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

Business

Variable and Fixed Cost There are two components in the cost of a product from the point of the manufacturer. One is the fixed cost which remains fixed at any level of sales and one is the variable cost which is directly propionate to the level of sales. If the quantity increases variable cost increases and quantity decreases the variable cost also decreases. Variable costs are relevant cost and fixed cost are irrelevant costs. Net Income: The resultant amount after reducing all expenses of the company whether direct or indirect for the period from all revenues is termed as net income.Financial statements: These are the basic elements of financial reporting. These are the set of books that a company maintains in order to record its financial transactions. The financial statements when complete at the end of the period include the below-mentioned elements. 1. Statement of Income 2. Balance Sheet 3. Statement showing changes in equity of the shareholders. 4. Cash Flow statement a.In the present case, the information regarding the financial performance of the company is given. The operating data of another company is also provided. Compute the Net income of the company by assuming that company J has already acquired the company S in the manner which is as follows: img The result of the above calculation is as follows: img Therefore the profit of the company with including the company S comes out to be $1,868.50. Note: The figures used above in the calculations are taken in thousands. b.The company J shall not acquire the company S because even if the car lane in S has increased the net income of the company by $1.9 million but still the Net present value is negative. This is because the income increased is before the taxes and after the taxes, this increase shall come up to $1.3 million. The amount of such return on a $38 million investment is very low. Moreover, there are no synergies which can be used for the justification of such an acquisition. c.The management of the company is of the opinion that if S is acquired then the overheads of the company will be appropriately calculated. If the company goes on with the decision of the management for acquiring S then the overheads will come down but the cost incurred marginally on the products will not change due to this. The main issue is that the company J has free capacity in excess for production and the managers appointed in the production department are charging these costs in the products. Therefore the cost of the product of the company is rising. The company J if acquires the company S just to have excess production is not feasible as it will increase the burden of costs on the products up to a higher level. d. The company J shall bring a change in the accounting policies for booking the overheads that pertain to the manufacturing. The company can also book the costs of the plant and its related overheads at one go. By doing this the company will save the cost of depreciation which is charged annually. The company can also remove the decisions which are based on pricing from the cost of the products as it will bring the cost of the products down. Also, the sales level of the company will increase.

Overhead Costs: These are the expenses incurred by the company and are shown in the income statement and also they are not direct expenses of the company. Overhead costs are the indirect expenses of the company. Overhead Rate: When all the overhead costs incurred by the company are summed up and divided by the appropriate allocation measure, the overhead rate is obtained. It can be calculated for both of the budgeted costs as well as the actual costs. In the given case, the difference in the net income due to different costing methods is provided. The information regarding the opening and closing inventory is also given. The difference in the amount of net income from both the methods arises because under the method of absorption costing the fixed overheads are prorated between the number of units sold and units available in the inventory. But in the variable costing the entire amount of cost incurred in the manufacturing are written off against the income in the same present case. So, therefore under the absorption costing the amount of income earned by the company is higher as compared with the variable costing method. Another reason for such higher income is the amount of closing inventory that is under the absorption costing method the value of closing stock is on a higher side in comparison with the variable costing method.

Variable costing: Variable costing is one of the costing methods that allocate only variable costs to the product. The change in level of output will cause change in variable costs. This is also known as direct costing. a) Calculate the break-even point if the Selling price is $50 as follows: img Calculate contribution per unit as follows: img Given fixed costs at 100,000 units per year, Therefore, Total fixed Costs img img Therefore, Break-even sales units are img b) Hurricane safe had no inventory of torches at the beginning of the year, but had 1,000 units at the end of the year. Hurricane Safe uses variable costing method. Compute the value of ending inventory using variable costing method as follows: Selling costs are not to be considered under variable costing method. Thus, advertising costs, selling and distributions costs are to be excluded and the value of inventory is prepared as follows. Compute the total variable costs: img Therefore, total variable cost per unit is $21. Compute the value of closing inventory: img Therefore, closing value of the inventory is img

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