Polk Company builds custom fishing lures for sporting goods stores. In its first year of operations, 2012, the company incurred the following costs.
Variable Cost per Unit
Direct materials $7.50
Direct labor $2.45
Variable manufacturing overhead $5.75
Variable selling and administrative expenses $3.90
Fixed Costs per Year
Fixed manufacturing overhead $234,650
Fixed selling and administrative expenses $240,100
• Polk Company sells the fishing lures for $25. During 2012, the company sold 80,000 lures and produced 95,000 lures.
• Instructions
(a) Assuming the company uses variable costing; calculate Polk’s manufacturing cost per unit for 2012.
(b) Prepare a variable costing income statement for 2012.
(c) Assuming the company uses absorption costing; calculate Polk’s manufacturing cost per unit for 2012.
(d) Prepare an absorption costing income statement for 2012.
a) Using variable costing, Polk’s manufacturing cost per unit consists of direct materials ($7.50), direct labor ($2.45), and variable overhead ($5.75) = $15.70 per unit.
Variable Costing Per Unit Cost
Direct Materials 7.5
Direct Labor 2.45
Variable Overhead 5.75
Per Unit Cost $ 15.70
b)
Polk Company
Income Statement Variable costing
Revenue (NNN) NNN-NNNN
Direct Costs 796000
Variable Overhead 460000
Gross Profit 744000
Less Variable selling 312000
Fixed Manufacturing Overhead 234650
Fixed Selling 240100
Net Income -42750
c) Using absorption costing, Polk’s manufacturing cost per unit consists of direct materials ($7.50), direct labor ($2.45), variable overhead ($5.75) and fixed overhead, which equates to (234,650 / 95,000) = $2.47 per unit. This gives a total manufacturing cost per unit of $18.17.
Absorption Costing Per Unit Cost
Direct Materials 7.5
Direct Labor 2.45
Variable Overhead 5.75
Fixed Overhead* 2.47
Per Unit Cost $ 18.17
FO = 234,650 / 95,000
d)
Polk Company
Income Statement Absorption Costing
Revenue (NNN) NNN-NNNN
Direct Costs 796000
Variable Overhead 460000
Fixed Overhead 197600
Gross Profit 546400
Less Variable selling 312000
Fixed Selling 240100
Net Income -5700
In this case, it would be better to use the absorption method because this method incorporates only the overhead that is allocated to the 80,000 units sold. The variable method counts fixed overhead as a period expense, meaning that the fixed overhead for this period is calculated on the basis of the 95,000 units produced, if the absorption method is used. The variable method only calculates fixed overhead on the basis of the 80,000 units that were sold. This provides management with a more accurate picture of the profitability of the fishing lures. Thus, the variable costing method is optimal.
The main benefit of the absorption method is to provide accurate information to management about product costs. The variable method is beneficial because it provides an output which is (net income) that is closer to the cash flow of the business. This is especially useful in businesses that might be short on cash flow. The variable costing method provides management with a clearer picture of the effect that fixed costs have on the total profitability of the company.
Absorption costing is particularly useful for firms that do not sell all of their output during the manufacturing period, as is the case with Polk. Under absorption costing, the cost of a good is not shown until the good has been sold (Johnston, 2013). This can be a disadvantage if a portion of the goods produced are ultimately not sold, as management would still have to know the cost of those goods.
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