Variable Costing Can Still Create Incentives to Over Produce

Question

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The Answer is a. Net income in year 1 using absorption costing and variable costing is the same because production and sales are the same. There is no inventory at the end of the year. Net income under both absorption and variable costing is:

\begin{array}{c} ext { Absorption Costing Net Income }\{ ext { Year 1 } } \\begin{array} { | l | r | } \hline \\hline ext { Revenue } ( 80,000 imes \$ 30 ) & \$ 2,400,000 \\hline ext { Direct material \& labor } ( 80,000 imes \$ 5 ) & 400,000 \\hline ext { Overhead } \left( 80,000 imes \$ 14.50 ^ { + } ight) & 1,160,000 \\hline ext { Net income } & \$ 840,000 \\hline\end{array}\end{array}

*$14.50 = ($1,000,000 + $2 × 80,000)/80,000

\begin{array}{l} ext { Wariable Costing N et Income }\ ext {Year1}\\begin{array} { | l | r | } \hline ext { Revenue } ( 80,000 imes \$ 30 ) & \$ 2,400,000 \\hline ext { Direct material \& labor } ( 80,000 imes \$ 5 ) & 400,000 \\hline ext { Variable overhead } ( 80,000 imes \$ 2.00 ) & 160,000 \\hline ext { Fixed overhead } & \underline{1,000,000} \\hline ext { Net income } & \$ 840,000 \\hline\end{array}\end{array}

b. Net income in year 2 using absorption costing where the overhead rate used to assign overhead to products is based on actual overhead incurred:

\begin{array}{c} ext { Absorption Costing }\ ext { Year 2 } \\begin{array} { | l | r | } \hline ext { Revenue } ( 60,000 imes \$ 30 ) & \$ 1,800,000 \\hline ext { Direct material \& labor } ( 60,000 imes \$ 5 ) & 300,000 \\hline ext { Overhead } \left( 60,000 imes \$ 16.875 ^ { * } ight) & 1,012,500 \\hline ext { Net income } & \$ 487,500 \\hline\end{array}\end{array}

*$16.875 = $1,350,000/80,000
c. Net income in year 2 using variable costing where the difference between budgeted overhead and actual overhead is treated as a fixed cost.

\begin{array}{c} ext { Variable Costing}\ ext { (Excess overhead is treated as fixed)}\ ext { Year 2}\\begin{array}{|l|r|}\hline ext { Revenue }(60,000 imes \$ 30) & \$ 1,800,000 \\hline ext { Direct material \& labor }(60,000 imes \$ 5) & 300,000 \\hline ext { Variable overhead }(60,000 imes \$ 2) & 120,000 \\hline ext { Fixed overhead }(\$ 1,000,000+(1,350,000- & 1,190,000 \\left.1,160,000^{*} ight) & \\hline ext { Net income } & \$ 190,000 \\hline \end{array}\end{array}

*$1,160,000 = $1,000,000 + $2 × 80,000
d. Net income in year 2 using variable costing where any difference between budgeted overhead and actual overhead is treated as a variable cost.

\begin{array}{c} ext { Variable Costing}\ ext { (Excess overhead is treated aswariable) }\ ext { Year 2}\\begin{array}{|l|r|}\hline ext { Revenue }(60,000 imes \$ 30) & \$ 1,800,000 \\hline ext { Direct material \& labor }(60,000 imes \$ 5) & 300,000 \\hline ext { Variable overhead }\left(60,000 imes \$ 4.375^{*} ight) & 262,500 \\hline ext { Fixed overhead } & \underline{1,000,000} \\hline ext { Net income } & \$ 237,500 \\hline\end{array}\end{array}

*$4.375 = $2.00 + ($1,350,000 - 1,160,000)/80,000
e. Absorption costing reports higher net income ($487,500) than variable costing ($190,000 or $237,500) when production exceeds sales because some of the fixed overhead costs are placed in the ending inventory. However, by treating the excess overhead costs as variable (part d) some of these excess overhead costs are placed in inventory by over producing. Thus, variable costing does not totally eliminate the incentives to over produce.

Variable Costing Can Still Create Incentives to Over Produce

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