Exam Prep 4e Topic Focus Variable and Absorption Costing

T3 – Topic Focus Variable and Absorption Costing

TRUE-FALSE STATEMENTS

1. The process of classifying all the costs incurred in the production of a product is referred to as absorption costing.
2. Absorption costing is also referred to as variable costing.
3. Absorption costing is also referred to as full costing.
4. Absorption costing is used for managerial accounting but is not allowed for reporting in accordance with generally accepted accounting principles.

LO: 1, Bloom: K, Unit: TF03-1, Difficulty: Easy, Min: 1, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. The underlying principle that absorption costing satisfies is the historical cost principle.
2. The matching principle states that expenses should be matched with the revenues they generate.
3. To make predictions about costs and income, you must first classify costs by their behavior.
4. In variable costing, fixed manufacturing overhead is treated as a product cost.
5. Mixed costs are divided into their direct and indirect components.
6. The only difference between variable and absorption costing is the treatment of fixed overhead costs.
7. The only difference between variable and absorption costing is the treatment of variable overhead costs.
8. The difference between absorption and variable costing is the timing difference in the expensing of fixed overhead costs.
9. The difference between absorption and variable costing is the timing difference in the expensing of variable overhead costs.
10. When production volume equals sales volume, the amount of fixed overhead expensed is larger using absorption costing than with variable costing.
11. When production volume exceeds sales volume, net income will be higher when using absorption costing than when using variable costing.

MULTIPLE-CHOICE QUESTIONS

1. Which of the following items is more complicated for a manufacturing company than for a retail operation?
   1. Applying the matching concept
   2. Trying to forecast the effects of financial decisions on the income statement
   3. Prepare the operating expenses section of the income statement
   4. Selling finished goods
2. Which of the following is not a product cost?
   1. Direct material
   2. Direct labor
   3. Selling expenses
   4. Manufacturing overhead
3. The cost accumulation method required by generally accepted accounting principles is referred to as
   1. permanent costing.
   2. absorption costing.
   3. direct costing.
   4. variable costing.
4. Absorption costing is also referred to as
   1. variable costing.
   2. full costing.
   3. direct costing.
   4. matching costing.
5. The underlying principle that absorption costing satisfies is the
   1. matching principle.
   2. relevance principle.
   3. historical cost principle.
   4. understandability principle.
6. The matching principle states that
   1. expenses should be matched with specific jobs.
   2. expenses should be matched with the revenues they generate.
   3. revenues should be recorded in the period in which the payment is received.
   4. expenses should be matched to assets which generated the expenses.
7. Based on the matching principle, all product costs flow through Raw Materials Inventory,
   1. Work in Process Inventory and Finished Goods Inventory until the goods are sold.
   2. Work in Process Inventory and Manufacturing Overhead until the goods are sold.
   3. Conversion Inventory and Work in Process Inventory.
   4. Conversion Inventory, and Finished Goods Inventory until the goods are sold.
8. Based on the matching principle, all product costs eventually end up in
   1. Raw Materials Inventory.
   2. Work in Process.
   3. Finished Goods.
   4. Cost of Goods Sold.
9. To make predictions about costs and income, costs must be classified as either
   1. fixed or variable.
   2. product or administrative.
   3. direct material or conversion.
   4. direct or indirect.
10. Mixed costs must be divided into which of the following components?
    1. Period and product
    2. Fixed and variable
    3. Direct and indirect
    4. Cost and profit
11. Variable costing is also referred to as
    1. absorption costing.
    2. normal costing.
    3. direct costing.
    4. full costing.
12. The costing method in which only variable product costs are accumulated in inventory is called
    1. absorption costing.
    2. normal costing.
    3. direct costing.
    4. full costing.
13. Fixed manufacturing overhead is treated as a period expense in which of the following costing methods?
    1. Absorption costing
    2. Normal costing
    3. Full costing
    4. Variable costing
14. When using variable costing, fixed manufacturing overhead is treated as which of the following types of costs?
    1. Product
    2. Mixed
    3. Period
    4. Variable
15. The only difference between absorption costing and variable costing is the treatment of
    1. all variable costs.
    2. variable overhead costs.
    3. all fixed costs.
    4. fixed overhead costs.
16. When the units produced equal the units sold, operating income
    1. is higher under absorption costing than under variable costing.
    2. is lower under absorption costing than under variable costing.
    3. is the same under absorption costing and variable costing.
    4. cannot be determined with the information given.
17. When the units produced exceed the units sold, operating income
    1. is higher under absorption costing than under variable costing.
    2. is lower under absorption costing than under variable costing.
    3. is the same under absorption costing and variable costing.
    4. cannot be determined with the information given.
18. When the units sold exceed the units produced, operating income
    1. is higher under absorption costing than under variable costing.
    2. is lower under absorption costing than under variable costing.
    3. is the same under absorption costing and variable costing.
    4. cannot be determined with the information given.
19. When the units produced exceed the units sold, ending inventory on the balance sheet
    1. is lower under absorption costing than under variable costing.
    2. is higher under absorption costing than under variable costing.
    3. is the same under absorption costing and variable costing.
    4. cannot be determined with the information given.
20. When the units produced is less than the units sold, ending inventory on the balance sheet
    1. is lower under absorption costing than under variable costing.
    2. is higher under absorption costing than under variable costing.
    3. is the same under absorption costing and variable costing.
    4. cannot be determined with the information given.
21. In absorption costing, all manufacturing costs are
    1. product costs.
    2. period costs.
    3. variable costs.
    4. mixed costs.
22. Variable costing is acceptable for which of the following purposes?
    1. GAAP reporting
    2. Internal reporting
    3. Reporting to the IRS
    4. SEC reporting
23. When using variable costing, period costs consist of
    1. selling and administrative costs.
    2. administrative costs and fixed manufacturing overhead
    3. fixed and variable manufacturing overhead.
    4. selling and administrative costs as well as fixed manufacturing overhead.
24. Under variable costing, subtract variable costs from sales to arrive at
    1. gross profit.
    2. gross margin.
    3. contribution margin.
    4. net income.
25. Walker Manufacturing began its operations on January 1 of the current year. Walker produced 10,000 units during the year, sold 8,000 units at an average selling price of $22 per unit, and had 2,000 units in ending inventory. Variable production costs were $14 per unit, variable selling expenses were $2 per unit, fixed overhead totaled $12,000, and fixed selling and administrative expenses totaled $30,000. Under absorption costing, what was Walker’s operating income?
    1. ($26,000)
    2. $6,000
    3. $8,400
    4. $10,000
26. Walker Manufacturing began its operations on January 1 of the current year. Walker produced 10,000 units during the year, sold 8,000 units at an average selling price of $22 per unit, and had 2,000 units in ending inventory. Variable production costs were $14 per unit, variable selling expenses were $2 per unit, fixed overhead totaled $12,000, and fixed selling and administrative expenses totaled $30,000. Under variable costing, what was Walker’s operating income?
    1. ($26,000)
    2. $6,000
    3. $8,400
    4. $10,000
27. Walker Manufacturing began its operations on January 1 of the current year. Walker produced 10,000 units during the year, sold 8,000 units at an average cost of $22 per unit, and had 2,000 units in ending inventory. Variable production costs were $14 per unit, variable selling expenses were $2 per unit, fixed overhead totaled $12,000, and fixed selling and administrative expenses totaled $30,000. Under variable costing, what was Walker’s ending inventory on the balance sheet?
    1. $8,000
    2. $28,000
    3. $30,000
    4. $30,400
28. Walker Manufacturing began its operations on January 1 of the current year. Walker produced 10,000 units during the year, sold 8,000 units at an average cost of $22 per unit, and had 2,000 units in ending inventory. Variable production costs were $14 per unit, variable selling expenses were $2 per unit, fixed overhead totaled $12,000, and fixed selling and administrative expenses totaled $30,000. Under absorption costing, what was Walker’s ending inventory on the balance sheet?
    1. $8,000
    2. $28,000
    3. $30,000
    4. $30,400

MATCHING

1. c – Full costing
2. e – Mixed cost
3. h – Variable costing, or b – Direct costing
4. f – Period cost
5. a – Absorption costing, or c – Full costing
6. g – Product cost
7. b – Direct costing
8. d – Matching principle

LO: 1, Bloom: K, Unit: TF03-1, Difficulty: Easy, Min: 3-4, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

BRIEF EXERCISES

1. For each item below, identify whether the item applies to an absorption costing or variable costing income statement by marking an “X” in the appropriate column.

LO: 2, Bloom: C, Unit: TF03-2, Difficulty: Easy, Min: 2-3, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. Monroe Corporation produced 20,000 units during the last period. The company incurred the following total costs to produce these units.

Direct materials $240,000

Direct labor 160,000

Variable overhead 80,000

Fixed overhead 120,000

Required:

• 1. Under the absorption costing method, what is the average unit product cost?
  2. Under the variable costing method, what is the average unit product cost?

1. ($240,000 + $160,000 + $80,000 + $120,000) ÷ 20,000 = $30 average unit product cost
2. ($240,000 + $160,000 + $80,000) ÷ 20,000 = $24 average unit product cost

LO: 2, Bloom: AP, Unit: TF03-4, Difficulty: Moderate, Min: 3, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None IMA: Reporting

1. The following table shows Jackson Company’s inventory balances, in units, for years 1, 2 and 3. Total fixed costs were $20,000 for each of the last three years. The units in year 1 beginning inventory were based on production of 500 units.

Required:

For each year, calculate the difference between absorption costing and variable costing operating income. Indicate which costing system has the highest income each year. Assume the LIFO method is used in year three.

Year 1 – Variable costing operating income is higher by $1,600.

Year 2 – Absorption costing operating income is higher by $4,615.

Year 3 – Operating income will be the same under absorption or variable costing.

LO: 2, Bloom: AN, Unit: TF03-2, Difficulty: Moderate, Min: 8-10, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

EXERCISES

1. Etters Manufacturing Company has provided the following financial data for its most recent month.

Required:

Prepare an income statement using an absorption costing format.

Fixed manufacturing overhead = ($12,000 ÷ 10,000) × 9,500 = $11,400

Variable manufacturing overhead = $3 × 9,500 = $123,500

Variable selling and administrative costs = $1 × 9,500 = $9,500

Sales $171,000

Less cost of goods sold:

Variable manufacturing $123,500

Fixed manufacturing 11,400 134,900

Gross profit 36,100

Less selling and administrative expenses

Variable 9,500

Fixed 8,000 17,500

Net operating income $ 18,600

LO: 2, Bloom: AP, Unit: TF03-2, Difficulty: Moderate, Min: 10, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. Etters Manufacturing Company has provided the following financial data for its most recent month.

Required:

Prepare an income statement using a variable costing format.

Variable manufacturing overhead = $3 × 9,500 = $123,500

Variable selling and administrative costs = $1 × 9,500 = $9,500

Sales $171,000

Less variable cost of goods sold:

Manufacturing $ 123,500

Selling and administrative 9,500 133,000

Contribution margin 38,000

Less fixed costs:

Manufacturing 12,000

Selling and administrative 8,000 20,000

Net operating income $ 18,000

LO: 2, Bloom: AP, Unit: TF03-2, Difficulty: Moderate, Min: 7-8, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Reporting

1. Describe the format for a variable costing income statement.

A variable costing income statement begins with sales revenue. All variable costs (product and period) are deducted from sales revenue to arrive at contribution margin. Finally, fixed costs, both product and period, are deducted to arrive at operating income.

LO: 2, Bloom: AP, Unit: TF03-2, Difficulty: Moderate, Min: 3, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting

1. What managerial behavior does variable costing render ineffective? Explain how this works.

Variable costing prevents managers from boosting operating income by producing more units than are sold, thus moving the fixed costs from Cost of Goods Sold on the income statement to the inventory balance reported on the balance sheet for the period. A disadvantage of absorption costing is that it encourages managers to engage in gaming behavior in an attempt to affect the income statement. That is, if production is always greater than sales, a portion of the manufacturing overhead cost will always remain in inventory rather than being expensed on the income statement. Producing more units spreads the overhead costs over more units, reducing the cost per unit. This improves income but wastes resources if the extra units are not needed.

LO: 2, Bloom: AN, Unit: TF03-2, Difficulty: Moderate, Min: 10-15, AACSB: Analytic, Communication, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting

ESSAY

1. You are assigned to a team responsible for reviewing the financial statements with lower-level departmental managers. Some of your team members want to use the absorption costing income statement generally distributed by the accounting department. You believe a variable costing income statement will be more appropriate to use in explaining items to lower-level managers. Your team has requested more information on the variable costing format.

Required:

Write a memo to your team members explaining why you believe the variable costing income statement should be used.

To: Team Members

Subject: Format for income statement presentation to department managers

As you requested at our last meeting, I have investigated the use of a variable costing income statement format for use in reviewing financial statements with our departmental managers. I have listed several items below that will help us come to a decision on the format most useful to our department managers.

Our accounting department provides financial statements using an absorption costing cost accumulation method. This is the method required by generally accepted accounting principles. The underlying principle that absorption costing satisfies is the matching principle, which states that expenses should be matched with the revenues they generate.

In a variable costing income statement format, only variable product costs are accumulated in inventory. Fixed manufacturing overhead is treated as a period expense rather than a product cost, meaning it is expensed in the period in which it is incurred. Both methods have the same product costs flows – Raw Materials Inventory to Work in Process Inventory to Finished Goods Inventory and, once the product is sold, Cost of Goods Sold. The only difference between the two methods is the treatment of fixed overhead costs.

When a company’s production volume and sales volume vary from one year to the next, income is harder to forecast under absorption costing, since the fixed cost per unit changes with the number of units produced. Variable costing is better for purposes of forecasting and decision making. A disadvantage of absorption costing is that it encourages managers to engage in gaming behavior in an attempt to affect the income statement. That is, if a manager were to ensure that production is always greater than sales, a portion of the manufacturing overhead cost would always reside in inventory rather than being expensed on the income statement. Making more units spreads the overhead costs over more units, reducing the cost per unit. This improves income but wastes resources if the extra units are not needed.

I hope the above information is beneficial in determining whether to present the income statements in a variable costing format or an absorption costing format. If I can provide any additional information, please let me know.

LO: 2, Bloom: S, AN, Unit: TF03-2, Difficulty: Moderate, Min: 12-15, AACSB: Communication, Analytic, AICPA FN: Reporting, AICPA PC: Communication, IMA: Reporting