CHAPTER 20 (FIN MAN); CHAPTER 5 (MAN) VARIABLE COSTING FOR MANAGEMENT ANALYSIS

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1 (FIN MAN); CHAPTER 5 (MAN) VARIABLE COSTING FOR MANAGEMENT ANALYSIS 1. a. Under absorption costing, both variable and fixed manufacturing costs are included as a part of the cost of the product manufactured. b. Under variable costing, only the variable manufacturing costs are included as a part of the cost of the product manufactured. The fixed manufacturing costs are treated as an expense of the period in which they are incurred. 2. Fixed factory overhead. DISCUSSION QUESTIONS 3. Included as part of the cost of product manufactured: (b), (d), (g). 4. In the variable costing income statement, the fixed manufacturing costs and the fixed selling and administrative expenses are reported in a special section for fixed costs and are deducted from the contribution margin. 5. All costs are controllable by someone within the business but not necessarily by the same level of management. For a specific level of management, noncontrollable costs are costs for which another level of management is responsible. 6. In the short run, income from operations is maximized if the revenue from the sale of the product exceeds the variable cost of making and selling the product. Under variable costing, these relevant costs are readily available. 7. Product profitability analysis can be used by management to set product prices, to emphasize promotional activity toward more profitable products or away from less profitable products, and to make decisions about keeping products or eliminating products from the product line. 8. Rewarding sales personnel on the basis of total sales will normally motivate the sales staff to expend their efforts promoting high-volume products, which will produce a large total amount of sales dollars. In some cases, more profit may be earned by promoting specialty products with lower sales volume but which have higher profit margins on each product sold. For example, grocery stores must generate a large volume of sales to earn the same profit as a jewelry store, because the profit margin for the grocery industry is low, while the profit margin for the jewelry industry is high. A better measure of sales performance is the total dollar contribution margin of each salesperson (total sales less variable cost of goods sold and variable selling expenses) to overall company profit. 9. A change in contribution margin can be attributed to a change in the following factors as they affect sales and/or variable costs: (1) quantity factor the effect of a difference in the number of units sold, assuming no change in unit sales price or unit cost, and (2) unit price or unit cost factor the effect of a difference in unit sales price or unit cost on the number of units sold. 10. The quantity factor for sales is computed as the difference between the actual quantity sold and the planned quantity sold, multiplied by the planned unit sales price. 11. The unit cost factor for variable cost of goods sold is computed as the difference between the planned unit cost and the actual unit cost, multiplied by the actual quantity sold Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2 PRACTICE EXERCISES PE 20 1A (FIN MAN); PE 5 1A (MAN) a. $345,600 = $540,000 $194,400 b. $302,400 = $345,600 $43,200 c. $140,400 = $302,400 $129,600 $32,400 PE 20 1B (FIN MAN); PE 5 1B (MAN) a. $364,800 = $760,000 $395,200 b. $167,200 = $364,800 $197,600 c. $53,200 = $167,200 $68,400 $45,600 PE 20 2A (FIN MAN); PE 5 2A (MAN) a. Variable costing income from operations is less than absorption costing income from operations because the units manufactured are greater than the units sold. b. $2,688,000 ($70 per unit 38,400 units) PE 20 2B (FIN MAN); PE 5 2B (MAN) a. Variable costing income from operations is less than absorption costing income from operations because the units manufactured are greater than the units sold. b. $739,200 ($44 per unit 16,800 units) PE 20 3A (FIN MAN); PE 5 3A (MAN) a. Variable costing income from operations is greater than absorption costing income from operations because the units manufactured are less than the units sold. b. $201,600 ($21.00 per unit 9,600 units) PE 20 3B (FIN MAN); PE 5 3B (MAN) a. Variable costing income from operations is greater than absorption costing income from operations because the units manufactured are less than the units sold. b. $776,160 ($14.70 per unit 52,800 units) 20-2

3 PE 20 4A (FIN MAN); PE 5 4A (MAN) a. $15,000 greater in producing 15,000 units. 12,000 units (6.25* 5.00**), or [3,000 units ($75,000 15,000 units)]. b. There would be no difference in variable costing income from operations. * $75,000 12,000 units ** $75,000 15,000 units PE 20 4B (FIN MAN); PE 5 4B (MAN) a. $52,500 greater in producing 15,000 units. 10,000 units (15.75* 10.50**), or [5,000 units ($157,500 15,000 units)]. b. There would be no difference in variable costing income from operations. * $157,500 10,000 units ** $157,500 15,000 units PE 20 5A (FIN MAN); PE 5 5A (MAN) a. $28,232,000 = [50,000 units ($480 $248)] + [(66,000 units ($500 $248)] b. $45,200,000 = [50,000 units ($480 $248)] + [(112,000 units ($560 $260)] PE 20 5B (FIN MAN); PE 5 5B (MAN) a. $40,080,000 = [60,000 units ($728 $360)] + [(50,000 units ($720 $360)] b. $30,312,000 = [38,000 units ($660 $336)] + [(50,000 units ($720 $360)] PE 20 6A (FIN MAN); PE 5 6A (MAN) a. $500,000 decrease in sales = 20,000 units $25 per unit b. $1,230,000 increase in sales = ($28 $25) 410,000 units PE 20 6B (FIN MAN); PE 5 6B (MAN) a. $326,400 increase in variable cost of goods sold = (2,400 units $136 per unit) b. $56,000 decrease in contribution margin = ($136 $140) 14,000 units 20-3

4 Ex (FIN MAN); Ex. 5 1 (MAN) a. The inventory valuation under the absorption costing concept would include the fixed factory overhead cost, as follows: 11,250 units $ = $1,563,750 Direct materials $ Direct labor Fixed factory overhead Variable factory overhead Total $ b. The inventory valuation under the variable costing concept would not include the fixed factory overhead cost, as follows: 11,250 units $ = $1,428,750 EXERCISES Direct materials $ Direct labor Variable factory overhead Total $ All of the fixed factory overhead cost would be expensed in the variable costing income statement as a period cost. Thus, the absorption costing income statement would have a higher net income than would the variable costing income statement. 20-4

5 Ex (FIN MAN); Ex. 5 2 (MAN) a. BEACH MOTORS INC. Absorption Costing Income Statement For the Month Ended July 31, 2014 Sales $9,000,000 Cost of goods sold (30,000 units $210.00*) 6,300,000 Gross profit $2,700,000 Selling and administrative expenses ($1,260,000 + $225,000) 1,485,000 Income from operations $1,215,000 * Production costs per unit: Direct materials per unit ($4,495,500 40,500 units) $ Direct labor per unit ($2,187,000 40,500 units) Variable factory overhead per unit ($1,093,500 40,500 units) Fixed factory overhead per unit ($729,000 40,500 units) Total production costs per unit $ b. BEACH MOTORS INC. Variable Costing Income Statement For the Month Ended July 31, 2014 Sales $9,000,000 Variable cost of goods sold (30,000 units $192* per unit) 5,760,000 Manufacturing margin $3,240,000 Variable selling and administrative expenses 1,260,000 Contribution margin $1,980,000 Fixed costs: Fixed factory overhead costs $729,000 Fixed selling and administrative expenses 225, ,000 Income from operations $1,026,000 * $111 + $54 + $27 = $

6 Ex (FIN MAN); Ex. 5 2 (MAN) (Concluded) c. The difference between the absorption and variable costing income from operations of $189,000 ($1,215,000 $1,026,000) can be explained as follows: Increase in inventory 10,500 Fixed factory overhead per unit $ Difference in income from operations $189,000 Under the absorption costing method, the fixed factory overhead cost included in the cost of goods sold is matched with the revenues. As a result, 10,500 units that were produced but unsold (inventory) include fixed factory overhead cost, which is not included in the cost of goods sold. Under variable costing, all of the fixed factory overhead cost is deducted in the period in which it is incurred, regardless of the amount of inventory change. Thus, when inventory increases, the absorption costing income statement will have a higher income from operations than will the variable costing income statement. 20-6

7 Ex (FIN MAN); Ex. 5 3 (MAN) a. EKIN INC. Absorption Costing Income Statement For the Month Ended February 28, 2014 Sales $24,750,000 Cost of goods sold: Beginning inventory (9,000 $120.00) $ 1,080,000 Cost of goods manufactured (90,000 $122.00) 10,980,000 Cost of goods sold 12,060,000 Gross profit $12,690,000 Selling and administrative expenses 5,539,500 Income from operations $ 7,150,500 b. EKIN INC. Variable Costing Income Statement For the Month Ended February 28, 2014 Sales $24,750,000 Variable cost of goods sold (99,000 units $ per unit) 9,900,000 Manufacturing margin $14,850,000 Variable selling and administrative expenses 4,752,000 Contribution margin $10,098,000 Fixed costs: Fixed manufacturing costs $1,980,000 Fixed selling and administrative expenses 787,500 2,767,500 Income from operations $ 7,330,500 c. The difference between the absorption and variable costing income from operations of $180,000 ($7,150,500 $7,330,500) can be explained as follows: Reduction in inventory (9,000) Fixed manufacturing cost per unit (at 100% capacity) $20.00 Difference in income from operations $(180,000) Under the absorption costing method, the fixed manufacturing cost included in the cost of goods sold is matched with the revenues. As a result, 9,000 units that were produced but unsold in January (beginning inventory for February) include fixed manufacturing cost, which is included in the cost of goods sold for February. Under variable costing, all of the fixed manufacturing cost is deducted in the period in which it is incurred, regardless of the amount of inventory change. Thus, when inventory decreases, the absorption costing income statement will have a lower income from operations than will the variable costing income statement. 20-7

8 Ex (FIN MAN); Ex. 5 4 (MAN) a. Variable cost of goods manufactured per unit Variable cost of goods manufactured per unit Variable cost of goods manufactured per unit = = = Variable cost of goods manufactured Number of units produced $20,736,000 10,800 units $1,920 b. Absorption cost of goods manufactured per unit = Total cost of goods manufactured (variable + fixed) Number of units produced Absorption cost of goods manufactured per unit = ($20,736,000 + $9,504,000) 10,800 units Absorption cost of goods manufactured per unit = $2,800 Ex (FIN MAN); Ex. 5 5 (MAN) HAMAN COMPANY Variable Costing Income Statement For the Month Ended June 30, 2015 Sales (14,400 units) $1,209,600 Variable cost of goods sold: Variable cost of goods manufactured* $932,400 Less inventory, June 30 (2,400 units)** 133,200 Variable cost of goods sold 799,200 Manufacturing margin $ 410,400 Variable selling and administrative expenses 68,400 Contribution margin $ 342,000 Fixed costs: Fixed manufacturing costs $ 75,600 Fixed selling and administrative expenses 54, ,320 Income from operations $ 211,680 * $1,008,000 $75,600 (total manufacturing cost less fixed manufacturing cost) ** ($932,400 $1,008,000) $144,000 (the ratio of variable to total manufacturing costs times the value of the ending inventory under absorption costing); or $932,400 16,800 units manufactured = $55.50; $55.50 $2,400 units = $133,

9 Ex (FIN MAN); Ex. 5 6 (MAN) COVELLI EQUIPMENT COMPANY Absorption Costing Income Statement For the Month Ended July 31, 2014 Sales (45,000 units) $6,750,000 Cost of goods sold: Cost of goods manufactured* $3,915,000 Less inventory, May 31 (9,000 units)** 652,500 Cost of goods sold 3,262,500 Gross profit $3,487,500 Selling and administrative expenses 2,250,000 Income from operations $1,237,500 * $3,240,000 + $675,000 (total variable plus fixed manufacturing cost) ** ($3,915,000 $3,240,000) $540,000 (the ratio of total to variable manufacturing cost times the ending inventory valuation under variable costing); or $3,915,000 54,000 units manufactured = $72.50/unit; $ ,000 units = $652,500. Ex (FIN MAN); Ex. 5 7 (MAN) a. PROCTER & GAMBLE COMPANY Variable Costing Income Statement (assumed) (in millions) Net sales $82,559 Variable cost of products sold 22,830 Manufacturing margin $59,729 Variable marketing, administrative, and other expenses 10,400 Contribution margin $49,329 Fixed costs: Fixed manufacturing costs $17,938 Fixed marketing, administrative, and other expenses 15,573 33,511 Income from operations $15,818 b. If Procter & Gamble Company reduced its inventories during the period, then the cost of products sold would include fixed costs allocated to the beginning inventories. These would not be fixed costs of the current period. Thus, the total fixed costs of products sold on the absorption costing income statement would be higher, and the income from operations would be lower. 20-9

10 Ex (FIN MAN); Ex. 5 8 (MAN) a. 1. MUZENSKI INDUSTRIES INC. Absorption Costing Income Statement For the Month Ending July 31, ,800 Units 36,000 Units Manufactured Manufactured Sales $2,160,000 $2,160,000 Cost of goods sold: Cost of goods manufactured: 28,800 units $69.50* $2,001,600 36,000 units $68** $2,448,000 Less inventory, July 31 (7,200 units $68) 489,600 Cost of goods sold $2,001,600 $1,958,400 Gross profit $ 158,400 $ 201,600 Selling and administrative expenses 64,900 64,900 Income from operations $ 93,500 $ 136,700 * Unit cost of goods manufactured: Direct materials ($1,324,800 28,800) $46.00 Direct labor ($316,800 28,800) Variable factory overhead cost ($144,000 28,800) 5.00 Fixed factory overhead cost ($216,000 28,800) 7.50 Total unit cost $69.50 ** Unit cost of goods manufactured: Direct materials $46.00 Direct labor Variable factory overhead cost 5.00 Fixed factory overhead cost ($216,000 36,000) 6.00 Total unit cost $

11 Ex (FIN MAN); Ex. 5 8 (MAN) (Concluded) 2. MUZENSKI INDUSTRIES INC. Variable Costing Income Statement For the Month Ending July 31, ,800 Units 36,000 Units Manufactured Manufactured Sales $2,160,000 $2,160,000 Variable cost of goods sold: Variable cost of goods manufactured: 28,800 units $62.00* $1,785,600 36,000 units $62.00* $2,232,000 Less inventory, July 31 (7,200 units $62.00) 446,400 Variable cost of goods sold $1,785,600 $1,785,600 Manufacturing margin $ 374,400 $ 374,400 Variable selling and administrative expenses** 35,500 35,500 Contribution margin $ 338,900 $ 338,900 Fixed costs: Fixed factory overhead $ 216,000 $ 216,000 Fixed selling and administrative expenses 29,400 29,400 Total fixed costs $ 245,400 $ 245,400 Income from operations $ 93,500 $ 93,500 * Unit variable cost of goods manufactured: Direct materials ($1,324,800 28,800) $46.00 Direct labor ($316,800 28,800) Variable factory overhead cost ($144,000 28,800) 5.00 Total unit variable cost $62.00 ** Variable selling and administrative expenses are constant with constant sales levels. b. If 36,000 units rather than 28,800 units are manufactured, the increase in income from operations of $43,200 ($136,700 $93,500) under absorption costing is caused by the allocation of $216,000 of fixed factory overhead cost over a larger number of units. If 28,800 units are manufactured, the fixed factory overhead cost is $7.50 per unit ($216,000 28,800) compared to $6.00 per unit ($216,000 36,000) if 36,000 units are manufactured. Thus, the cost of goods sold is $43,200 less by the amount of $1.50/unit ($7.50 $6.00) times the number of units sold, or $ ,800 units = $43,200. The $43,200 difference can also be explained by the amount of fixed factory overhead cost included in the ending inventory if 36,000 units are manufactured ($6.00 per unit 7,200 units)

12 Ex (FIN MAN); Ex. 5 9 (MAN) a. WHIRLPOOL CORPORATION Variable Costing Income Statement (assumed) (in millions) Sales $18,666 Variable cost of goods sold: Beginning inventory (70% $2,792) $ 1,954 Variable cost of goods manufactured* 11,627 Less: Ending inventory (70% $2,354) (1,648) Variable cost of goods sold 11,933 Manufacturing margin $ 6,733 Variable selling and administrative expenses** 691 Contribution margin $ 6,042 Fixed costs: Fixed manufacturing costs $ 4,024 Fixed selling and administrative expenses 930 4,954 Income from operations $ 1,088 * Variable cost of goods manufactured: Cost of goods sold $16,089 Plus: Ending inventory 2,354 Less: Beginning inventory (2,792) Cost of goods manufactured $15,651 Less: Manufacturing fixed costs 4,024 Variable cost of goods manufactured $11,627 ** Variable selling and administrative expenses: Selling and administrative expenses $ 1,621 Less: Selling and administrative fixed expenses 930 Variable selling and administrative expenses $

13 Ex (FIN MAN); Ex. 5 9 (MAN) (Concluded) b. The income from operations under the variable costing concept will not be the same as the income from operations under the absorption costing concept when the inventories either increase or decrease during the year. In this case, Whirlpool s inventory decreased, meaning it sold more than it produced. As a result, the income from operations under the variable costing concept will be greater than the income from operations under the absorption costing concept. The reason is because the variable costing concept will deduct the fixed costs in the period that they are incurred, regardless of changes in inventory balances. In contrast, absorption costing will match costs with sales by allocating the fixed costs to the beginning and ending inventories. When sales are less than the cost of goods manufactured (when inventories decrease), fixed costs from the beginning inventory are included in cost of goods sold under absorption costing. Thus, more fixed costs will be included in cost of goods sold than were actually incurred during the period. This will result in a lower income from operations than would be reported under the variable costing concept. The difference between the income from operations under the two concepts can be explained as follows (rounded): Fixed cost portion of Jan. 1 inventory (30% $2,792) $ 838 Less: Fixed cost portion of Dec. 31 inventory (30% $2,354) 706 Difference in income from operations $ 132 Income from operations variable costing $1,088 Income from operations absorption costing 956 Difference $

14 Ex (FIN MAN); Ex (MAN) a. Management s decision and conclusion are incorrect. The profit will not be improved by $114,000 because the fixed costs used in manufacturing and selling running shoes will not be avoided if the line is eliminated. These fixed costs total $192,000 for the running shoe line. Thus, the actual profit will go down by $78,000 ($192,000 $114,000) if the running shoe line is eliminated. This is shown in the variable costing income statements in (b). The absorption costing product profit reports should not be used for making this type of decision. b. KOBEER, INC Variable Costing Income Statements Three Product Lines For the Year Ended December 31, 2014 Basketball Cross Training Running Shoes Shoes Shoes Revenues $696,000 $588,000 $ 504,000 Variable cost of goods sold 252, , ,000 Manufacturing margin $444,000 $378,000 $ 264,000 Variable selling and administrative expenses 204, , ,000 Contribution margin $240,000 $234,000 $ 78,000 Fixed costs: Fixed manufacturing costs $108,000 $ 78,000 $ 96,000 Fixed selling and administrative expenses 84,000 72,000 96,000 $192,000 $150,000 $ 192,000 Income from operations $ 48,000 $ 84,000 $(114,000) c. If the running shoe line were eliminated, then the contribution margin of the product line also would be eliminated. The fixed costs would not be eliminated. Thus, the profit of the company would actually decline by $78,000. Management should keep the line and attempt to improve the profitability of the product by increasing prices, increasing volume, or reducing costs. Alternatively, if the volume of the other two products were to increase, then the running shoe line could be eliminated and replaced with volume from the other two products

15 Ex (FIN MAN); Ex (MAN) Silent No Noise Candy Headphone Headphone Unit volume increase 35,700 39,600 Contribution margin per unit $14.40 $20.20 Increase in profitability $514,080 $799,920 The increase in total profitability would be $1,314,000 ($514,080 + $799,920). Note that the income from operations per unit figures are not used in the analysis, since the fixed costs should be excluded in determining the incremental income from operations to be earned from the incremental sales. This is because the company has sufficient capacity for the additional production. Thus, fixed costs will not be affected by the decision. Ex (FIN MAN); Ex (MAN) a. SNOW MOTOR SPORTS INC. Contribution Margin by Product Revenues Variable cost of goods sold Manufacturing margin Variable selling and administrative expenses Contribution margin Contribution margin ratio ARCTIC CAT $12,600,000 $5,720,000 7,440,000 3,696,000 $ 5,160,000 $2,024,000 1,884, ,600 $ 3,276,000 $1,258, % 22.00% b. The Arctic line provides the largest total contribution margin and the largest contribution margin ratio. If the sales mix were shifted more toward the Arctic, the overall profitability of the company would increase

16 Ex (FIN MAN); Ex (MAN) a. Sales Variable cost of goods sold Manufacturing margin Variable selling expenses Contribution margin Contribution margin ratio COAST TO COAST SURFBOARDS INC. Contribution Margin by Territory East Coast West Coast $8,000,000 $8,000,000 6,000,000 6,000,000 $2,000,000 $2,000,000 1,360,000 1,250,000 $ 640,000 $ 750, % 9.38% b. The total contribution margin is slightly lower for the East Coast, while the contribution margin ratio is slightly higher for West Coast. This is because East Coast sells only Atlantic Waves, which have a lower contribution margin ratio (8.0% vs. 11.7%)* but a higher contribution margin per unit ($16 vs. $14). In attempting to improve the company s profitability, it is unlikely that changing the mix of products to the two territories will have much effect. East Coast will sell very few Pacific Pounders (due to surf style), while West Coast has a mixed surf. However, there appears to be a number of profit opportunities. First, the Atlantic Wave has a manufacturing margin of $50 per unit, while the Pacific Pounder is only $30 per unit. Why such a large difference? Maybe the Pacific Pounder is underpriced or made in inefficient manufacturing processes. Second, the variable selling expense per unit for the Atlantic Wave is much higher than that of the Pacific Pounder ($34 vs. $16). This suggests that the variable selling expenses per unit for the Atlantic Wave may be too high. It seems difficult to justify a more than two-to-one difference in this expense. Reducing the variable selling expense for the Atlantic Wave by half, for example, would have a significant impact on the firm s overall profitability. * 8% = $16 $200, rounded to one decimal place 11.7% = $14 $

17 Ex (FIN MAN); Ex (MAN) a. 1. REYES INDUSTRIES INC. Contribution Margin by Salesperson Cassy G. Todd Tim Jeff Sales $2,688,000 $2,016,000 $2,592,000 $2,964,000 Variable cost of goods sold 1,612, ,400 1,555,200 1,185,600 Manufacturing margin $1,075,200 $1,209,600 $1,036,800 $1,778,400 Variable expense Commission 322, , , ,680 Contribution margin $752,640 $887,040 $622,080 $1,422,720 Contribution margin ratio 28.00% 44.00% 24.00% 48.00% 2. Jeff earns the highest contribution margin and has the highest contribution margin ratio. This is because he sells the most units, has a low commission rate, and sells a product mix with a high manufacturing margin (60% of sales, $1,778,400 $2,964,000). Todd also sells products with a high average manufacturing margin (60% of sales, $1,209,600 $2,016,000) but at a high commission rate. This accounts for the four percentage point difference in the contribution margin ratio between Jeff and Todd. The other two salespersons sell products with lower average manufacturing margins (40% of sales). Combining this with the high commission rate causes Tim to have the poorest contribution margin ratio among the four salespersons. In addition, because Tim has the lowest sales volume and the highest variable cost of goods sold, he also provides the lowest overall contribution margin. Again, the four percentage point difference between Tim and Cassy is due to the difference in their commission rates

18 Ex (FIN MAN); Ex (MAN) (Concluded) b. 1. Sales Variable cost of goods sold Manufacturing margin Variable commission expense Contribution margin Contribution margin ratio REYES INDUSTRIES INC. Contribution Margin by Territory Northeast Southwest $4,704,000 $5,556,000 2,419,200 2,740,800 $2,284,800 $2,815, , ,400 $1,639,680 $2,044, % 36.8% 2. The Southwest Region has $852,000 more sales and $405,120 more contribution margin. In addition, the Southwest Region has the largest contribution margin ratio. In the Southwest Region, the salesperson with the highest sales unit volume also has the highest contribution margin ratio (Jeff). The Southwest Region has the highest performance, even though it also has the salesperson with the lowest contribution margin and contribution margin ratio (Tim). In the Northeast Region, both salespersons are performing similarly. The Northeast Region contribution margin is less than the Southwest Region because of the outstanding performance of Jeff. Jeff is driving the Southwest Region s performance

19 Ex (FIN MAN); Ex (MAN) a. CATERPILLAR, INC. Contribution Margin by Segment (assumed) (in millions, except ratio figures) Building Large Marine & Construction Core Electric Power Petroleum Products Cat Japan Components Earthmoving Power Excavation Systems Logistics Power Mining Turbines Sales $2, $1, $1, $5, $2, $4, $2, $ $2, $3, $3, Variable cost of goods sold , , , , , , , Manufacturing margin $1, $ $ $2, $1, $2, $1, $ $1, $1, $ 1, Dealer commissions $ $ $ $ $ $ $ $ $ $ Variable promotion expenses Variable selling expenses $ $ $ $1, $ $ $ $ $ $ $ Contribution margin $ $ $ $1, $ $1, $ $ $ $1, $1, Contribution margin ratio 32.0% 24.2% 30.8% 29.1% 29.0% 28.8% 31.6% 28.6% 28.3% 28.9% 31.0% b. Building Large Marine & Construction Core Electric Power Petroleum Products Cat Japan Components Earthmoving Power Excavation Systems Logistics Power Mining Turbines Manufacturing margin 55.0% 45.0% 51.0% 49.0% 46.0% 48.0% 47.0% 50.0% 50.0% 48.0% 52.0% Commission 9.0% 11.0% 8.0% 8.0% 10.0% 6.0% 5.0% 10.0% 9.0% 7.0% 9.0% Variable promotion 14.0% 9.8% 12.2% 11.9% 7.0% 13.2% 10.4% 11.4% 12.7% 12.1% 12.0% Contribution margin ratio 32.0% 24.2% 30.8% 29.1% 29.0% 28.8% 31.6% 28.6% 28.3% 28.9% 31.0% Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20 Ex (FIN MAN); Ex (MAN) (Concluded) c. The Building Construction Products segment has the highest contribution margin ratio. The manufacturing margin is high, while the dealer commission rate is average. The variable promotion expenses as a percent of sales is higher than average. Cat Japan is the poorest performing segment in terms of contribution margin ratio. This is because the manufacturing margin is the lowest and dealer commissions are the highest. The high dealer commission is out of balance with the rest of the business segments. This may be the result of the high labor cost structure of Japan. The Large Power Systems are sold mostly to other manufacturers. As a result, each sale has more volume and requires less effort, so the commission rate is lower. This helps the Large Power Systems segment perform well in light of a low manufacturing margin. The Electric Power segment operates similarly to the Large Power Systems segment and exhibits similar contribution margin characteristics

21 Ex (FIN MAN); Ex (MAN) a. Filmed Entertainment Networks Publishing Revenues $11,784.0 $13,562.0 $6,328.0 Variable costs 4, , ,429.6 Contribution margin $ 7,777 $ 9,222 $ 1,898 Contribution margin ratio 66% 68% 30% b. The Filmed Entertainment and Networks segments sell an information or media product that has a very small variable cost per unit. For example, the Networks segment earns revenue monthly from each customer. However, the variable cost of each customer is rather small. The cost of providing the service is essentially fixed. The same holds true for the Filmed Entertainment segment. The variable cost per ticket sold to a motion picture is rather small. The costs of producing and promoting a new film are essentially fixed to the number of tickets sold. The studio will have enough capacity to release a set number of films per year. The costs will be incurred regardless of the number of tickets sold. The same logic holds for HBO and the cable network. Much of their costs are fixed to the number of subscribers. The Publishing segment produces and sells products that do have a variable cost per unit. The total cost of producing a magazine will increase as more units are sold. The editorial costs will likely be fixed, but the printing and distribution costs will be variable to the number of units sold. Thus, the Publishing segment will have a much lower contribution margin ratio than the other segments. c. The higher contribution margin ratios of the Filmed Entertainment and Networks segments should not be interpreted as being the most profitable. The fixed costs cannot be ignored. These segments will have high fixed costs. If the volume of business is not sufficient to exceed the break-even point, then the segments would be unprofitable. In the final analysis, the fixed costs also should be considered in determining the overall profitability of the segments. The contribution margin ratio shows how sensitive the profit will be to changes in volume. These segments increase their profitability rapidly with increases in subscription or audience volume, compared to the Publishing segment

22 Ex (FIN MAN); Ex (MAN) a. BUY BEST INC. Contribution Margin Analysis Sales For the Year Ended December 31, 2015 Effect of change in sales: Sales quantity factor (36,000 32,250) $32.50 $121,875 Unit price factor ($30 $32.50) 36,000 (90,000) Total effect of change in sales* $31,875 * This represents the total effect that the change in sales has on Buy Best Inc. s contribution margin. b. The sales will increase by $31,875. If the variable cost per unit were $10, and there were 3,750 more units than planned, then the variable cost will increase by $37,500 due to the variable cost quantity factor. Thus, the contribution margin will decrease by $5,625 ($37,500 $31,875) as a result of the price reduction. Ex (FIN MAN); Ex (MAN) ROMERO PRODUCTS INC. Contribution Margin Analysis Sales For the Year Ended December 31, 2014 Effect of change in sales: Sales quantity factor (38,000 41,000) $200 $(600,000) Unit price factor ($220 $200) 38, ,000 Total effect of change in sales* $160,000 * This represents the total effect that change in sales has on Romero Products Inc. s contribution margin

23 Ex (FIN MAN); Ex (MAN) ROMERO PRODUCTS INC. Contribution Margin Analysis Variable Costs For the Year Ended December 31, 2014 Effect of changes in variable costs of goods sold: Variable cost quantity factor (41,000 38,000) $80 $ 240,000 Unit cost factor ($80 $92) 38,000 (456,000) Total effect of change in variable cost of goods sold $(216,000) Effect of changes in variable selling and administrative expenses: Variable cost quantity factor (41,000 38,000) $22 $ 66,000 Unit cost factor ($22 $20) 38,000 76,000 Total effect of changes in selling and 142,000 administrative expenses Decrease in contribution margin from change in variable costs $ (74,000) 20-23

24 Ex (FIN MAN); Ex (MAN) a. EAST COAST RAILROAD Contribution Margin by Route For the Month Ended April 30, 2014 Atlanta/ Baltimore/ Pittsburgh/ Baltimore Pittsburgh Atlanta Total Revenues $255,000 $594,000 $542,080 $1,391,080 Variable costs: Labor costs for loading and unloading railcars $ 19,550 $ 99,360 $ 56,672 $ 175,582 Fuel costs 159, , , ,226 Train crew labor costs 92,412 73, , ,228 Switchyard labor costs 13,175 66,960 38, ,327 Total variable costs $284,291 $366,240 $370,832 $1,021,363 Contribution margin $ (29,291) $227,760 $171,248 $ 369,717 Contribution margin ratio 11.5% 38.3% 31.6% 26.6% Revenues: Revenue per railcar Number of railcars Labor costs for loading and unloading railcars: $46.00 Number of railcars Fuel costs: $12.40 Number of train-miles Train crew labor costs: $7.20 Number of train-miles Switchyard labor costs: $31 Number of railcars b. The Atlanta/Baltimore route performs significantly worse than do the other two routes. A close examination of the operating statistics indicates that this route runs very few railcars, combined with fairly high total mileage. This combination suggests that the railroad is running many short trains on the railroad. That is, the railroad s profitability is very sensitive to the size, or length, of the train in railcar terms. A short train costs nearly as much fuel and crewing costs as does a longer train. Thus, short trains will be inherently less profitable than longer trains. The other two routes have much better ratios of train-miles to railcars, indicating that their train sizes are larger. Note to Instructors: Part (b) is somewhat subtle but a worthy discussion. The cost behavior issues discussed in (b) are common in service companies. For example, large classes in a university are inherently more profitable than small classes, dense data traffic on a telecommunication system is more profitable than less traffic, full airplanes are more profitable than empty airplanes, and faster table turns in a restaurant create greater profitability than do slower turns, etc

25 Ex (FIN MAN); Ex (MAN) a. EAST COAST RAILROAD Contribution Margin for Atlanta/Baltimore Route For the Month Ended May 31, 2014 Revenues ($ railcars) $350,000 Labor costs for loading and unloading railcars ($ railcars) $ 32,200 Fuel costs ($ ,835 train-miles) 159,154 Train crew labor costs ($ ,835 train-miles) 92,412 Switchyard labor costs ($ railcars) 21,700 Total variable costs $305,466 Contribution margin $ 44,534 Contribution margin ratio 12.7% b. EAST COAST RAILROAD Contribution Margin Analysis Atlanta/Baltimore Route For the Month Ended May 31, 2014 Planned contribution margin $(29,291) Effect of change in sales: Sales quantity factor ( ) $600 $165,000 Unit price factor ($500 $600) 700 (70,000) Total effect of change in sales 95,000 Effect of changes in variable cost of goods sold: Variable cost quantity factor ( ) $77* $ (21,175) Unit cost factor ($77 $77) Total effect of changes in variable cost of goods sold (21,175) Actual contribution margin $ 44,534 * $46 per car + $31 per car Note to Instructors: If Exercise was assigned, the increase in contribution margin can be reconciled. The increase in the contribution margin is reconciled from the planned contribution margin for the route from Exercise of $(29,291) to the actual contribution margin of $44,534 in part (b)

26 Ex (FIN MAN); Ex (MAN) a. UNDERWATER UNIVERSITY Variable Costing Income Statement For the Fall Term 2014 Revenue $7,254,000 Variable costs: Registration, records, and marketing cost $1,237,500 Instructional costs 3,868,800 Total variable costs $5,106,300 Contribution margin $2,147,700 Depreciation on classrooms and equipment 825,600 Income from operations $1,322,100 Supporting Calculations Revenue: $120 60,450 credit hours Registration, records, and marketing costs: $275 4,500 students Instructional costs: $64 60,450 credit hours b. UNDERWATER UNIVERSITY Contribution Margin Analysis For the Fall Term 2014 Planned contribution margin* $ 2,105,625 Effect of change in revenue: Revenue quantity factor (60,450 43,200) $135 $ 2,328,750 Unit price factor ($120 $135) 60,450 (906,750) Total effect of change in sales 1,422,000 Effect of changes in registration, records, and marketing costs: Variable cost quantity factor (4,125 4,500) $275 $ (103,125) Unit cost factor ($275 $275) 4,500 0 Total effect of changes in registration, (103,125) records, and marketing costs Effect of changes in instructional costs: Variable cost quantity factor (43,200 60,450) $60 $(1,035,000) Unit cost factor ($60 $64) 60,450 (241,800) Total effect of changes in instructional cost (1,276,800) Actual contribution margin $ 2,147,700 Note: There was no unit cost change for registration, records, and marketing cost. * $5,832,000 $1,134,375 $2,592,

27 Prob. 20 1A (FIN MAN); Prob. 5 1A (MAN) PROBLEMS 1. ICE COLD FRIDGE COMPANY Absorption Costing Income Statement For the Month Ended May 31, 2014 Sales $4,095,000 Cost of goods sold: Cost of goods manufactured $3,465,000 Less inventory, May 31 (1,120 units $198.00*) 221,760 Cost of goods sold 3,243,240 Gross profit $ 851,760 Selling and administrative expenses 475,020 Income from operations $ 376,740 * $3,465,000 17,500 units = $ ICE COLD FRIDGE COMPANY Variable Costing Income Statement For the Month Ended May 31, 2014 Sales $4,095,000 Variable cost of goods sold: Variable cost of goods manufactured $3,202,500 Less inventory, May 31 (1,120 units $183.00*) 204,960 Variable cost of goods sold 2,997,540 Manufacturing margin $1,097,460 Variable selling and administrative expenses 327,600 Contribution margin $ 769,860 Fixed costs: Fixed manufacturing costs $ 262,500 Fixed selling and administrative expenses 147, ,920 Income from operations $ 359,940 * $3,202,500 17,500 units = $ The income from operations reported under absorption costing exceeds the income from operations reported under variable costing by $16,800 ($376,740 $359,940). This $16,800 is due to including $16,800 of fixed manufacturing cost in inventory under absorption costing [1,120 units 15 ($262,500 17,500)]. The $16,800 was thus deferred to a future month under absorption costing, while it was included as an expense of May (part of fixed costs) under variable costing

28 Prob. 20 2A (FIN MAN); Prob. 5 2A (MAN) 1. HEYWARD INDUSTRIES INC. Estimated Income Statement Absorption Costing Solvent For the Month Ending May 31, 2015 Sales (2,925 units) $315,900 Cost of goods sold: Direct materials $117,000 Direct labor 52,650 Variable manufacturing cost 43,875 Fixed manufacturing cost 70,000 Cost of goods sold 283,525 Gross profit $ 32,375 Selling and administrative expenses: Variable selling and administrative expenses $ 35,100 Fixed selling and administrative expenses 36,500 71,600 Loss from operations $ (39,225) 2. HEYWARD INDUSTRIES INC. Estimated Income Statement Variable Costing Solvent For the Month Ending May 31, 2015 Sales (2,925 units) $315,900 Variable cost of goods sold: Direct materials $117,000 Direct labor 52,650 Variable manufacturing cost 43, ,525 Manufacturing margin $102,375 Variable selling and administrative expenses 35,100 Contribution margin $ 67,275 Fixed costs: Fixed manufacturing cost $ 70,000 Fixed selling and administrative expenses 36, ,500 Loss from operations $ (39,225) 3. $106,500. The loss from operations from temporarily closing the portion of the plant associated with solvent would be $106,500 (fixed manufacturing cost of $70,000 plus fixed selling and administrative expenses of $36,500). 4. Production of solvent should be continued. Temporary suspension of production would result in an operating loss of $106,500 [from (3) above], compared with a loss from operations of $39,225 if production is continued. The savings of $67,275, measured by the excess of $106,500 over $39,225, is the amount reported as contribution margin on the variable costing income statement

29 Prob. 20 3A (FIN MAN); Prob. 5 3A (MAN) 1. a. HIP AND CONSCIOUS CLOTHING COMPANY Absorption Costing Income Statement For the Month Ended January 31, 2015 Sales $771,750 Cost of goods sold: Cost of goods manufactured $715,950 Less inventory, January 31 (4,050 units $12.90*) 52,245 Cost of goods sold 663,705 Gross profit $108,045 Selling and administrative expenses 61,740 Income from operations $ 46,305 * $715,950 55,500 units = $12.90 b. HIP AND CONSCIOUS CLOTHING COMPANY Absorption Costing Income Statement For the Month Ended February 28, 2015 Sales $771,750 Cost of goods sold: Inventory, February 1 (4,050 units $12.90) $ 52,245 Cost of goods manufactured 619,560 Cost of goods sold 671,805 Gross profit $ 99,945 Selling and administrative expenses 61,740 Income from operations $ 38, a. HIP AND CONSCIOUS CLOTHING COMPANY Variable Costing Income Statement For the Month Ended January 31, 2015 Sales $771,750 Variable cost of goods sold: Variable cost of goods manufactured $660,450 Less inventory, January 31 (4,050 units $11.90*) 48,195 Variable cost of goods sold 612,255 Manufacturing margin $159,495 Variable selling and administrative expenses 36,015 Contribution margin $123,480 Fixed costs: Fixed manufacturing costs $ 55,500 Fixed selling and administrative expenses 25,725 81,225 Income from operations $ 42,255 * $660,450 55,500 units = $

30 Prob. 20 3A (FIN MAN); Prob. 5 3A (MAN) (Concluded) 2. b. HIP AND CONSCIOUS CLOTHING COMPANY Variable Costing Income Statement For the Month Ended February 28, 2015 Sales $771,750 Variable cost of goods sold: Inventory, February 1 (4,050 units $11.90) $ 48,195 Variable cost of goods manufactured 564,060 Variable cost of goods sold 612,255 Manufacturing margin $159,495 Variable selling and administrative expenses 36,015 Contribution margin $123,480 Fixed costs: Fixed manufacturing costs $ 55,500 Fixed selling and administrative expenses 25,725 81,225 Income from operations $ 42, a. For January, the income from operations reported under absorption costing exceeds the income from operations reported under variable costing by $4,050. This difference is due to including $4,050 of fixed manufacturing cost in inventory under absorption costing [4,050 units $1.00 ($55,500 55,500)]. The $4,050 was thus deferred to February under absorption costing, while it was included as an expense of January (part of fixed costs) under variable costing. b. For February, the income from operations reported under absorption costing is less than the income from operations reported under variable costing by $4,050. This difference is due to including $4,050 of fixed manufacturing cost in the February 1 inventory under absorption costing (4,050 units $1.00). Thus, this $4,050 was included in February s cost of goods sold under absorption costing. Under variable costing, this $4,050 was included as an expense of January (part of the fixed costs) and thus is excluded from February s income statement. 4. The Hip and Conscious Clothing Company was equally profitable in January and February under the variable costing concept. Sales and the variable cost per unit were the same for both January and February. The difference in income reported under the absorption costing concept is due to allocating $4,050 of fixed manufacturing cost to the January 31 ending inventory. Note: The combined income from operations reported for January and February ($84,510) is the same for both absorption costing and variable costing. This problem illustrates the need for management to exercise care in interpreting income from operations reported under absorption costing when large changes in inventory levels occur

31 Prob. 20 4A (FIN MAN); Prob. 5 4A (MAN) 1. VICTORN INSTRUMENTS COMPANY Salespersons Analysis For the Year Ended December 31, 2014 Variable Variable Cost Selling of Goods Sold Expenses Contribution Contribution as a Percent as a Percent Margin Salesperson Margin of Sales of Sales Ratio Case $147, % 19.0% 31.0% Dix 139, % 21.0% 29.0% Johnson 140, % 18.0% 36.0% LaFave 177, % 18.0% 41.0% Orcas 171, % 18.0% 38.0% Sussman 312, % 16.0% 53.0% Willbond 157, % 19.0% 37.0% 2. Sussman has the highest contribution margin and contribution margin ratio for the year. This is because of two factors. First, Sussman has the smallest variable cost of goods sold as a percent of sales. This is probably due to selling a favorable mix of product that has high manufacturing margins as a percent of sales. Second, Sussman has the lowest variable selling expenses as a percent of sales. This could be due to a lower sales commission or selling support costs. 3. Other factors that should be considered in evaluating the performance of salespersons include rate of growth in sales for the current year compared with past years, years of experience for salespersons, size of sales territory, and actual sales compared with budgeted sales

32 Prob. 20 5A (FIN MAN); Prob. 5 5A (MAN) 1. VALDESPIN COMPANY Contribution Margin by Size Segment For the Year Ended June 30, 2014 Size S M L Total Sales $668,000 $737,300 $956,160 $2,361,460 Variable cost of goods sold 300, , ,760 1,094,880 Manufacturing margin $368,000 $380,180 $518,400 $1,266,580 Variable operating expenses 132, , , ,820 Contribution margin $235,520 $224,680 $322,560 $ 782,760 Fixed costs: Manufacturing costs $ 385,930 Operating expenses 311,040 Total fixed costs $ 696,970 Income from operations $ 85, Annual income from operations would be reduced below its present level by $146,360 if Size M were to be discontinued (Proposal 2), as indicated below: Contribution margin for Size M $224,680 Less reduction in fixed production costs and fixed operating expenses ($46,080 + $32,240) 78,320 Reduction in annual income from operations $146,360 If Size M is discontinued, $224,680 of contribution margin would be forgone and only $78,320 in fixed costs would be saved, resulting in a decrease of $146,360 in income from operations

33 Prob. 20 5A (FIN MAN); Prob. 5 5A (MAN) (Concluded) 3. VALDESPIN COMPANY Contribution Margin Proposal 3 Size S L Total Sales $1,536,400 $956,160 $2,492,560 Variable cost of goods sold 690, ,760 1,127,760 Manufacturing margin $846,400 $518,400 $1,364,800 Variable operating expenses 304, , ,544 Contribution margin $ 541,696 $322,560 $ 864,256 Fixed costs: Manufacturing costs $ 385,930 Operating expenses (including $34,560 additional rent) 345,600 Total fixed costs $ 731,530 Income from operations $ 132, $46,936. A comparison of the amount of income from operations under present conditions, as indicated in (1), and under Proposal 3, as indicated in (3), suggests an increase of $46,936 if Proposal 3 is accepted, as illustrated below. Income from operations, Proposal 3 $132,726 Income from operations, present conditions 85,790 Increase in income from operations $ 46,936 Alternatively, the $46,936 increase can be determined as follows: Contribution margin, Size S, Proposal 3 $541,696 Contribution margin, Size S, present operations 235,520 Increase in contribution margin $306,176 Less contribution margin, Size M, present operations $224,680 Additional rent 34, ,240 Increase in income from operations $ 46,

34 Prob. 20 6A (FIN MAN); Prob. 5 6A (MAN) 1. DOZIER INDUSTRIES INC. Contribution Margin Analysis For the Year Ended December 31, 2014 Planned contribution margin $1,386,000 Effect of change in sales: Sales quantity factor (19,250 22,000) $125 $(343,750) Unit price factor ($144 $125) 19, ,750 Total effect of change in sales 22,000 Effect of changes in variable cost of goods sold: Variable cost quantity factor (22,000 19,250) $51 $ 140,250 Unit cost factor ($51 $55) 19,250 (77,000) Total effect of changes in variable cost of goods sold 63,250 Effect of changes in variable selling and administrative expenses: Variable cost quantity factor (22,000 19,250) $11 $ 30,250 Unit cost factor ($11 $15) 19,250 (77,000) Total effect of changes in variable selling and administrative expenses (46,750) Actual contribution margin $1,424, The president s first statement appears correct taken at face value. The president is incorrect regarding variable cost of goods sold. The majority of the decrease in the variable cost of goods sold was due to the variable cost quantity factor. However, this decrease was offset by a $4.00 increase in the variable cost of goods sold per unit. The contribution margin improved, but some inefficiency reduced the expected amount of improvement from the variable cost quantity factor. The president is correct in saying that an investigation of the increase in variable selling and administrative expenses is needed. The unit cost factor increased by $4.00, which more than offset the favorable variable cost quantity factor, resulting in an overall decrease in the contribution margin. The increase in the variable selling and administrative expenses is probably due to the additional selling effort required in the face of price increases. It will probably be very difficult to improve the efficiency of this effort as prices go up. Therefore, the president s suggestion is probably unwarranted. Increasing the price again will require even more selling effort to overcome this negative influence. In addition, there is a limit as to how much price increase the market will likely be able to support

35 Prob. 20 1B (FIN MAN); Prob. 5 1B (MAN) 1. YOSAN INC. Absorption Costing Income Statement For the Month Ended July 31, 2014 Sales $2,150,000 Cost of goods sold: Cost of goods manufactured $1,824,000 Less inventory, July 31 (400 units $760*) 304,000 Cost of goods sold 1,520,000 Gross profit $ 630,000 Selling and administrative expenses 300,000 Income from operations $ 330,000 * $1,824,000 2,400 units = $ YOSAN INC. Variable Costing Income Statement For the Month Ended July 31, 2014 Sales $2,150,000 Variable cost of goods sold: Variable cost of goods manufactured $1,536,000 Less inventory, July 31 (400 units $640*) 256,000 Variable cost of goods sold 1,280,000 Manufacturing margin $ 870,000 Variable selling and administrative expenses 204,000 Contribution margin $666,000 Fixed costs: Fixed manufacturing costs $ 288,000 Fixed selling and administrative expenses 96, ,000 Income from operations $ 282,000 * $1,536,000 2,400 units = $ The income from operations reported under absorption costing exceeds the income from operations reported under variable costing by $48,000 ($330,000 $282,000). This difference is due to including $48,000 of fixed manufacturing cost in inventory under absorption costing [400 units $120 ($288,000 2,400)]. The $48,000 was thus deferred to a future month under absorption costing, while it was included as an expense of July (part of fixed costs) under variable costing

36 Prob. 20 2B (FIN MAN); Prob. 5 2B (MAN) 1. SMOOTH SKIN CARE PRODUCTS INC. Estimated Income Statement Absorption Costing Aloe Vera Hand Lotion For the Month Ending February 28, 2014 Sales (320,000 units) $25,600,000 Cost of goods sold: Direct materials $ 4,800,000 Direct labor 5,440,000 Variable manufacturing cost 11,200,000 Fixed manufacturing cost 1,530,000 Cost of goods sold 22,970,000 Gross profit $ 2,630,000 Selling and administrative expenses: Variable selling and administrative expenses $ 3,200,000 Fixed selling and administrative expenses 270,000 3,470,000 Operating loss $ (840,000) 2. SMOOTH SKIN CARE PRODUCTS INC. Estimated Income Statement Variable Costing Aloe Vera Hand Lotion For the Month Ending February 28, 2014 Sales (320,000 units) $25,600,000 Variable cost of goods sold: Direct materials $ 4,800,000 Direct labor 5,440,000 Variable manufacturing cost 11,200,000 21,440,000 Manufacturing margin $ 4,160,000 Variable selling and administrative expenses 3,200,000 Contribution margin $ 960,000 Fixed costs: Fixed manufacturing cost $ 1,530,000 Fixed selling and administrative expenses 270,000 1,800,000 Operating loss $ (840,000) 3. $1,800,000. The operating loss from temporarily closing the portion of the plant associated with A.V. lotion would be $1,800,000 (fixed manufacturing cost of $1,530,000 plus fixed selling and administrative expenses of $270,000). This assumes that the variable costs would be eliminated with the shutdown. 4. Production of A.V. lotion should be continued. Temporary suspension of production would result in an operating loss of $1,800,000 [from (3) above], compared with an operating loss of $840,000 if production is continued. The savings of $960,000, measured by the excess of $1,800,000 over $840,000, is the amount reported as contribution margin on the variable costing income statement

37 Prob. 20 3B (FIN MAN); Prob. 5 3B (MAN) 1. a. HEAD GEAR INC. Absorption Costing Income Statement For the Month Ended January 31, 2014 Sales $104,000 Cost of goods sold: Cost of goods manufactured $97,280 Less inventory, January 31 (1,200 units $15.20*) 18,240 Cost of goods sold 79,040 Gross profit $ 24,960 Selling and administrative expenses 16,120 Income from operations $ 8,840 * $97,280 6,400 units = $15.20 b. HEAD GEAR INC. Absorption Costing Income Statement For the Month Ended February 28, 2014 Sales $104,000 Cost of goods sold: Inventory, February 1 (1,200 units $15.20) $18,240 Cost of goods manufactured 66,560 Cost of goods sold 84,800 Gross profit $ 19,200 Selling and administrative expenses 16,120 Income from operations $ 3, a. HEAD GEAR INC. Variable Costing Income Statement For the Month Ended January 31, 2014 Sales $104,000 Variable cost of goods sold: Variable cost of goods manufactured $81,920 Less inventory, January 31 (1,200 units $12.80*) 15,360 Variable cost of goods sold 66,560 Manufacturing margin $ 37,440 Variable selling and administrative expenses 10,920 Contribution margin $ 26,520 Fixed costs: Fixed manufacturing costs $15,360 Fixed selling and administrative expenses 5,200 20,560 Income from operations $ 5,960 * $81,920 6,400 units = $

38 Prob. 20 3B (FIN MAN); Prob. 5 3B (MAN) (Concluded) 2. b. HEAD GEAR INC. Variable Costing Income Statement For the Month Ended February 28, 2014 Sales $104,000 Variable cost of goods sold: Inventory, February 1 (1,200 units $12.80) $15,360 Variable cost of goods manufactured 51,200 Variable cost of goods sold 66,560 Manufacturing margin $ 37,440 Variable selling and administrative expenses 10,920 Contribution margin $ 26,520 Fixed costs: Fixed manufacturing costs $15,360 Fixed selling and administrative expenses 5,200 20,560 Income from operations $ 5, a. For January, the income from operations reported under absorption costing exceeds the income from operations reported under variable costing by $2,880. This difference is due to including $2,880 of fixed cost in inventory under absorption costing [1,200 units $2.40 ($15,360 6,400)]. The $2,880 was thus deferred to February under absorption costing, while it was included as an expense of January (part of fixed costs) under variable costing. b. For February, the income from operations reported under absorption costing is less than the income from operations reported under variable costing by $2,880. This difference is due to including $2,880 of fixed cost in the February 1 inventory under absorption costing (1,200 units $2.40). Thus, this $2,880 was included in February s cost of goods sold under absorption costing. Under variable costing, this $2,880 was included as an expense of January (part of the fixed costs) and thus is excluded from February s income statement. 4. Head Gear Inc. was equally profitable in January and in February under the variable costing concept. Sales and the variable cost per unit were the same for both January and February. The difference in income reported under the absorption costing concept is due to allocating $2,880 of fixed manufacturing cost to the January 31 ending inventory. Note: The combined income from operations reported for January and February ($11,920) is the same for both absorption costing and variable costing. This problem illustrates the need for management to exercise care in interpreting income from operations reported under absorption costing when large changes in inventory levels occur

39 Prob. 20 4B (FIN MAN); Prob. 5 4B (MAN) 1. PACHEC INC. Salespersons Analysis For the Year Ended June 30, 2014 Variable Variable Cost Selling of Goods Sold Expenses Contribution Contribution as a Percent as a Percent Margin Salesperson Margin of Sales of Sales Ratio Asarenka $157, % 19.0% 36.0% Crowell 250, % 16.0% 44.0% Dempster 222, % 21.0% 33.0% MacLean 217, % 21.0% 37.0% Ortiz 183, % 24.0% 35.0% Sullivan 240, % 17.0% 41.0% Williams 207, % 20.0% 36.0% 2. Crowell has the highest contribution margin and contribution margin ratio for the year. This is because of two factors. First, Crowell had the smallest variable cost of goods sold as a percent of sales. This is probably due to selling a favorable mix of product that has high manufacturing margins as a percent of sales. Second, Crowell has the lowest variable selling expenses as a percent of sales. This could be due to a lower sales commission or selling support costs. 3. Other factors that should be considered in evaluating the performance of salespersons include rate of growth in sales for the current year compared with past years, years of experience for salespersons, size of sales territory, and actual sales compared with budgeted sales

40 Prob. 20 5B (FIN MAN); Prob. 5 5B (MAN) 1. KIMBRELL, INC. Contribution Margin by Size Segment For the Year Ended January 31, 2015 Size S M L Total Sales $990,000 $1,087,500 $945,000 $3,022,500 Variable cost of goods sold 538, , ,000 1,824,000 Manufacturing margin $451,500 $ 369,000 $378,000 $1,198,500 Variable operating expenses 118, ,750 85, ,900 Contribution margin $333,400 $ 260,250 $292,950 $ 886,600 Fixed costs: Manufacturing costs $ 779,000 Operating expenses 88,900 Total fixed costs $ 867,900 Income from operations $ 18, Annual income from operations would be reduced below its present level by $89,400 if Size M were to be discontinued (Proposal 2), as indicated below. Contribution margin for Size M $260,250 Less reduction in fixed production costs and fixed operating expenses ($142,500 + $28,350) 170,850 Reduction in annual income from operations $ 89,400 If Size M is discontinued, $260,250 of contribution margin would be forgone and only $170,850 in fixed costs would be saved, resulting in a decrease of $89,400 in income from operations

41 Prob. 20 5B (FIN MAN); Prob. 5 5B (MAN) (Concluded) 3. KIMBRELL, INC. Contribution Margin Proposal 3 Size S L Total Sales $2,277,000 $945,000 $3,222,000 Variable cost of goods sold 1,238, ,000 1,805,550 Manufacturing margin $1,038,450 $378,000 $1,416,450 Variable operating expenses 271,630 85, ,680 Contribution margin $ 766,820 $292,950 $1,059,770 Fixed costs: Manufacturing costs $ 779,000 Operating expenses (including $85,050 additional salary) 173,950 Total fixed costs $ 952,950 Income from operations $ 106, $88,120. A comparison of the amount of income from operations under present conditions, as indicated in (1), and under Proposal 3, as indicated in (3), suggests an increase of $88,120 if Proposal 3 is accepted, as illustrated below. Income from operations, Proposal 3 $106,820 Income from operations, present conditions 18,700 Increase in income from operations $ 88,120 Alternatively, the $88,120 increase can be determined as follows: Contribution margin, Size S, Proposal 3 $766,820 Contribution margin, Size S, present operations 333,400 Increase in contribution margin $433,420 Less contribution margin, Size M, present operations $260,250 Additional salaries 85, ,300 Increase in income from operations $ 88,

42 Prob. 20 6B (FIN MAN); Prob. 5 6B (MAN) 1. MATHEWS COMPANY Contribution Margin Analysis For the Year Ended December 31, 2014 Planned contribution margin $540,000 Effect of change in sales: Sales quantity factor (34,500 30,000) $69 $ 310,500 Unit price factor ($66 $69) 34,500 (103,500) Total effect of change in sales 207,000 Effect of changes in variable cost of goods sold: Variable cost quantity factor (30,000 34,500) $33 $(148,500) Unit cost factor ($33 $30) 34, ,500 Total effect of changes in variable cost of (45,000) goods sold Effect of changes in variable selling and administrative expenses: Variable cost quantity factor (30,000 34,500) $18 $ (81,000) Unit cost factor ($18 $24) 34,500 (207,000) Total effect of changes in variable selling and administrative expenses (288,000) Actual contribution margin $ 414, No, the president is not correct in saying that the variable cost of goods sold got out of control in The majority of the increase in the variable cost of goods sold was due to the variable cost quantity factor. Specifically, the increase of 4,500 units in the quantity of product sold increased the variable cost of goods sold by $148,500, based on planned unit costs. Actually, the unit cost of variable cost of goods sold decreased $3.00, which had a favorable effect of $103,500 on the contribution margin. The president is correct in saying that an investigation of the increase in variable selling and administrative expenses is needed. Of the $288,000 increase in these expenses, only $81,000 was due to the quantity factor. The unit cost increase of $6.00 for selling and administrative expenses does raise concern. This increase may have been caused by additional selling expenses associated with the increased sales. The increase in selling and administrative expenses also could have been caused by increased marketing and advertising expenditures to promote the price decrease. Thus, the increase in sales may not have been caused entirely by the lowering of the unit sales price. If this is the case, the president should exercise caution in deciding to lower the selling price further to increase sales. In addition, the reduction in sales price does not generate sufficient volume to compensate for the variable cost quantity factor. Therefore, reducing the price further will not likely be a successful strategy

43 CASES & PROJECTS CP 20 1 (FIN MAN); CP 5 1 (MAN) Aston Melon has performed the task requested by the division manager. However, Aston Melon has not exercised good judgment, to the point of bordering on unethical behavior. Aston Melon should question the wisdom of manipulating the amount of inventory solely for purposes of meeting numerical profit targets. The Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management states that the management accountant should recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. In addition, the management accountant should communicate unfavorable as well as favorable information and professional judgments or opinions. The absorption costing income statements could mislead the senior management overseeing the division managers. It may erroneously conclude that the division has become more efficient. Moreover, it may not be wise for the division to build more inventory. The excess inventory may need to be sold at a later date at fire sale prices. Thus, the division actually may be worse off in the long run by building the excess inventory. Aston Melon has a responsibility to communicate these concerns to the general manager. As a last resort, Aston Melon may need to report the concerns to the company s senior management if the division manager refuses to respond favorably

44 CP 20 2 (FIN MAN); CP 5 2 (MAN) 1. Absorption costing is required under generally accepted accounting principles. Under this approach, the fixed manufacturing costs are allocated to sold and inventoried units. Thus, if production exceeds sales, a portion of the fixed manufacturing cost is included in the ending inventory balance and not matched against current period sales. This has the effect of reducing cost of goods sold by the amount of fixed costs allocated to the inventory. Thus, net income is improved by increasing inventory. Likewise, when sales exceed production and the inventory is liquidated, the fixed manufacturing cost in the beginning goods sold by the amount of fixed costs included in the beginning inventory. Therefore, net income is reduced when inventory is liquidated. 2. Gordon is incorrect in implying that nothing can be done because of generally accepted accounting principles (GAAP). GAAP is required for external financial reporting. However, the income reports used to guide management may be developed under the variable costing concept. Under variable costing, the fixed manufacturing cost is not allocated to sold goods and inventory. Rather, fixed manufacturing cost is allocated to the period in which it is incurred. Treating fixed manufacturing cost in this way causes net income to be unaffected by either inventory building or reduction. Changes in net income under variable costing only occur from business events such as changes in volume, price, or cost. Reporting under variable costing would address Matt s concern by tying profit more directly to profit-changing business events rather than inventory decisions

45 CP 20 3 (FIN MAN); CP 5 3 (MAN) Martin is earning more contribution margin than Dean; however, both salespersons are earning the same contribution margin ratio. Dean s total sales are less than Martin s. However, the manufacturing margin ratio is much different between the two salespersons. Dean is selling products with a much higher manufacturing margin than is Martin. This indicates that Dean is selling a more attractive product mix than is Martin. Unfortunately, Dean s very attractive manufacturing margin is offset by very high promotional costs (as a percent of sales). As a result, Dean s final contribution margin ratio is no better than Martin s. Both employees apparently earn the same commission rate of 14% of sales. Thus, the promotion expenses as a percent of sales for Dean (18%) are much greater than for Martin (9%). In summary, Martin should be encouraged to sell products with higher manufacturing margins, while Dean should be encouraged to trim promotional costs. Both salespersons should be encouraged to improve total sales volume (with a little more encouragement going to Dean). As a final point, it may be the case that the high manufacturing margin product mix sold by Dean requires extensive promotional support. For example, maybe Dean is selling newly introduced products that have high margins but require extensive launch-related promotional expenses. In this case, there may be little opportunity for Dean to improve profitability, except by increasing total sales. CP 20 4 (FIN MAN); CP 5 4 (MAN) 1. Danica Kyle Richard Tom Manufacturing margin as a percent of sales 65% 50% 50% 50% Contribution margin ratio 32% 22% 22% 22% 2. Danica has the highest contribution margin and contribution margin ratio of the four salespersons, even though Danica s sales level is ranked third. There are two reasons for Danica s superior performance. First, Danica sells products that have the highest manufacturing margin (65% vs. 50% for the others). This means that Danica is selling a more profitable mix of products than the other three salespersons. However, Danica spends more on variable selling expenses as a percent of sales than do the other three salespersons (33% vs. 28% for the others). Together these two explanations cause Danica to have a contribution margin ratio that is 10 percentage points higher than the other three salespersons. As a result, Danica is able to contribute more profit than either Kyle or Richard, both of whom have higher sales

46 CP 20 5 (FIN MAN); CP 5 5 (MAN) 1. TRANS SPORT COMPANY Contribution Margin by State Florida Georgia Tennessee Revenue $1,125,000 $1,000,000 $1,181,250 Variable cost of goods sold 450, , ,000 Manufacturing margin $ 675,000 $ 690,000 $ 745,250 Variable operating expenses 281, , ,375 Contribution margin $ 393,775 $ 487,500 $ 438,875 Contribution margin ratio 35.0% 48.8% 37.2% Note: The variable cost of goods sold and variable selling expenses are determined by subtracting the respective fixed costs from the cost of goods sold and selling expenses found on the income statement. 2. Florida Georgia Tennessee Increase in contribution margin $78,755 $97,500 $87,775 Less additional advertising 42,200 42,200 42,200 Additional profit $36,555 $55,300 $45,575 Note: The increase in contribution margin is determined by multiplying the contribution margin in (1) by 20%. 3. Georgia will generate the greatest profit increase for an additional $42,200 in advertising. This may seem surprising, because the profit report indicates that Georgia is the least profitable on an absorption costing basis. However, Georgia also has the largest fixed costs. These costs will not change with a change in sales volume. Thus, the contribution margin and contribution margin ratio for Georgia are actually higher than the other two states [from (1)]. Increasing sales volume by 20% will produce the greatest increase in contribution margin in Georgia. Increases in contribution margin translate directly into increases in income from operations because the fixed costs are not expected to change beyond the increase in advertising

47 CP 20 6 (FIN MAN); CP 5 6 (MAN) 1. CRAIG COMPANY Absorption Costing Income Statement 44,000 units manufactured For the Year Ended December 31, 2014 Sales (44,000 $106) $4,664,000 Cost of goods sold (44,000 $61) 2,684,000 Gross profit $1,980,000 Selling and administrative expenses ($1,050,000 + $330,000) 1,380,000 Income from operations $ 600,000 CRAIG COMPANY Absorption Costing Income Statement 55,000 units manufactured For the Year Ended December 31, 2014 Sales (44,000 $106) $4,664,000 Cost of goods sold: Cost of goods manufactured (55,000 $58.8) $3,234,000 Less inventory, December 31 (11,000 $58.8) 646,800 Cost of goods sold 2,587,200 Gross profit $2,076,800 Selling and administrative expenses ($1,050,000 + $330,000) 1,380,000 Income from operations $ 696, The $96,800 difference in the amount of income from operations ($696,800 $600,000) is due to the allocation of fixed manufacturing costs to ending inventory. The entire amount of the $484,000 of fixed manufacturing costs is included in the cost of goods sold when 44,000 units are manufactured. When 55,000 units are manufactured, $96,800 (11,000 units $8.8) of the fixed manufacturing costs are included in ending inventory and are thus excluded from the cost of goods sold. 3. a. Base salary $140,000 Bonus ($600,000 $670,000) 10% Total salary $140,000 b. Base salary $140,000 Bonus ($696,800 $670,000) 10% 2,680 Total salary $142, By manufacturing 55,000 units, Pinder increased his salary by $2,680. Note: Instructors may also point out that by increasing the ending inventory by 11,000 units, Craig Company will risk higher obsolescence and incur additional costs of carrying and storing inventory, and these costs will reduce future income of Craig Company

48 CP 20 6 (FIN MAN); CP 5 6 (MAN) (Concluded) 5. If Pinder s salary were $140,000 (plus a bonus based on income from operations) and the variable costing method had been used, income from operations would have been $600,000, regardless of how many units were manufactured. Thus, Pinder would not have been able to increase his salary simply by manufacturing more units. Note: Instructors may ask students to verify that income from operations, using the variable costing method, would be $600,000 regardless of whether 44,000 or 55,000 units are manufactured. The variable costing income statements are as follows: CRAIG COMPANY Variable Costing Income Statement 44,000 Units Manufactured For the Year Ended December 31, 2014 Sales (44,000 $106) $4,664,000 Cost of goods sold (44,000 $50) 2,200,000 Manufacturing margin $2,464,000 Variable selling and administrative expenses 1,050,000 Contribution margin $1,414,000 Fixed costs: Fixed manufacturing costs $484,000 Fixed selling and administrative expenses 330, ,000 Income from operations $ 600,000 CRAIG COMPANY Variable Costing Income Statement 55,000 units manufactured For the Year Ended December 31, 2014 Sales (44,000 $106) $4,664,000 Variable cost of goods sold: Variable cost of goods manufactured (55,000 $50) $2,750,000 Less inventory, December 31 (11,000 $50) 550,000 Variable cost of goods sold 2,200,000 Manufacturing margin $2,464,000 Variable selling and administrative expenses 1,050,000 Contribution margin $1,414,000 Fixed costs: Fixed manufacturing costs $ 484,000 Fixed selling and administrative expenses 330, ,000 Income from operations $ 600,