additional Snuffy volume in the plant. iv. There is sufficient excess capacity in the plant and the local labor markets to absorb the additional Snuffy volume without causing labor rates or raw material prices to rise. b. Based on your financial analysis in part (a), should Joon acquire Snuffy? c. Evaluate management's arguments in favor of acquiring Snuffy. d. What other advice would you offer Joon's management?
Essay
Tags
Choose question tag
Avant Designs designs and manufactures polished-nickel fashion bracelets. It offers two bracelets: Aztec and Mayan. The following data summarize budgeted operations for the current year: Budgeted fixed manufacturing overhead for the year was $258,000. Required: a. Prepare the budgeted income statement for the year using variable costing. b. Prepare the budgeted income statement for the year using absorption costing. Budgeted fixed manufacturing overhead is allocated to the two bracelets using machine minutes. c. Explain the difference in the two net income figures computed in parts ( a ) and ( b ). That is, reconcile any difference in earnings and explain why it occurs. Essay Answer: Tags Choose question tag Medford Mug Company The Medford Mug Company is an old-line maker of ceramic coffee mugs. It imprints company logos and other sayings on mugs for both commercial and wholesale markets. The firm has the capacity to produce 50 million mugs per year, but the recession has cut production and sales in the current year to 15 million mugs. The accompanying table shows the operating statement for 2016. At the end of 2016, there was no ending inventory of finished goods. The board of directors is very concerned about the$1.5 million operating loss. It hires an outside consultant who reports back that the firm suffers from two problems. First, the president of the company receives a fixed salary, and because she owns no stock, she has very little incentive to worry about company profits. The second problem is that the company has not aggressively marketed its product and has not kept up with changing markets. The current president is 64, and the board of directors makes her an offer to retire one year early so that they can hire a new president to turn the firm around. The current president accepts the offer to retire, and the board immediately hires a new president with a proven track record as a turnaround specialist. The new president is hired with an employment contract that pays a fixed wage of $50,000 a year plus 15 percent of the firm's operating profits (if any). Operating profits are calculated using absorption costing. In 2017, the new president doubles the selling and administration budget to$8 million (which includes the president's salary of $50,000). He designs a new line of "politically correct" sayings to imprint on the mugs and expands inventory and the number of distributors handling the mugs. Production is increased to 45 million mugs, and sales climb to 18 million mugs at$2 each. Variable costs per mug remain at $.50 and fixed costs at$20 million in 2017. At the end of 2017, the president meets with the board of directors and announces he has accepted another job. He believes he has successfully gotten Medford Mug back on track and thanks the board for giving him the opportunity. His new job is helping to turn around another struggling company. Required: a. Calculate the president's bonus for 2017. b. Evaluate the performance of the new president in 2017. Did he do as good a job as the numbers in part (a) suggest?
Essay
Tags
Choose question tag
Federal Mixing Federal Mixing (FM) is a division of Federal Chemicals, a large diversified chemical company. FM provides mixing services for both outside customers and other Federal divisions. FM buys or receives liquid chemicals and combines and packages them according to the customer's specifications. FM computes its divisional net income on both a fully absorbed and variable costing basis. For the year just ending, it reported Overhead is assigned to products using machine hours. There is no finished goods inventory at FM, only work-in-process (WIP) inventory. As soon as a product is completed, it is shipped to the customer. The beginning inventory based on absorption costing was valued at $6.3 million and contained 70,000 machine hours. The ending WIP inventory based on absorption costing was valued at$9.9 million and contained 90,000 machine hours. Required : Write a short nontechnical note to senior management explaining why variable costing and absorption costing net income amounts differ.
Essay
Tags
Choose question tag
Zeflax Bottles Zeflax manufactures insulated plastic bottles for bikes that the company sells for $4.00 per bottle. Last year, the company produced 230,000 bottles and sold 200,000 bottles. This year, Zeflax produced 200,000 bottles and sold 230,000 bottles. In both years, Zeflax's fixed manufacturing cost was$500,000 and its variable manufacturing cost was $1.00 per bottle. The president of Zeflax commented, "I don't understand these crazy financial statements. Our prices and costs didn't change, we sell more bottles this year, and we show lower income. Something has got to be wrong." Required : a. Prepare income statements for Zeflax for last year and this year using absorption costing. Assume that Zeflax's only costs are the fixed and variable manufacturing costs given in the problem. b. Prepare income statements for Zeflax for last year and this year using variable costing. Assume that Zeflax's only costs are the fixed and variable manufacturing costs given in the problem. c. Explain to the president of Zeflax in nontechnical terms why the financial statements prepared by the accountant in part (a) are not in error. In other words, explain to the president why net income fell this year from last year even though Zeflax sold more bottles. Essay Answer: Tags Choose question tag Diagnostic Imaging Medical (DIM) has introduced a revolutionary new magnetic resonance imaging (MRI) device that it sells to hospital radiology departments. Their new device has a much larger chamber that reduces patients' claustrophobic reactions compared to current machines. The following table displays how total cost per year varies with annual production. In other words, if DIM produces nine machines, the nine machines have a total manufacturing cost of$2.93 million. To simplify the analysis, assume DIM has no period costs, only the product costs in the preceding table. Management receives a bonus based on reported profits, where profits are calculated using absorption costing. Required: a. At a selling price of $500,000 per MRI, management expects to sell six units next year and plans to produce a few extra machines. The extra units are for training, marketing, and temporary spare parts in case an installed MRI fails and spare parts are needed. Management has financing and production capacity to vary production between 6 and 10 units. How many MRIs do you expect management to produce? Show your analysis that leads to this conclusion. b. Instead of expecting to sell six units at$500,000 each as in part (a), management expects to sell 11 units at $400,000 per unit. With expected sales at 11 units and a price of$400,000, DIM has the resources to produce between 11 and 15 MRIs. How many MRIs do you expect management to produce if expected sales are 11 units? Show your analysis that leads to this conclusion. c. Describe the differences and similarities in your answers to parts (a) and (b). Pay particular attention to the relation between units sold [6 in part (a) and 11 in part (b)] and expected units produced, and how this relation differs or does not differ between parts (a) and (b). Also, explain what is causing your answers in parts (a) and (b) to differ or not differ. d. Provide some plausible explanations of why average costs may increase beyond a certain quantity of production.
Essay
Tags
Choose question tag
Aspen View Aspen View produces a full line of sunglasses. This year it began producing a new model of sunglasses, the Peak 32. It produced 5,300 pairs and sold 4,900 pairs. The following table summarizes the fixed and variable costs of producing Peak 32 sunglasses. Aspen View uses variable costing to value its ending inventory. Required : a. What is Aspen View's ending inventory value of Peak 32 sunglasses? b. Aspen View is considering switching from variable costing to absorption costing. Would this year's net income from Peak 32 sunglasses be higher or lower using absorption costing? Explain. c. Suppose Aspen View uses absorption costing. If, instead of producing 5,300 pairs of Peak 32s it produced only 5,000, would net income from Peak 32 sunglasses be higher or lower from the smaller production compared to the larger production? Explain. d. Aspen View has an opportunity cost of capital of 20 percent. What is the cost of producing 5,300 pairs of Peak 32s instead of 4,900 pairs?
Essay
Tags
Choose question tag
Milan DiElectrics (MDE), an Italian firm founded by Frank and Florence Potestio 25 years ago, produces a unique class of ruggedized capacitors for military, aerospace, and industrial applications. Ruggedized solid-state components must be able to withstand extreme temperatures and vibration. The Potestios built MDE into a multimillion-euro firm before they sold it last year to BTX, a large Dutch conglomerate. The Potestios agreed to stay with MDE for one year to ensure the smooth integration of MDE into BTX. The sale agreement between the Potestios and BTX set aside a significant portion of the purchase price for MDE that would be paid out to Frank and Florence if certain net income targets were achieved in the year following the sale. The higher the reported income of MDE, the more of the set-aside Frank and Florence receive. The contract specified that generally accepted accounting procedures (including MDE's existing absorption costing system) would be used to calculate MDE's net income for determining the amount of the set-aside returned to the Potestios. MDE's existing absorption costing system allocates fixed manufacturing overhead to units produced, using the number of capacitors produced. While MDE produces several different models of capacitors with different electrical specifications, there are negligible differences in the variable costs and manufacturing facility resource demands of the various models. So volume is measured in terms of capacitors produced. MDE incurs annual fixed manufacturing overhead of €30 million. Because of the scarcity of certain precious metals and the limited supply of highly skilled technicians to achieve the demanding standards required of MDE capacitors, MDE faces the following variable cost per unit schedule: All MDE capacitors sell for €200. Based on detailed conversations with their customers, Frank and Florence are highly certain they will sell 300,000 capacitors this year and for the next several years. However, this is private information known only to the Potestios and not to BTX. The sale agreement does not specify any inventory holding costs or any penalties for excessive ending inventories. Assume that MDE had no beginning inventories and the only costs (expenses) MDE incurs are the fixed and variable manufacturing costs described earlier. Required: a. Given the information provided, how many capacitors do you expect the Potestios will produce this year? Justify your answer with clearly labeled numerical calculations and a short essay explaining how you arrived at your conclusion. b. Assume that the managers of BTX have all the private knowledge held by the Potestios, the BTX managers are in control of MDE, and the BTX managers want to maximize the net cash

There is no answer for this question

Tags
Choose question tag
Essay
Tags
Choose question tag
Easton Plant The Easton plant produces sheet metal chassis for flat-panel televisions. The chassis are manufactured on a computerized, numerically controlled (NC) machine that cuts, drills, and bends the metal to form the chassis for the television set. Two different chassis are produced: HX-3 and DX-55. Easton has a single plantwide overhead account. Actual machine minutes on the NC machine are used to distribute overhead to the two products. There were no beginning inventories of work in process or finished goods. The following table summarizes the planned and actual production data for the year: The following data summarize the flexible overhead budget: At the end of the year, the following overhead amounts had been incurred: Any over- or underabsorbed overhead is written off to cost of goods sold. The ending finished goods inventory consists of 2,000 units of HX-3 and 1,000 units of DX-55, representing 13,400 minutes and 10,300 minutes of actual machine time, respectively. Required : (Round all dollars, including overhead rates, to two decimal places.) a. Calculate the overhead absorption rate set at the start of the year. b. Calculate the over- or underabsorbed overhead for the year. c. The firm is considering switching to variable costing. What effect would this decision have on Easton's reported profit for this year? To implement variable costing at the end of the year, variable overhead is calculated as $3.00 per machine minute times the actual number of machine minutes. Fixed overhead is the difference between total actual overhead and variable overhead. d. Instead of defining fixed overhead as all overhead in excess of variable overhead as in part (c), assume the following: Fixed overhead is budgeted fixed overhead ($820,000), and variable overhead is the difference between total actual overhead and budgeted fixed overhead. What is the difference between absorption net income and variable costing income given these new assumptions?
Essay
Tags
Choose question tag
Navisky designs, manufactures, and sells specialized GPS (global positioning system) devices for commercial applications. For example, Navisky currently sells a system for environmental studies and is planning systems for private aviation and fleet management. The firm has a design team that identifies potential commercial GPS applications and then designs and develops prototypes. Once a prototype is deemed successful and senior management determines that a market exists for the new application, the new design is put into production, and the firm markets the new product through independent salespeople, direct marketing, trade shows, or whatever channel is most appropriate for that market. Currently, Navisky has one very successful system in production (for environmental studies) and several others in development. Navisky, located in Austria, is one of nine wholly owned subsidiaries of a large Swiss conglomerate. Andreas Hoffman, president of Navisky, expects to retire next year. He receives a fixed salary and a bonus based on reported accounting earnings. The bonus is 5 percent of earnings in excess of €850,000 for actual earnings between €850,000 and €1,400,000. If actual earnings exceed €1,400,000, the bonus is capped at €27,500 (5% × €[1,400,000 - €850,000]). (Earnings, both actual and target, are before taxes.) The following data summarize Navisky's current operations (in euros). Senior management at Navisky, including Mr. Hoffman, expects to sell about 1,200 units of the environmental GPS device this year. However, they have considerable discretion in setting production levels. Their plant has excess capacity and can produce up to 1,500 environmental devices without seeing any increase in the variable manufacturing costs per unit. Navisky uses a traditional absorption costing system to absorb manufacturing overhead into product costs for inventory valuation and to calculate earnings for internal compensation purposes as well as external reporting. At the beginning of the current fiscal year, there was no beginning inventory of the environmental GPS devices. Required : a. How many units of the environmental GPS device would Mr. Hoffman like to see Navisky produce if he expects to sell 1,200 devices this year? b. Suppose Mr. Hoffman's bonus calculation was based on net income after including a charge for inventory holding costs at 20 percent of the ending inventory value. In other words, his bonus is 5 percent of net income in excess of $850,000 up to$1,400,000 where net income includes a 20 percent inventory holding cost. How many units of the environmental GPS device would Mr. Hoffman like to see produced if he expects to sell 1,200 devices this year? c. Explain why your answers in parts (b) and (c) differ, if they do. d. How many units of the environmental GPS device would Mr. Hoffman like to see produced, assuming he expects to sell 1,200 devices this year if Navisky's net income is calculated using variable costing and net income includes a 20 percent inventory holding cost?
Essay
Tags
Choose question tag
CLIC Lighters CLIC manufactures two types of cigarette lighters: Basic and Super. A new plant began producing both lighter models this year. The following variable costing statement summarizes the first year of operations: For internal control purposes, variable costing is used. Management also wants income from manufacturing calculated using absorption costing. Fixed overhead is allocated to the two lighters using actual machine minutes. Each Basic lighter requires 1.1 machine minutes and each Super lighter requires 1.2 machine minutes. Required : a. Calculate the fixed overhead rate per machine minute. b. Calculate the plant's income from manufacturing for both Basic and Super lighters and for the entire plant using absorption costing. c. Prepare a table that reconciles the difference in income from manufacturing reported using variable costing and absorption costing. d. Explain in one or two sentences why income from manufacturing differs depending on whether variable costing or absorption costing is used.
Essay
Tags
Choose question tag
The Breckenridge, Colorado, plant of Conner Coffees roasts, grinds, and packages premier coffees for upscale coffee cafés. The manager of the Breckenridge plant is evaluated and rewarded based on absorption costing net income of her plant. The Breckenridge plant sells its coffees in five-pound vacuum-sealed foil packs for $60 per five-pound pack. Each pack has a variable manufacturing cost of$30. Annual total fixed manufacturing cost is $48,000. The Breckenridge plant expects to sell 10,000 packs this year, and the manager can choose to produce 10,000, 11,000, or 12,000 packs. Variable cost per pack of$30 will not change if the plant manager produces between 10,000 and 12,000 packs. Assume there are no beginning inventories, fixed and variable period costs are zero, and the corporate income tax rate is zero. Required : a. If the manager of the Breckenridge plant has the discretion to set the production level and seeks to maximize her bonus, what production level (10,000, 11,000, or 12,000) will be chosen, and how much absorption costing net income will be reported? b. Instead of evaluating the Breckenridge manager based on absorption costing net income, the Breckenridge manager is evaluated based on absorption costing residual income of her plant using a 12 percent weighted-average cost of capital. What production level (10,000, 11,000, or 12,000) will the Breckenridge manager select, and how much absorption costing residual income will be reported? c. Critically analyze the statement: "The use of residual income solves the overproduction problem created by absorption costing." Under what conditions is this statement true, and under what conditions is it false?
Essay