[jessanqi]

Hi, I’m frustrated on this one, hope anyone can give some advise.
1. I think the Fixed manufacturing overhead should not change with the output change, since it’s fixed..
2. I don’t think just because the Fixed manufacturing cost per unit based on the 5000 production is $2/unit, means when you produce more, it’s still $2/unit??

Can someone help!!

Thank you!

Question

Troughton Company manufactures radio-controlled toy dogs. Summary budget financial data for Troughton for the current year are as follows.
Sales (5,000 units at $150 each) $750,000
Variable manufacturing cost $400,000
Fixed manufacturing cost $100,000
Variable selling and administrative cost $80,000
Fixed selling and administrative cost $150,000

Troughton uses an absorption costing system with overhead applied based on the number of units produced, with a denominator level of activity of 5,000 units. Underapplied or overapplied manufacturing overhead is written off to cost of goods sold in the year incurred. The $20,000 budgeted operating income from producing and selling 5,000 toy dogs planned for this year is of concern to Trudy George, Troughton’s president. She believes she could increase operating income to $50,000 (her bonus threshold) if Troughton produces more units than it sells, thus building up the finished goods inventory. How much of an increase in the number of units in the finished goods inventory would be needed to generate the $50,000 budgeted operating income?

A. 556 units
B. 600 units
C. 1,500 units
D. 7,500 units

Explanation
The correct answer is C. Absorption (full) costing considers fixed manufacturing overhead costs as product costs and they are inventoried. With absorption (full) costing, all manufacturing costs (both fixed and variable) are included in calculating product costs. However, a proportionate amount of such costs would be held back in inventory based upon the difference between units manufactured and units sold (finished goods).

In this question, under absorption costing, fixed costs can be “accumulated” in ending finished goods inventory if more units are produced. Each additional unit produced and not sold, increases operating income by the incremental amount of fixed production cost.

To generate $30,000 of additional operating income, 1,500 units ($30,000/$20) have to be produced and included in ending finished goods inventory. Each product has fixed manufacturing overhead applied at $20 ($100,000/5,000). If 1,500 additional units are manufactured, fixed manufacturing overhead will be over-applied by $30,000 (1,500 × $20). Troughton reduces the cost of goods sold by any over-applied overhead. Therefore, the operating income will increase $30,000 to the desired $50,000 budgeted operating income.

Note: Often, companies use variable (fixed) costing internal performance measures to address potential issues caused by accumulating more ending finished goods inventory.

[RB]

Jessa –

I think there are a few components of this concept you need to understand.

Overall, fixed costs will be what they are regardless of production levels. That is correct.

But – related to your question on ABC costing, the company has to take their fixed overhead and figure out hey, where do we account for this cost? The fact is the only reason to rent the factory is in order to make products, so they take those expenses and somehow “allocate” them to the products.

In generally they do so by taking the full estimated costs (100,000) and estimated cost driver (5,000 units in this case), and say okay, for each unit we actually produce we’ll assign $20 of that fixed cost to that unit and call it a product cost ($20 being $100,000 / 5,000 units of production assumed).
This is the difference between Absorption and variable costing, VC will just say that 100K is a period expense, but AC (which is required for GAAP and financials) says yea, each $20 is applied as a product cost.
This now means, say we produce 5,000 units but only sell 3,000 of them, well those 2,000 units in sitting in ending inventory each have $20 of that cost assigned to them, which is part of inventory and is not a part of our expenses yet. They only become an “expense” when you sell it and it passes out of cost of goods sold. So as far as the income is concerned her “expenses” for that period’s income statements are lower by $20 X 2,000 = $40,000 (or $20 x 1,500 in the actual example)

This is beyond your question but important to understand (took me a few days for it to sink in), overhead costs are allocated based on the ESTIMATED cost and ESTIMATED driver, and only at the end of the year will they look at the difference in how much they actually spent and then apply that against the pool of COGS. That gets into some of the variance analysis which you will eventually address. Overhead variances took me a while.

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REG - 91

Justin - reach out for more help

[jessanqi]

Thanks so much RB!!

The thing I'm still confused is, if we still produce 5000 units, but only sell 3000, I'm sure the fixed operating cost would be lower because part of it goes to the inventory, However, the sales revenue should decrease also.

The operating expense is sales-GOGS-operaring expense, so how come the operating expense just affected by the Fixed manufacturing overhead part??

Please advise if I'm wrong.. thank you!!!

[RB]

Okay yes, this is a pretty complex question actually. So in my hypothetical, you got the point that those pieces don’t get expensed. What’s actually happening is that she wants to produce ABOVE the sales amount so you have extra expenses sitting in inventory.

I can’t quite run the math perfectly so I’m going to try to give you the 90% sufficient explanation, which is just that, hypothetically here, if we made 6,500 units and still sold the 5,000 units, 1,500 of those in this case mean that $20 x 1,500 = $30,000 in fixed manufacturing costs sit in inventory. Cost of goods sold is almost always calculated based on total goods available for sale less ending inventory, so if ending inventory is up by $30,000, cost of goods sold is down by $30,000, operating income is up by $30,000.

Just, memorize that piece if you can. It actually gets more clouded, because theoretically since they’re saying this is “for the year”, any difference between actual fixed costs and what they allocated for the year ends up as an adjustment to inventory / COGS at the end of the year. So, I’m not clear how that piece works here, that could mess up her plan. But conceptually the question wants you just to think hey, ending inventory up $30k means COGS (expenses) are down by 30K, and thus operating income is up by 30K.

I’m sorry, I really don’t like 90% answers myself, they don’t give you the whole picture that you would need to tackle any variation. But, I think that piece will help you get “90%” of the questions correct, at least for this type with absorption vs variable costing

AUD - 95
BEC - 98
FAR - 98
REG - 91

Justin - reach out for more help

[jessanqi]

okay got it!

Thank you so mucn RB! You are the best!!!! 🙂

[Author]

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