Product Costing in Service and Manufacturing Entities CHAPTER 11 Product Costing in Service and Manufacturing Entities Chapter 11: Product Costing in Service and Manufacturing Entities In Chapter 11 we will study manufacturing costs as they flow through the three inventory accounts of a manufacturer. One of the manufacturing costs, manufacturing overhead, cannot be traced directly to units of product so we will use a predetermined overhead rate to apply the manufacturing overhead to products. In the final part of the chapter, we will focus on the difference between absorption costing and variable costing.

Managerial Accounting Chapter Opening Financial Accounting Product costs are used to value inventory and to compute cost of goods sold. Managerial Accounting Product costs are used for planning, control, directing, and management decision making. The focus of financial accounting is external, while the focus of managerial accounting is internal. In financial accounting, we use product costs to value inventory for the balance sheet and to compute cost of goods sold for the income statement. In managerial accounting we use product costs for planning, controlling, directing, and management decision making.

Learning Objective To describe the nature and treatment of product cost information for manufacturing and service companies Learning objective number 1 is to describe the nature and treatment of product cost information for manufacturing and service companies. LO1

Cost Flow in Manufacturing Companies Materials waiting to be processed. Raw Materials Partially complete products – material to which some labor and/or overhead has been added. Work-in-Process (WIP) Manufacturers have three inventory accounts: raw materials, work-in-process and finished goods. Raw materials are materials that have not yet entered the production process. Work-in-process consists of units of product that are partially complete, but will require further work before they can be sold to customers. Finished goods consist of units of product that have been completed but not yet sold to customers. Completed products awaiting sale. Finished Goods

Cost Flow in Manufacturing Companies Income Statement Balance Sheet Raw Materials Work-in- Process Finished Goods Materials Used Labor Overhead Cost of Purchases Ending Inventory Total Mfg. Costs Incurred Starting on the left side of this flow chart, we see that material purchases are either used in work-in-process or they remain in inventory. In the center portion of the flow chart, we see the materials being used are combined with labor and overhead in work-in-process. The sum of materials used, direct labor, and manufacturing overhead is called total manufacturing costs incurred. As goods are finished, they are transferred out of work-in-process inventory into the finished goods inventory account. The cost of the goods finished in the period is called cost of goods manufactured. Finished goods are either sold and called cost of goods sold, or they remain in the finished goods inventory account. Cost of Goods Mfd. Cost of Goods Sold Ending Inventory Ending Inventory

Cost Flow in Service Companies Public Accountants Airlines Plumbing Companies Insurance Firms Attorneys Hospitals Service Companies While our primary focus is on manufacturing companies, we should realize that the same cost concepts also apply to service companies such as airlines, hotels, and the other examples of service companies on your screen. Banks Hotels

Cost Flow in Service Companies Service companies do not have work-in-process and finished goods inventory accounts where costs are stored before being transferred to a cost of goods sold account. The major difference between service companies and manufacturing companies is the inventory accounts. Service companies do not have work-in-process and finished goods inventory accounts where product costs are stored before being transferred to a cost of goods sold account.

Learning Objective To demonstrate the flow of materials and labor costs for a manufacturing company Learning objective number 2 is to demonstrate the flow of materials and labor costs for a manufacturing company. LO2

Manufacturing Cost Flow Direct Labor Direct Material Manufacturing Overhead The Product Manufacturing costs are called product costs and they are usually grouped into three major categories: direct materials, direct labor, and manufacturing overhead. Product costs are not expensed as they are incurred. Instead, they are assigned to inventory and do not become expenses until the product is sold.

Wages paid to an automobile assembly worker. Direct Labor Cost of wages and fringe benefits for personnel who work directly on manufactured products. Example: Wages paid to an automobile assembly worker. Direct labor is the effort of employees who actually convert materials into a finished product. Direct labor costs can be separately and readily traced to the individual units of product being manufactured. Assembly workers in an automobile assembly plant would be considered direct labor.

Steel used to manufacture the automobile. Direct Material Raw material that is used to make, and can be conveniently traced, to the finished product. Example: Steel used to manufacture the automobile. Direct materials are raw materials that become an integral part of the finished product and that can be physically and conveniently traced to the product. Direct materials are sufficiently significant in amount to justify the separate tracing. Examples include the steel in an automobile body, aircraft engines on a commercial jet airliner, and the processing chip in a personal computer.

Manufacturing Overhead All other manufacturing costs Indirect Material Indirect Labor Other Costs Materials used to support the production process. Examples: Lubricants and cleaning supplies used in an automobile assembly plant. Manufacturing overhead consists of all manufacturing costs other than direct materials and direct labor. These costs cannot be easily and conveniently traced to products. There are three categories of manufacturing overhead costs: indirect material, indirect labor, and all other manufacturing overhead costs. Examples of indirect materials are lubricants and cleaning supplies used in an automobile assembly plant.

Manufacturing Overhead All other manufacturing costs Indirect Material Indirect Labor Other Costs Cost of personnel who do not work directly on the product. Examples: Maintenance workers, janitors and security guards. Indirect labor costs are incurred for personnel who do not work directly on the product. Examples of indirect labor are maintenance workers, janitors and security guards.

Manufacturing Overhead All other manufacturing costs Indirect Material Indirect Labor Other Costs Examples: Depreciation on plant and equipment, property taxes, insurance, utilities, overtime premium, and unavoidable idle time. Other manufacturing overhead costs include depreciation on plant and equipment, property taxes, insurance, utilities, overtime premium, and unavoidable idle time.

Manufacturing Cost Flow Let’s examine the cost flows in a manufacturing company. We will use T-accounts and start with materials. T-accounts are helpful in visualizing the cost flows in a manufacturing company.

Manufacturing Cost Flow Raw Materials Work-in-Process Material Purchases Direct Material Direct Material Indirect Material Material purchases are entered as debits (left side) in the materials inventory account. A credit entry (right side) in the materials inventory account is recorded when material is withdrawn. Direct materials usage is recorded in the work-in-process inventory account and on the job cost sheet for an individual job. Indirect materials are removed from raw materials inventory with a credit and debited to the manufacturing overhead account. Mfg. Overhead Indirect Material

Manufacturing Cost Flow Next let’s add labor costs and applied manufacturing overhead to the job-order cost flows. Are you with me? Direct labor and applied factory overhead are the remaining product costs that we must record.

Overhead Applied to Work in Process Manufacturing Cost Flow Wages Payable Work-in-Process Direct Labor Direct Material Indirect Labor Direct Labor Overhead Applied Mfg. Overhead Direct labor cost is recorded in the work-in-process inventory account. Indirect labor cost is recorded in the manufacturing overhead account. Manufacturing overhead is applied to jobs in the work-in-process inventory account using a predetermined overhead rate. Because of the estimating process used in calculating the predetermined overhead rate, the amount of overhead applied to products during the operating period may differ from the actual overhead costs incurred in the same period. If actual and applied manufacturing overhead are not equal, a year-end adjustment is required. We will look at the procedure to accomplish this later. If actual and applied manufacturing overhead are not equal, a year-end adjustment is required. We will look at the procedure to accomplish this later. Indirect Material Overhead Applied to Work in Process Indirect Labor

Now let’s complete the goods and sell them. Still with me? Manufacturing Cost Flow Now let’s complete the goods and sell them. Still with me? Once we have combined the proper amount of direct labor and factory overhead to convert material into a finished product, we will move the product out of the factory and prepare it for sale.

Manufacturing Cost Flow Work-in-Process Finished Goods Direct Material Cost of Goods Mfd. Cost of Goods Mfd. Cost of Goods Sold Direct Labor Overhead Applied Direct material, direct labor, and manufacturing overhead are combined in work-in-process. As products are completed, they are transferred to finished goods and then sold (delivered to customers). The dollar amount of the transfer from the work-in-process inventory account to the finished goods inventory account is called cost of goods manufactured. When a finished product is sold to the customer, the cost of that job is transferred from finished goods inventory to cost of good sold. Recall that cost of goods sold is an income statement account. Cost of Goods Sold Cost of Goods Sold

Manufacturing Cost Flow Let’s look at the January transactions of Ventra Manufacturing Company. Now that we have seen the accounts and cost flows for a manufacturer, let’s illustrate the process with transactions from the Ventra Manufacturing Company.

Manufacturing Cost Flow Here we see a January 1, 2005 trial balance for Ventra. The transactions that we will analyze occur during January 2005. During January, Ventra will manufacture 500 jewelry boxes.

Manufacturing Cost Flow Ventra pays $26,500 cash to purchase raw materials. Cash Bal. 64,500 Raw Materials Bal. 500 Part I Ventra pays $26,500 cash to purchase raw materials. Part II Purchasing the materials decreases cash and increases materials. There is no effect on the Income Statement when the material is purchased. The cash outflow is reported in the operating section of the Statement of Cash Flows. Part III Here we see the T-accounts for Cash and Raw Materials. The Cash account is decreased with a credit and the Raw Materials account is increased with a debit. 26,500 26,500

Manufacturing Cost Flow Ventra places $1,100 of raw materials into production in the process of making jewelry boxes. Part I Ventra places $1,100 of raw materials into production in the process of making jewelry boxes. Part II Raw materials is decreased and work-in-process is increased. There is no effect on the Income Statement or on the Statement of Cash Flows when the material is used. Part III The Raw Materials account is decreased with a credit and the Work-in-Process account is increased with a debit. Raw Materials 26,500 Bal. 500 Work-in-Process Bal. 0 1,100 1,100

Manufacturing Cost Flow Ventra pays $2,000 cash to purchase production supplies. Production Supplies Part I Ventra pays $2,000 cash to purchase production supplies. Part II Purchasing the production supplies decreases cash and increases supplies. There is no effect on the Income Statement when supplies are purchased. The cash outflow is reported in the operating section of the Statement of Cash Flows. Part III The Cash account is decreased with a credit and the Production Supplies account is increased with a debit. Cash 26,500 Bal. 64,500 2,000 2,000

Manufacturing Cost Flow Ventra pays production workers $1,400 cash. 26,500 Cash Bal. 64,500 2,000 1,100 Work-in-Process Bal. 0 Part I Ventra pays production workers $1,400 cash. Part II Paying the production workers decreases cash and increases work-in-process. There is no effect on the Income Statement when workers are paid. The cash outflow is reported in the operating section of the Statement of Cash Flows. Part III The cash account is decreased with a credit and the work-in-process account is increased with a debit. 1,400 1,400

To assign estimated overhead costs to inventory and cost of goods sold Learning Objective To assign estimated overhead costs to inventory and cost of goods sold Learning objective number 3 is to assign estimated overhead costs to inventory and cost of goods sold. LO3

$ Flow of Overhead Costs Using a predetermined rate makes it possible to estimate total job costs sooner. Actual overhead for the period is not known until the end of the period. $ We need to apply overhead as work progresses during a period. We cannot wait until the end of the period when we know the actual overhead costs. If we wait, many products will be completed and sold without any overhead costs charged to them.

Flow of Overhead Costs A predetermined overhead rate (POHR), used to apply overhead to products, is determined before the period begins. Estimated total manufacturing overhead cost for the period Estimated total units in the allocation base for the period POHR = Part I A predetermined overhead rate, used to apply overhead to products, is determined before the period begins. To calculate the predetermined overhead rate, we divide estimated total manufacturing overhead cost for the period by estimated total units in the allocation base for the period. Part II Ventra’s predetermined overhead rate is $3.36 per jewelry box. So, Ventra will charge $3.36 to each jewelry box completed. Let’s see how this works. $40,320 12,000 jewelry boxes POHR = = $3.36 per box

Based on estimates, and determined before the period begins. Flow of Overhead Costs Based on estimates, and determined before the period begins. Overhead applied = POHR × Actual activity Actual amount of the allocation base such as units produced, direct labor hours, or machine hours. We calculate the predetermined overhead rate before the period begins. As we work on products during the period, we apply overhead by multiplying the predetermined rate times the actual level of activity. If overhead is applied on the basis of units produced, we would apply overhead by multiplying the predetermined rate times the actual number of units, not the estimated or budgeted number of units.

Manufacturing Overhead Manufacturing Cost Flow Ventra applies $1,680 of estimated manufacturing overhead costs at the end of the month of January. Applied Manufacturing Overhead Actual 1,100 Work-in-Process 1,400 Bal. 0 Part I Ventra applies $1,680 of estimated manufacturing overhead costs at the end of the month of January. Part II Manufacturing overhead, a temporary asset account, is decreased and work-in-process is increased. There is no effect on the Income Statement or on the Statement of Cash Flows when the overhead is applied. Part III The Manufacturing Overhead account is decreased with a credit and the Work-in-Process account is increased with a debit. The $1,680 of applied overhead is computed by multiplying the $3.36 predetermined overhead rate times 500 jewelry boxes. 1,680 1,680 Applied overhead = 500 boxes × $3.36 per box = $1,680

To account for completion and sale of products Learning Objective To account for completion and sale of products Learning objective number 4 is to account for completion and sale of products. LO4

Manufacturing Cost Flow Ventra transfers the total cost of 500 jewelry boxes from work-in-process to finished goods. 1,100 Work-in-Process 1,400 1,680 Bal. 0 Finished Goods Bal. 836 100 boxes @ $8.36 Part I Ventra transfers the total cost of 500 jewelry boxes from work-in-process to finished goods. Part II Work-in-process is decreased and finished goods is increased. There is no effect on the Income Statement or on the Statement of Cash Flows when the jewelry boxes are completed and transferred to finished goods. Part III The Work-in-Process account is decreased with a credit and the Finished Goods account is increased with a debit. The sum of the material, labor and overhead costs in the Work-in-Process account, divided by the 500 jewelry boxes, results in a unit cost of $8.36. 4,180 4,180 Unit cost = $4,180 ÷ 500 boxes = $8.36 per box

Manufacturing Cost Flow Ventra recognizes cost of goods sold for 400 jewelry boxes sold to customers. Finished Goods 4,180 Bal. 836 Cost of Goods Sold Part I Ventra recognizes cost of goods sold for 400 jewelry boxes sold to customers. Part II Finished goods is decreased and equity is decreased. Net Income is decreased because an expense (cost of goods sold) is increased on the Income Statement. There is no effect on the Statement of Cash Flows. Part III The Finished Goods account is decreased with a credit and the Cost of Goods Sold account is increased with a debit. Cost of Goods Sold is computed by multiplying 400 boxes times the unit cost of $8.36. 3,344 3,344 400 boxes @ $8.36 per box = $3,344

Manufacturing Cost Flow Ventra recognizes $5,600 of sales revenue for the cash sale of 400 boxes. 26,500 Cash Bal. 64,500 2,000 1,400 Revenue Part I Ventra recognizes $5,600 of sales revenue for the cash sale of 400 jewelry boxes. Part II Cash is increased and equity is increased. Net Income is increased because revenue is increased on the Income Statement. The cash inflow is reported in the operating section of the Statement of Cash Flows. Part III The Revenue account is increased with a credit and the Cash account is increased with a debit. The amount of Revenue is computed by multiplying 400 boxes times the unit sales price of $14.00. 5,600 5,600 400 boxes @ $14.00 per box = $5,600

Manufacturing Overhead Manufacturing Cost Flow Ventra pays $1,200 cash for actual manufacturing overhead costs including indirect labor, utilities, rent, etc. Applied Manufacturing Overhead Actual 1,680 Cash 26,500 Bal. 64,500 2,000 1,400 5,600 Part I Ventra pays $1,200 cash for actual manufacturing overhead costs including indirect labor, utilities, rent, etc. Part II Paying cash for the actual manufacturing overhead items decreases cash and increases manufacturing overhead. There is no effect on the Income Statement. The cash outflow is reported in the operating section of the Statement of Cash Flows. Part III The Cash account is decreased with a credit and the Manufacturing Overhead account is increased with a debit. 1,200 1,200

Manufacturing Overhead Manufacturing Cost Flow Ventra pays $1,200 cash for actual manufacturing overhead costs including indirect labor, utilities, rent, etc. Manufacturing overhead is $480 overapplied at the end of January. Any difference between actual and applied overhead remaining at year end will be closed to cost of goods sold. Manufacturing Overhead The amount of applied overhead is 480 greater than the amount of actual overhead incurred for the month of January. No entry is needed at the end of January. However, any difference between actual and applied overhead remaining at year end will be closed to cost of goods sold. Actual Applied 1,200 1,680

Manufacturing Cost Flow At the end of the year, Ventra has the following account balances: Let’s move from January 31, 2005, to the end of the year on December 31, 2005.

Manufacturing Cost Flow Here we see a December 31, 2005, trial balance for Ventra. On the next several slides we will examine the balances in the inventory accounts and in the manufacturing overhead account.

See Cost of Goods Manufactured and Sold Schedule Manufacturing Cost Flow Supplies: $2,000 purchased, $1,700 used. See Cost of Goods Manufactured and Sold Schedule We have a $300 ending balance in production supplies because purchases were $2,000 but only $1,700 of production supplies were used. Raw materials and finished goods have balances that we will examine later when we prepare the Cost of Goods Manufactured and Sold Schedule.

Explanation of Manufacturing Overhead balance follows. Manufacturing Cost Flow Manufacturing overhead has a zero balance because the difference between actual and applied overhead was closed to cost of goods sold. Let’s see how the entry is made and how it affects cost of goods sold. Explanation of Manufacturing Overhead balance follows.

Analyzing Underapplied Overhead Manufacturing overhead is $3,752 underapplied. Applied Manufacturing Overhead Actual 39,648 43,400 3,752 Ventra applied $39,648 of manufacturing overhead during the year by multiplying 11,800 jewelry boxes manufactured times the predetermined overhead rate of $3.36 per box. Ventra incurred $43,400 of manufacturing overhead costs during the year, leaving the manufacturing overhead account $3,752 underapplied at the end of the year. 11,800 boxes manufactured × $3.36 POHR

Analyzing Underapplied Overhead Manufacturing overhead is $3,752 underapplied. Manufacturing Overhead Cost of Goods Sold Actual Applied 83,600 43,400 39,648 3,752 3,752 3,752 The underapplied overhead leaves a debit balance in the manufacturing overhead account. To close this amount we need to credit the account for $3,752 . The adjustment necessary at the end of the year is to credit the manufacturing overhead account for $3,752, and debit (increase) cost of goods sold by the same amount. 87,352 Underapplied overhead is closed to Cost of Goods Sold leaving a zero balance in the overhead account. 10,000 boxes @ $8.36

Analyzing Underapplied Overhead $43,400 $40,320 $39,648 Actual Overhead Overhead Overhead Incurred Budget Applied Spending variance $3,080 unfavorable Volume variance $672 unfavorable An analysis of the underapplied overhead results in two variances: the overhead spending variance and the overhead volume variance. Recall the original estimated overhead (budget) for the year was $40,320. We used that amount to compute the predetermined overhead rate. The actual amount of overhead costs was $43,400. The difference between the actual costs and the budgeted costs is a spending variance. The spending variance is unfavorable because the actual costs are greater than the budgeted costs. The second variance is the volume variance. It results because the actual volume of activity differs from the estimated (budgeted) volume of activity. Recall that the estimate that we used to calculate the predetermined overhead rate was 12,000 jewelry boxes. Actual production was only 11,800 jewelry boxes. The $672 unfavorable volume variance results from production falling 200 boxes short of the original estimate at a predetermined overhead rate of $3.36 per box. Total variance is $3,752 unfavorable, the amount of underapplied overhead.

To prepare a schedule of cost of goods manufactured and sold Learning Objective To prepare a schedule of cost of goods manufactured and sold Learning objective number 5 is to prepare a schedule of cost of goods manufactured and sold. LO5

Schedule of Cost of Goods Manufactured and Sold Now, let’s prepare a Schedule of Cost of Goods Manufactured and Sold for Ventra for the year. As we prepare the schedule, we will explain the ending balances in the raw materials and finished goods accounts that we saw earlier in the December 31, 2005, trial balance. Here you see the Schedule of Cost of Goods Manufactured and Sold for Ventra for the year in a highly summarized form. We will build each of the major parts of the statement starting with raw materials.

Schedule of Cost of Goods Manufactured and Sold Material purchases for the current year are added to the beginning balance of materials inventory. The beginning balance of materials inventory for the current year is the ending balance of materials inventory from last year. Materials are either used or they remain in inventory. Subtracting the amount of materials on hand in inventory at the end of the year results in the cost of materials used for the current year.

Schedule of Cost of Goods Manufactured and Sold Manufacturing overhead costs are indirect manufacturing costs that support the manufacturing activities. The manufacturing overhead items in this example total $43,400.

Schedule of Cost of Goods Manufactured and Sold Part I Total manufacturing costs incurred are added to the beginning work-in-process balance to get the total work-in-process amount of $102,400. Subtracting the ending balance of work-in-process from the total work-in-process inventory results in the $94,040 cost of goods manufactured for the current year. Cost of goods manufactured is cost of goods completed and transferred to finished goods for the current year. It is added to the the beginning balance of finished goods to get cost of goods available for sale. Subtracting the ending balance of finished goods from cost of goods available for sale results in the cost of goods sold of $87,352. Part II The ending work-in-process balance and the ending finished goods balance, along with the ending balance of raw materials are reported in the current assets section of a manufacturer’s balance sheet. Reported in the current assets section of the balance sheet.

Learning Objective To prepare financial statements for a manufacturing company Learning objective number 6 is to prepare financial statements for a manufacturing company. LO6

Financial Statements Here is Ventra’s Income Statement for the year ended December 31, 2005. The first amount is Sales Revenue that we computed earlier, 10,000 boxes at $14.000. The second item is Cost of Goods Sold which we saw on the Schedule of Cost of Goods Manufactured and Sold.

Financial Statements Here is Ventra’s Balance Sheet as of December 31, 2005. Notice the three inventory accounts: Raw Materials, Work-in-Process, and Finished Goods. We computed these amounts as we prepared the Schedule of Cost of Goods Manufactured and Sold.

Financial Statements Here is Ventra’s Statement of Cash Flows for the year ended December 31, 2005. We have dealt with the first two items on this statement as we examined transactions of Ventra company. The first item is the cash inflow form customers resulting from selling 10,000 jewelry boxes at $14.00 each. The second item is the cash outflow for production of jewelry boxes. These cash outflows were for the purchase of materials and production supplies, payment of production workers, and the cost of manufacturing overhead items. See the next slide for more detail on the cash outflow for production of inventory.

From Schedule of Cost of Goods Manufactured and Sold Financial Statements Here we see the detail behind the $93,240 of cash outflows for the production of inventory. Noncash items are excluded from the Statement of Cash flows. For example, the $10,000 of depreciation, that is a manufacturing overhead item in the Schedule of Cost of Goods Manufactured and Sold is a noncash amount. Depreciation is not included in the Statement of Cash Flows. From Schedule of Cost of Goods Manufactured and Sold

To distinguish between absorption and variable costing Learning Objective To distinguish between absorption and variable costing Learning objective number 7 is to distinguish between absorption and variable costing. LO7

Motive to Overproduce Absorption Costing Hokai Company incurs the following costs to produce 2,000 units of inventory: Absorption costing charges products with four manufacturing costs: direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Variable costing charges products with only three manufacturing costs: direct material, direct labor, and variable manufacturing overhead. The only difference is the treatment of fixed manufacturing overhead. With absorption costing, fixed manufacturing overhead is a product cost. With variable costing, fixed manufacturing overhead is a period cost. Let’s take a look at an example to see how income and inventory are affected by the different treatment of fixed manufacturing overhead. Hokai Company makes 2,000 units of a single product. Variable manufacturing costs total $9.00 per unit. Fixed manufacturing overhead is $12,000. Let’s see what happens to unit costs as Hokai increases production above 2,000 units. Let’s see what happens to costs if Hokai increases production.

Motive to Overproduce Absorption Costing Now let’s compute income at the three levels of production if Hokai sells 2,000 units. As the production level increases from 2,000 units to 4,000 units the fixed overhead per unit declines from $6.00 to $3.00. We are dividing a fixed amount by an increasing volume which causes the decline in fixed overhead per unit. The variable manufacturing cost per unit remains unchanged at $9.00 for all levels. Combining the variable and fixed unit costs yields full absorption unit costs of $15.00 at 2,000 units, $13.00 at 3,000 units, and $12.00 at 4,000 units. Now let’s prepare partial absorption cost income statements for Hokai at the the three levels of production activity.

Motive to Overproduce Absorption Costing The production activity increases from 2,000 units to 4,000 units, but the sales level remains constant at 2,000 units. Since the absorption unit cost is lower at the higher production activity levels, cost of goods sold is lower. This results in a higher gross margin and a higher income. The increase in income when production is greater than sales can lead to decisions to overproduce merely to inflate income. Internally, many companies use variable costing to motivate managers to increase profitability without motivating them to overproduce. Let’s prepare income statements using variable costing to see why this is true. Internally, many companies use variable costing to motivate managers to increase profitability without motivating them to overproduce.

Net income is not affected by production increases. Variable Costing Notice that variable costing statements are contribution format statements. First, we subtract variable cost of goods sold from sales to get contribution margin. After computing contribution margin, we subtract fixed overhead to get the variable costing income. Note that all of the fixed manufacturing overhead is expensed as a lump sum of $12,000. Variable costing income is the same $10,000 regardless of the level of production. The only difference between the two methods is the treatment of fixed manufacturing overhead. Traditional costing treats fixed manufacturing overhead as a product cost using an overhead rate that declines as production increases. As a result some fixed overhead remains in inventory as a part of the cost of unsold units when production is greater than sales. Income computed using variable costing expenses all $12,000 of the fixed manufacturing overhead. None of the fixed manufacturing overhead remains in inventory. Net income is not affected by production increases.

End of Chapter 11 End of Chapter 11.