Cost Description
Classification
The cost of advertising in the Puget Sound Computer User newspaper
Selling cost
Sales commissions paid to the company’s salespeople
The cost of a hard drive installed in a computer
Direct materials
The wages of employees who assemble computers from components
Direct labor
The salary of the assembly shop’s supervisor
Manufacturing overhead
Depreciation on equipment used to test assembled computers before release to customers
Rent on the facility in the industrial park
The salary of the company’s accountan
Administrative cost
What are the different classifications of costs?
Definition: These are raw materials that are directly traceable to the production of the finished product. They become a physical part of the product being manufactured.
Example: The hard drive installed in a computer.
Definition: Direct labor includes wages and salaries paid to workers who are directly involved in manufacturing the product. These costs can be directly traced to individual units of production.
Example: The wages of employees who assemble the computers.
Definition: Manufacturing overhead includes all indirect costs associated with manufacturing that are not directly traceable to specific units of production. This can include indirect materials, indirect labor, and other factory-related costs such as depreciation, utilities, and rent.
Example: Depreciation on equipment used to test computers or the salary of the assembly shop’s supervisor.
Definition: Selling costs are expenses incurred to secure customer orders and get the product into the hands of customers. These costs are related to marketing, advertising, and sales functions.
Example: Advertising expenses and sales commissions paid to salespeople.
Definition: Administrative costs are expenses incurred for the general management of the business. These are not directly tied to manufacturing or selling the product but are essential to running the business.
Example: The salary of the company’s accountant or other general office expenses.
Prepare a traditional income statement.
Formula:
Sales = Number of units sold × Selling price per unit
Cost of goods sold (COGS) = Beginning inventory + Purchases - Ending inventory
Gross profit = Sales - COGS
Operating expenses = Selling expenses (both fixed and variable) + Administrative expenses (both fixed and variable)
Net operating income = Gross profit - Operating expenses
Prepare a contribution format income statement
The contribution format income statement organizes costs by behavior (variable vs. fixed) and focuses on the contribution margin.
Variable expenses = Variable selling expense + Variable administrative expense + COGS
Contribution margin = Sales - Variable expenses
Fixed expenses = Fixed selling expenses + Fixed administrative expenses
Net operating income = Contribution margin - Fixed expenses
What is the main difference between a traditional income statement and a contribution format income statement?
Traditional Income Statement: Organizes costs by function (e.g., cost of goods sold, operating expenses) and focuses on gross profit.
Contribution Format Income Statement: Organizes costs by behavior (variable vs. fixed) and focuses on contribution margin.
Post the above transactions to T-accounts.
Determine the adjusted cost of goods sold for the period.
a. Raw Materials(RM)
Raw Materials
Debit ($)
Credit ($)
a.Purchased RM
94,000
b. Used RM
89,000
Ending balance
5,000
Explanation: $94,000 worth of raw materials were purchased (Debit). $89,000 were used in production (Credit), leaving a remaining ending balance of $5,000.
b. Wages
Wages Payable
c.Direct labor
112,000
c.Indirect labor
20,000
132,000
Explanation: $132,000 in labor costs were incurred, with $112,000 for direct labor (Credit) and $20,000 for indirect labor (Credit).
c. Work in Process(WIP)
WIP
b. Direct materials
78,000
c. Direct labor
e. Manufacturing overhead
152,000
f. Jobs in Process
342,000
Explanation: Work in Progress (WIP) is charged with direct materials ($78,000), direct labor ($112,000), and applied overhead ($152,000).Total costs transferred to finished goods: $342,000.
d.Finished Goods
To adjust for underapplied or overapplied overhead:
Actual Overhead:
Indirect materials = $11,000
Indirect labor = $20,000
Other overhead = $143,000
Total actual overhead = $174,000
Applied Overhead = $152,000
Difference = $174,000 - $152,000 = $22,000 underapplied
Since the overhead was underapplied, add this difference to Cost of Goods Sold.
Adjusted COGS=Unadjusted COGS+Underapplied Overhead
Adjusted COGS=342,000+22,000=364,000
Finished Goods
f. Transferred from WIP
h. Underapplied or overapplied overhead
22,000
Total production cost
364,000
Explanation: Finished goods are charged with $342,000 (transferred from WIP). An additional $22,000 is added due to overapplied overhead. Total: $364,000.
Adjusted COGS
=COGS (before adjustment)+Underapplied Overhead
=342,000+22,000=364,000
Prepare a schedule of cost of goods manufactured for the month.
Prepare a schedule of cost of goods sold for the month. Assume the underapplied or overapplied overhead is closed to Cost of Goods Sold.
RM
Beginning balance
12,000
Purchased material
30,000
Used Material
24,000
18,000
Explanation: The beginning inventory is $12,000. Purchases of $30,000 are added. $24,000 are used in production, of which $5,000 are indirect materials. The ending inventory is therefore $18,000.
56,000
19,000
58,000
Applied overhead
87,000
Transferred to finished goods
155,000
65,000
Explanation: The beginning inventory is $56,000. Direct materials, direct labor, and applied manufacturing overhead are added. The ending inventory is $65,000.
FG
35,000
Transferred from WIP
Transferred to COGS
148,000
42,000
Explanation: The beginning inventory is $35,000. An additional $155,000 is transferred from WIP, and finally, $148,000 is transferred to Cost of Goods Sold. The ending inventory is $42,000.
COGM
Beginning RM
$12,000
+purchase RM
$30,000
= RM available
$42,000
- end. RM
$(18,000)
=RM used in production
$24,000
-Indirect materials (included in overhead)
$(5,000)
=Direct materials
$19,000
+Direct labor
$58,000
+Applied manufacturing overhead
$87,000
=Total manufacturing costs
$164,000
+Beg. WIP
$56,000
-End. WIP
$(65,000)
=COGM
$155,000
Explanation: The calculation starts with the beginning inventories, purchases, and the deduction of the ending balance of raw materials. Then, direct labor and applied overhead are added. Finally, the beginning balance of work in progress is added, and the ending balance is subtracted.
COGS
Beg. FG
$35,000
+COGM
=Goods available for sale
$190,000
-End. FG
$(42,000)
=Unadjusted COGS
$148,000
+Underapplied manufacturing overhead
$5,000
=Adjusted COGS
$153,000
Summary:
Cost of goods manufactured (COGM): $155,000
Adjusted cost of goods sold (COGS): $153,000 If this is the expected value, it indicates that the actual underapplied overhead is indeed $5,000, as described in the task.
EXERCISE 3–5 Journal Entries and T-accounts LO3–1, LO3–2 The Polaris Company uses a job-order costing system.
The following transactions occurred in October:
a. Raw materials purchased on account, $210,000.
b. Raw materials used in production, $190,000 ($178,000 direct materials and $12,000 indirect
materials).
c. Accrued direct labor cost of $90,000 and indirect labor cost of $110,000.
d. Depreciation recorded on factory equipment, $40,000.
e. Other manufacturing overhead costs accrued during October, $70,000.
f. Jobs costing $520,000 according to their job cost sheets were completed during October and transferred to Finished Goods.
g. Jobs that had cost $480,000 to complete according to their job cost sheets were shipped to customers during the month.
1. Prepare journal entries to record the transactions given above.
2. Prepare T-accounts for Manufacturing Overhead and Work in Process. Post the relevant transactions from above to each account. Compute the ending balance in each account, assuming that Work in Process has a beginning balance of $42,000.
a. Raw materials were purchased on account
b. Raw materials were used in production
c. Accrued wages (direct and indirect labor)
d. Depreciation on factory equipment
e. Additional manufacturing overhead costs
f. Transfer of completed jobs to finished goods
g. Delivery of completed jobs to customers
T-Accounts
Credit($)
Beginning Balance
0
Purchases
210,000
Used in Production (Direct)
178,000
Used in Production (Indirect)
Ending Balance
Indirect materials
Indirect labor
110,000
Depreciation
40,000
Other overhead costs
70,000
Applied to WIP
232,000
Total debits
Total credits
Debit($)
90,000
Transferred to Finished Goods
520,000
542,000
Total credit
Shipped to Customers (COGS)
480,000
Total Manufacturing Costs =Direct Materials+Direct Labor+Manufacturing Overhead
=178,000+90,000+232,000
=500,000
Total Inventory Balance:
Total Ending Inventory =End. RM+End. WIP+End. FG
=20,000+22,000+40,000
=82,000
Prepare schedules of cost of goods manufactured and cost of goods sold and an income statement. (Hint: Prepare the income statement and schedule of cost of goods sold first followed by the schedule of cost of goods manufactured.)
Given Information:
Total Manufacturing Costs: $683,000
Cost of Goods Available for Sale: $740,000
Unadjusted Cost of Goods Sold (COGS): $660,000
Net Operating Income: $30,000
Underapplied or Overapplied Manufacturing Overhead: Included in the Cost of Goods Sold (COGS)
Selling Expenses: $140,000
Administrative Expenses: $100,000
Step 1: Calculation of Cost of Goods Sold (COGS)
First, we calculate the adjusted Cost of Goods Sold, considering under- or overapplied manufacturing overhead.
COGS overview
Beginning Finished Goods Inventory
50,000
690,000=740,000-50,000
= Goods Available for Sale (COGAS)
740,000
- Ending Finished Goods Inventory (calculated)
(80,000)
= Cost of Goods Sold (COGS)
660,000
Explanation:
The ending finished goods inventory is calculated so that the Goods Available for Sale (COGAS) of $740,000 matches the unadjusted COGS of $660,000.
Thus, the calculation is as follows:
End. FG = Goods Available for Sale−COGS
End. FG = 740,000−660,000=80,000
Step 2: Calculation of Cost of Goods Manufactured (COGM)
The calculation of COGM takes into account the beginning and ending balances of Work in Process (WIP).
COGM overview
Amount ($)
Beg. WIP
+total manufacturing cost
683,000
=Total Costs of WIP
725,000
(35,000)
690,000
The beginning balance of Work in Process (WIP) is calculated to match the COGM of $690,000 as follows:
Beginning WIP = COGM−Total Manufacturing Costs+Ending WIP
= 690,000−683,000+35,000
= 42,000
Thus, the beginning WIP balance is $42,000.
Step 3: Calculation of Net Sales
Net Sales=COGS+Net Operating Income+Selling Expenses
+Administrative Expenses
Net Sales=660,000+30,000+140,000+100,000
=930,000
Thus, the Net Sales amount to $930,000.
Step 4: Creation of the Income Statement
Net Sales
930,000
-COGS
(660,000)
=Cross margin
270,000
-Selling expense
(140,000)
-administrative expense
(100,000)
=Net Operating Income
The Gross Margin is $270,000. After deducting Selling Expenses ($140,000) and Administrative Expenses ($100,000), the Net Operating Income is $30,000.
Step 5: T-Accounts for Raw Materials, Work in Process (WIP), and Finished Goods
290,000
Used in Production
320,000
10,000
Explanation: The ending balance of raw materials is $10,000.
Direct Materials
Direct Labor
85,000
Applied Manufacturing Overhead
285,000
Explanation: The ending balance of Work in Process is $35,000
total debit - transferred = (320,000+85,000+285,000+35000+x)-690,000
80,000
Adjusted Cost of Goods Sold (COGS): $660,000
Cost of Goods Manufactured (COGM): $690,000
Net Sales: $930,000
PROBLEM 3–14 Schedule of Cost of Goods Manufactured; Overhead Analysis LO3–3, LO3–4
Gitano Products operates a job-order costing system and applies overhead cost to jobs on the basis of direct materials used in production (not on the basis of raw materials purchased). Its predetermined overhead rate was based on a cost formula that estimated $800,000 of manufacturing overhead for an estimated allocation base of $500,000 direct material dollars to be used in production. The company has provided the following data for the just completed year:
Compute the predetermined overhead rate for the year.
Compute the amount of underapplied or overapplied overhead for the year.
Prepare a schedule of cost of goods manufactured for the year. Assume all raw materials are used in production as direct materials.
Compute the unadjusted cost of goods sold for the year. Do not include any underapplied or overapplied overhead in your answer. What options are available for disposing of underapplied or overapplied overhead?
Assume that the $70,000 ending balance in Work in Process includes $24,000 of direct materials.
Given this assumption, supply the information missing below:
?
Work in process inventory
$70,000
Step 1: Calculate the Predetermined Overhead Rate
The predetermined overhead rate is calculated as:
Step 2: Compute the Amount of Underapplied or Overapplied Overhead
Total Actual Manufacturing Overhead Incurred:
Total Actual Overhead
=170,000 (Indirect Labor)+48,000 (Property Taxes)
+260,000 (Depreciation)+95,000 (Maintenance)+7,000 (Insurance)
+180,000 (Rent)
=760,000
Total Direct Materials Used in Production:
Direct Materials Used = Beg. RM+Purchase-End. RM
Direct Materials Used = 20,000+510,000−80,000
= 450,000
Applied Overhead:
App. Overhead = Direct Materials Used×Pre. Overhead Rate
App. Overhead = 450,000×1.6 = 720,000
Underapplied or Overapplied Overhead:
Under./Overapp.Overhead = T.A. Overhead−App.Overhead Under./Overapp.Overhead = 760,000−720,000
= 40,000 (Underapplied)
Conclusion: There is $40,000 of underapplied overhead.
Description
Beginning Work in Process Inventory
150,000
+ Direct Materials Used
450,000
+ Direct Labor
+ Applied Manufacturing Overhead
720,000
= Total Manufacturing Costs
1,410,000
- Ending Work in Process Inventory
(70,000)
= Cost of Goods Manufactured (COGM)
1,340,000
Explanation: The beginning WIP of $150,000 is added to the total manufacturing costs (including direct materials, direct labor, and applied overhead) and then adjusted for the ending WIP balance to find the COGM of $1,340,000.
Step 4: Calculation of Unadjusted Cost of Goods Sold (COGS)
260,000
+ Cost of Goods Manufactured (COGM)
= Goods Available for Sale
1,600,000
- Ending Finished Goods Inventory
(400,000)
= Unadjusted Cost of Goods Sold (COGS)
1,200,000
Explanation: The COGS is calculated by adding the beginning FG inventory to the COGM and then subtracting the ending FG inventory, giving an unadjusted COGS of $1,200,000.
Step 5: Calculation of Missing Direct Labor and Overhead in WIP Inventory
Given:
Ending WIP Inventory: $70,000
Direct Materials in Ending WIP: $24,000
Calculate Direct Labor and Manufacturing Overhead in WIP:
Total Ending WIP
=Direct Materials+Direct Labor+Manufacturing Overhead
70,000=24,000+Direct Labor+Manufacturing Overhead
Using Predetermined Overhead Rate:
Manufacturing Overhead
= 1.6 × Direct Materials
= 1.6 × 24,000
= 38,400
Calculate Direct Labor:
70,000=24,000 + Direct Labor + 38,400
Direct Labor= 70,000 − 24,000 − 38,400
= 7,600
EXERCISE 5–7 Target Profit Analysis LO5–6
Lin Corporation has a single product whose selling price is $120 per unit and whose variable expense is $80 per unit.
The company’s monthly fixed expense is $50,000.
Required:
1. Calculate the unit sales needed to attain a target profit of $10,000.
2. Calculate the dollar sales needed to attain a target profit of $15,000.
Selling Price per Unit: $120
Variable Expense per Unit: $80
Fixed Expenses per Month: $50,000
Step 1: Contribution Margin (CM) per Unit
The Contribution Margin (CM) per Unit is calculated as:
CM per Unit=Selling Price per Unit−Variable Expense per Unit
CM per Unit=120−80=40
We use the following formula to calculate the required unit sales:
To calculate the required dollar sales, we use the following formula:
The company needs to generate $195,015 in sales to attain a target profit of $15,000.
EXERCISE 5–14 Break-Even and Target Profit Analysis LO5–3, LO5–4, LO5–5, LO5–6
Lindon Company is the exclusive distributor for an automotive product that sells for $40 per unit and has a CM ratio of 30%. The company’s fixed expenses are $180,000 per year.
The company plans to sell 16,000 units this year.
What are the variable expenses per unit?
What is the break-even point in unit sales and in dollar sales?
What amount of unit sales and dollar sales is required to attain a target profit of $60,000 per year?
Assume that by using a more efficient shipper, the company is able to reduce its variable expenses by $4 per unit.
What is the company’s new break-even point in unit sales and in dollar sales?
What dollar sales is required to attain a target profit of $60,000?
Selling Price per Unit: $40
CM Ratio: 30%
Fixed Expenses: $180,000 per year
Planned Sales: 16,000 units
The Contribution Margin (CM) Ratio is the proportion of the selling price that contributes to covering fixed expenses and generating profit. The remaining portion represents variable expenses.
We know the formula for the CM Ratio:
The variable expense per unit is $28.
1.Break-even Point in Unit Sales:
The formula for the break-even point in units is:
2.Break-even Point in Dollar Sales:
The formula for the break-even point in dollars is:
The break-even point is 15,000 units.
The break-even sales in dollars is $600,000.
1.Required Unit Sales:
To calculate the unit sales needed to attain a target profit, use the formula:
2.Required Dollar Sales:
To calculate the required dollar sales, use the formula:
The company needs to sell 20,000 units to attain a target profit of $60,000.
The required dollar sales are $800,000.
If the company reduces its variable expenses by $4 per unit, the new variable expense per unit will be:
The new break-even point is 11,250 units and $450,000 in dollar sales.
The dollar sales required to attain a target profit of $60,000 is $600,000.
EXERCISE 6–1 Variable and Absorption Costing Unit Product Costs LO6–1
Ida Sidha Karya Company is a family-owned company located in the village of Gianyar on the island of Bali in Indonesia. The company produces a handcrafted Balinese musical instrument called a gamelan that is similar to a xylophone. The gamelans are sold for $850.
Selected data for the company’s operations last year follow:
Units in beg. inventory
Units produced
250
Units sold
225
Units in end. inventory
25
Variable costs per unit:
$100
$320
Variable manufacturing overhead
$40
Variable selling and administrative
$20
Fixed costs:
Fixed manufacturing overhead
$60,000
Fixed selling and administrative
$20,000
Assume that the company uses absorption costing. Compute the unit product cost for one gamelan.
Assume that the company uses variable costing. Compute the unit product cost for one gamelan.
Under absorption costing, both variable costs and a portion of fixed manufacturing overhead are included in the unit product cost.
Under variable costing, only variable costs are included in the unit product cost. Fixed manufacturing overhead is treated as a period expense.
Costing Method
Unit Product Cost
Absorption Costing
$700
Variable Costing
$460
Absorption costing includes fixed manufacturing overhead in the unit cost.
Variable costing only includes variable costs, treating fixed overhead as a period expense.
EXERCISE 6–2 Variable Costing Income Statement; Explanation of Difference in Net Operating Income LO6–2
Refer to the data in Exercise 6–1 for Ida Sidha Karya Company. The absorption costing income statement prepared by the company’s accountant for last year appears as shown:
Sales
$191,250
Cost of goods sold
$157,500
Gross margin
$33,750
Selling and administrative expense
$24,500
Net operating income
$9,250
Under absorption costing, how much fixed manufacturing overhead cost is included in the company’s inventory at the end of last year?
Prepare an income statement for last year using variable costing. Explain the difference in net operating income between the two costing methods.
Part 1: Fixed Manufacturing Overhead Cost in Ending Inventory under Absorption Costing
Under absorption costing, fixed manufacturing overhead is included in the unit product cost and is spread across all units produced.
Step 1: Calculate Fixed Manufacturing Overhead per Unit
Total Fixed Manufacturing Overhead: $60,000
Units Produced: 250 units
Under variable costing, only variable manufacturing costs are included in the cost of goods sold, while fixed manufacturing overhead is treated as a period expense.
Let's prepare the variable costing income statement.
Step 1: Calculate Variable Cost of Goods Sold (COGS)
Variable Cost per Unit (from Exercise 6–1):
Direct materials: $100
Direct labor: $320
Variable manufacturing overhead: $40
Total Variable Cost per Unit: $460
Units Sold: 225 units
Variable Costing Income Statement:
Sales (225 units × $850)
191,250
- Variable Cost of Goods Sold (225 units × $460)
103,500
- Variable Selling and Admin Expenses (225 units × $20)
4,500
= Contribution Margin
83,250
- Fixed Manufacturing Overhead
60,000
- Fixed Selling and Administrative Expenses
= Net Operating Income
3,250
Net Operating Income under Absorption Costing: $9,250
Net Operating Income under Variable Costing: $3,250
Reason for the Difference:
Under absorption costing, $6,000 of fixed manufacturing overhead is deferred in the ending inventory (as it’s included in the inventory cost and not expensed until the units are sold). This results in a higher net operating income.
Under variable costing, all fixed manufacturing overhead is treated as a period expense, so it is expensed fully in the current period. This leads to a lower net operating income.
Reconciliation of Net Operating Income Difference:
Difference in Net Operating Income
=Fixed Manufacturing Overhead in Ending Inventory under Absorption Costing Difference
Difference=6,000
he $6,000 difference is due to the fixed manufacturing overhead that is included in the ending inventory under absorption costing.
Absorption Costing Net Operating Income: $9,250
Variable Costing Net Operating Income: $3,250
Difference: $6,000 (due to fixed manufacturing overhead in ending inventory under absorption costing).
EXERCISE 6–9 Variable and Absorption Costing Unit Product Costs and Income Statements LO6–1, LO6–2, LO6–3
Walsh Company manufactures and sells one product.
The following information pertains to each of the company’s first two years of operations:
Manufacturing:
$25
$15
$5
$2
Fixed costs per year:
$250,000
Fixed selling and administrative expenses
$80,000
During its first year of operations, Walsh produced 50,000 units and sold 40,000 units.
During its second year of operations, it produced 40,000 units and sold 50,000 units.
The selling price of the company’s product is $60 per unit.
a. Compute the unit product cost for Year 1 and Year 2.
b. Prepare an income statement for Year 1 and Year 2.
Assume the company uses absorption costing:
Explain the difference between variable costing and absorption costing net operating income in Year 1. Also, explain why the two net operating incomes differ in Year 2.
Part 1: Variable Costing – Unit Product Cost and Income Statements
Part 2: Absorption Costing – Unit Product Cost and Income Statements
Year 1:
Variable Costing Net Operating Income = $190,000
Absorption Costing Net Operating Income = $240,000
Difference = $50,000
Explanation: The difference arises because absorption costing includes $50,000 of fixed manufacturing overhead in ending inventory (10,000 units × $5 fixed overhead per unit). Under variable costing, all fixed manufacturing overhead is expensed immediately, resulting in lower net income.
Year 2:
Variable Costing Net Operating Income = $320,000
Absorption Costing Net Operating Income = $357,500
Difference = $37,500
Explanation: In Year 2, 10,000 units from Year 1’s ending inventory are sold. The $50,000 of fixed manufacturing overhead deferred in Year 1 is now expensed under absorption costing, reducing the net operating income difference. However, absorption costing still reports a higher income because the fixed manufacturing overhead per unit in Year 2 is higher ($6.25 vs. $5).
Year 1 Net Operating Income
Year 2 Net Operating Income
$320,000
$240,000
$357,500
PROBLEM 6–19 Variable Costing Income Statement; Reconciliation LO6–2, LO6–3
During Heaton Company’s first two years of operations, it reported absorption costing net operating income as follows:
Year 1
Year 2
Sales (@ $25 per unit)
$1,000,000
$1,250,000
Cost of goods sold (@ $18 per unit)
900,000
280,000
350,000
Selling and administrative expenses*
230,000
$ 70,000
$ 120,000
*$2 per unit variable; $130,000 fixed each year.
The company’s $18 unit product cost is computed as follows
$4
7
1
Fixed manufacturing overhead ($270,000 ÷ 45,000 units)
6
Absorption costing unit product cost
$18
Forty percent of fixed manufacturing overhead consists of wages and salaries;
the remainder consists of depreciation charges on production equipment and buildings.
Production and cost data for the first two years of operations are:
45,000
1. Using variable costing, what is the unit product cost for both years?
2. What is the variable costing net operating income in Year 1 and in Year 2?
3. Reconcile the absorption costing and the variable costing net operating income figures for each year.
Under variable costing, only variable manufacturing costs are included in the unit product cost.
Fixed manufacturing overhead is treated as a period cost.
Part 3: Reconciliation of Absorption and Variable Costing Net Operating Income
Absorption Costing Net Operating Income: $70,000
Variable Costing Net Operating Income: $40,000
Difference: $30,000
Explanation: The difference of $30,000 arises because under absorption costing, some of the fixed manufacturing overhead is deferred in ending inventory. In Year 1, 5,000 units (45,000 units produced - 40,000 units sold) are still in inventory, and each unit contains $6 of fixed manufacturing overhead.
Fixed Manufacturing Overhead Deferred=5,000×6=30,000
Absorption Costing Net Operating Income: $120,000
Variable Costing Net Operating Income: $150,000
Difference: -$30,000
Explanation: In Year 2, the 5,000 units from Year 1's ending inventory were sold, releasing the $30,000 of fixed manufacturing overhead that had been deferred in Year 1 under absorption costing. This reduces net income under absorption costing compared to variable costing.
Year
Absorption Costing Net Income
Variable Costing Net Income
Difference
Explanation
$40,000
$30,000 of fixed manufacturing overhead in ending inventory
$120,000
$150,000
-$30,000
$30,000 of fixed manufacturing overhead released from ending inventory
EXERCISE 5A–1 High-Low Method LO5–10 The Cheyenne Hotel in Big Sky, Montana, has accumulated records of the total electrical costs of the hotel and the number of occupancy-days over the last year. An occupancy-day represents a room rented for one day.
The hotel’s business is highly seasonal, with peaks occurring during the ski season and in the summer.
Month
Occupancy-Days
Electrical Costs
January
1,736
$4,127
February
1,904
$4,207
March
2,356
$5,083
April
960
$2,857
May
360
$1,871
June
744
$2,696
July
2,108
$4,670
August
2,406
$5,148
September
840
$2,691
October
124
$1,588
November
720
$2,454
December
1,364
$3,529
Using the high-low method, estimate the fixed cost of electricity per month and the variable cost of electricity per occupancy-day. Round off the fixed cost to the nearest whole dollar and the variable cost to the nearest whole cent.
What other factors in addition to occupancy-days are likely to affect the variation in electrical costs from month to month?
Occupancy-Days: Number of days with rented rooms.
Electrical Costs: Monthly electrical expenses.
Step 1: Identify the High and Low Points
High Point:
Occupancy-Days: 2,406 (August)
Electrical Costs: $5,148
Low Point:
Occupancy-Days: 124 (October)
Electrical Costs: $1,588
Step 2: Calculate the Variable Cost per Occupancy-Day
The high-low method calculates the variable cost per unit (in this case, per occupancy-day) using the formula:
Step 3: Calculate the Total Fixed Cost
To find the total fixed cost, use the high or low point data:
Fixed Cost Formula:
Fixed Cost =Total Cost−(Variable Cost per Occupancy-Day×Occupancy-Days)
Using the high point (August):
Fixed Cost=5,148−(1.56×2,406)=5,148−3,755=1,390
Conclusion:
Fixed Cost per Month: $1,393
Variable Cost per Occupancy-Day: $1.56
Apart from the number of occupancy-days, several other factors could impact electrical costs:
Seasonal Temperature Changes: Heating or cooling costs may vary with the seasons, leading to fluctuations in electrical usage.
Hotel Amenities and Services: The operation of amenities such as pools, spas, or on-site restaurants may increase electricity consumption.
Occupant Behavior: Guests might leave lights, heating, or air conditioning on for extended periods, increasing electrical costs.
Events and Functions: Hosting events or conferences could lead to a temporary increase in electricity usage.
Energy Efficiency: The age and efficiency of electrical systems and appliances can impact overall electricity usage.
Additional Factors: Seasonal variations, guest behavior, hotel services, events, and energy efficiency.
PROBLEM 5A–8 High-Low Method; Predicting Cost LO5–10 Nova Company’s total overhead cost at various levels of activity are presented below:
Machine- Hours
Total Overhead Cost
$198,000
$174,000
June.
$222,000
$246,000
Assume that the total overhead cost above consists of utilities, supervisory salaries, and maintenance. The breakdown of these costs at the 60,000 machine-hour level of activity is:
Utilities (variable)
$ 48,000
Supervisory salaries (fixed)
21,000
Maintenance (mixed)
105,000
Total overhead cost
Nova Company’s management wants to break down the maintenance cost into its variable and fixed cost elements.
Estimate how much of the $246,000 of overhead cost in July was maintenance cost. (Hint: to do this, it may be helpful to first determine how much of the $246,000 consisted of utilities and supervisory salaries. Think about the behavior of variable and fixed costs.)
Using the high-low method, estimate a cost formula for maintenance in the form Y = a + bX .
Express the company’s total overhead cost in the form Y = a + bX.
What total overhead cost would you expect to be incurred at an activity level of 75,000
machine-hours?
Machine-Hours and Total Overhead Costs:
April: 70,000 machine-hours, $198,000
May: 60,000 machine-hours, $174,000
June: 80,000 machine-hours, $222,000
July: 90,000 machine-hours, $246,000
Breakdown of Overhead Costs at 60,000 Machine-Hours:
Utilities (variable): $48,000
Supervisory Salaries (fixed): $62,000
Maintenance: (unknown variable and fixed components)
Breakdown of Overhead Costs at 60,000 Machine-Hours
Utilities Cost: $48,000
Variable Cost per Machine-Hour for utilities:
Supervisory Salaries (Fixed Cost): $62,000
Calculate the Total Utilities and Supervisory Salaries in July (90,000 Machine-Hours)
Utilities Cost in July:
Utilities Cost=90,000×0.80=72,000
Maintenance Cost for July
We can now estimate the maintenance cost for July by subtracting the utilities and supervisory salaries from the total overhead cost:
Maintenance Cost for July=Total Overhead−Utilities Cost−Supervisory Salaries
Maintenance Cost for July=246,000−72,000−21,000
=153,000
So, the maintenance cost in July is $153,000.
The high-low method will help us break down the maintenance cost into its variable and fixed components.
2.1 Identify the High and Low Points
High Point: 90,000 machine hours (July), maintenance cost = $153,000
Low Point: 60,000 machine hours (May), maintenance cost = $105,000 (from the provided breakdown)
2.2 Calculate the Variable Maintenance Cost per Machine Hour
Using the high-low method formula:
Calculate the Variable Cost per Machine-Hour for Maintenance
3 Calculate the Fixed Maintenance Cost
Now that we know the variable cost, we can calculate the fixed portion of the maintenance cost using either the high or low point. Let’s use the low point (60,000 machine hours, $105,000 maintenance cost):
Fixed Maintenance Cost
=Total Maintenance Cost−(Variable Cost per Unit×Activity Level)
Fixed Maintenance Cost=105,000−(1.60×60,000)
=105,000−96,000
=9,000
So, the fixed maintenance cost is $9,000.
Maintenance Cost Formula:
Maintenance Cost (Y)=9,000+1.60X
Where:
Y = Total maintenance cost
X = Number of machine hours
Now that we have broken down the maintenance cost into its fixed and variable components, we can express the total overhead cost formula by combining all the cost elements:
Utilities: $0.80 per machine hour (variable)
Supervisory Salaries: $21,000 (fixed)
Maintenance: $9,000 fixed, $1.60 per machine hour (variable)
Total Overhead Cost Formula:
Total Overhead Cost (Y)=21,000+9,000+(0.80X)+(1.60X)
Total Overhead Cost (Y)=30,000+2.40X
Now, using the total overhead cost formula, we can estimate the total overhead cost for 75,000 machine hours:
Total Overhead Cost=30,000+(2.40×75,000)
Total Overhead Cost=30,000+180,000=210,000
So, the total overhead cost for 75,000 machine hours is $210,000.
Maintenance cost for July (90,000 machine hours) = $153,000.
Maintenance cost formula: Maintenance Cost (Y)=9,000+1.60X\text{Maintenance Cost (Y)} = 9,000 + 1.60XMaintenance Cost (Y)=9,000+1.60X
Total overhead cost formula: Total Overhead Cost (Y)=30,000+2.40X\text{Total Overhead Cost (Y)} = 30,000 + 2.40XTotal Overhead Cost (Y)=30,000+2.40X
Total overhead cost for 75,000 machine hours = $210,000.
PROBLEM 5A–9 High-Low Method; Contribution Format Income Statement LO5–10
Milden Company is a distributor who wants to start using a contribution format income statement for planning purposes. The company has analyzed its expenses and developed the following cost formulas:
Cost
Cost Formula
Cost of good sold
$35 per unit sold
Advertising expense
$210,000 per quarter
Sales commissions
6% of sales
Shipping expense
Administrative salaries
$145,000 per quarter
Insurance expense
$9,000 per quarter
Depreciation expense
$76,000 per quarter
Because shipping expense is a mixed cost, the company needs to estimate the variable shipping expense per unit sold and the fixed shipping expense per quarter using the following data:
Quarter
Units Sold
Shipping Expense
First
$119,000
Second
16,000
$175,000
Third
Fourth
15,000
11,000
$130,000
17,000
$185,000
$210,000
13,000
$147,000
Using the high-low method, estimate a cost formula for shipping expense in the form Y = a + bX.
In the first quarter of Year 3, the company plans to sell 12,000 units at a selling price of $100 per unit. Prepare a contribution format income statement for the quarter.
Given Data for Shipping Expense:
High Point
Low Point
Step 1: Calculate the Variable Cost per Unit for Shipping Expense
High-Low Method Formula:
Step 2: Calculate the Fixed Cost Component for Shipping Expense
Fixed Cost=Total Cost−(Variable Cost per Unit×Units)
Using the high point (20,000 units):
Fixed Cost=210,000−(9.10×20,000)
= 210,000 - 182,000
= 28,000
Step 3: Write the Cost Formula for Shipping Expense
The formula is in the form:
Y=a+bX
a = Fixed cost = $28,000
b = Variable cost per unit = $9.10
X = Number of units sold
Final Cost Formula for Shipping Expense:
Y=28,000+9.10X
Given Data:
Planned Sales in Q1, Year 3: 12,000 units
Selling Price per Unit: $100
Cost of Goods Sold: $35 per unit
Sales Commissions: 6% of sales
Advertising Expense: $210,000 per quarter
Administrative Salaries: $145,000 per quarter
Insurance Expense: $9,000 per quarter
Depreciation Expense: $76,000 per quarter
Shipping Expense Formula: Y=28,000+9.10XY = 28,000 + 9.10XY=28,000+9.10X
Step 1: Calculate Sales and Variable Expenses
Sales:
Sales=12,000×100=1,200,000
Cost of Goods Sold:
Cost of Goods Sold=12,000×35=420,000
Sales Commissions:
Sales Commissions=0.06×1,200,000=72,000
Variable Shipping Expense:
Variable Shipping Expense=9.10×12,000=109,200
Step 2: Calculate Contribution Margin
Total Variable Expenses=420,000+72,000+109,200=601,200
Contribution Margin=Sales−Total Variable Expenses
Contribution Margin=1,200,000−601,200=598,800
Step 3: Calculate Fixed Expenses
Fixed Shipping Expense: $28,000
Advertising Expense: $210,000
Administrative Salaries: $145,000
Insurance Expense: $9,000
Depreciation Expense: $76,000
468,000Total Fixed Expenses
=28,000+210,000+145,000+9,000+76,000
=468,000
Step 4: Calculate Net Operating Income
Net Operating Income=Contribution Margin−Total Fixed Expense
Net Operating Income=598,800−468,000=130,800
Contribution Format Income Statement:
Sales (12,000 units × $100)
Variable Expenses
Cost of Goods Sold (12,000 × $35)
420,000
Sales Commissions (6% of Sales)
72,000
Shipping Expense (12,000 × $9.10)
109,200
-Total Variable Expenses
601,200
=Contribution Margin
598,800
Fixed Expenses
28,000
Advertising Expense
Administrative Salaries
145,000
Insurance Expense
9,000
Depreciation Expense
76,000
-Total Fixed Expenses
468,000
Net Operating Income
130,800
Traditional Income Statement
Sales (12,000 units @ $100)
Cost of Goods Sold
Cost of Goods Sold (12,000 units @ $35)
Variable Shipping (12,000 units @ $9.10)
Total Cost of Goods Sold
529,200
Gross Profit
670,800
Operating Expenses:
Sales Commissions (6% of sales)
Fixed Shipping Expense
Total Operating Expenses
540,000
Net Operating Income for Q1, Year 3: $130,800
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