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American Public University System Absorption Costing

American Public University System Absorption Costing

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STUDENT
1: Susan

What
denominator level is Smart Safety using to allocate fixed manufacturing costs
to the bicycle helmets?

The
denominator level that is being used appears to be master-budget
utilization. Master budget capacity results in a higher cost per unit,
because the fixed costs are spread over expected demand for the
budgeted year of 52,000 units, which is presumably less than available
capacity. Using practical capacity as the denominator level spreads fixed
costs over capacity available, which reduces the cost per unit and
eliminates the need to have to recalculate cost per unit each year. In
addition, it highlights used and unused capacity for management decisions, such
as what to do with unused capacity, or whether they should downsize, etc.
Smart Safety has a favorable production-volume variance in 2014, because
they utilized more capacity than was budgeted. As a result, fixed costs
were over allocated due to the higher cost per unit, giving Smart Safety a
favorable production-volume variance. It looks like they reduced the
production level in 2015, given the lack of additional demand for their product
in 2014. The president should use practical capacity as their
denominator level for allocating fixed costs, so he can make better production
and costing decisions in the long run.

How is
Smart Safety disposing of any favorable or unfavorable production-volume
variance at the end of the year?

The
favorable production-volume variance of $260,000 in 2014, is being inventoried
rather than expensed to cost of goods sold in the current period. This
means it is added to ending inventory, reducing cost of goods sold, and
increasing operating income. An unfavorable production-volume variance
would have increased cost of goods of goods sold under this method, and
decreased operating income. Under absorption costing, all fixed
manufacturing costs are allocated to the unit cost of the product and
inventoried, so when inventory is increasing, as it does when there is a
favorable production-volume variance, operating income will also increase under
this costing method. This is true regardless of whether the company is
operating at capacity. There was no beginning inventory at the start of
2014, and production increased by $405,600. Smart Safety was not able to
sell the additional inventory, so the costs were not deducted in Cost of Goods
Sold; they were instead left on the balance sheet. Smart safety starts
2015 with $405,600 of inventory, and brought production back down to 2013
levels. They had zero inventory on hand at the end of 2015, so all fixed
costs incurred in 2014 were expensed in 2015, which explains the significant
decrease in operating income. Had the additional units been sold in 2014,
then 2015 would have a higher operating income, but not enough inventory to
meet demand.

Susan

Horngren, C. T.,
Datar, S. M., Rajan, M. V. Cost Accounting. [VitalSource Bookshelf].
Retrieved from https://online.vitalsource.com/#/books/97813234844…


STUDENT
2: Chris

Hello
Class, I hope
everyone’s week was/is productive. With
absorption costing, manufacturing costs are absorbed by the units produced.
This simply means that the cost of a finished product will also include direct
expense cost and fixed/variable manufacturing overhead cost. This appears to be
the method that Smart Safety is using when preparing their income statement.

In the
years 2013, 2014, and 2015, the operating cost were $0, $260,000, and $41,600
respectively. Furthermore, the units sold those years were $52,000 for the
first two, and $62,400 in the last. We see that the operating income decreased
in the third, which is the year that they sold more units. The prior years had
the same number of sales for both years ($52,000), but in the case of 2014, the
operating income was $260,000. What does this mean? Well, in the first year the
company broke even at $52,000. The second year, they produced more than 52,000
units, which was 62,400, leaving 10,400. This caused an “over absorption” of
production (10,400 x 25 = $260,000). In other words, the fixed manufacturing
cost that correlated with those units are not recorded on the income statement
and cause an overstatement in operating cost. The following year reflects a
transfer of beginning inventory and a sale of fixed manufacturing overhead
related to beginning inventory. Now, the fixed manufacturing overhead cost will
be recorded and an understatement of that portion is seen in 2015.

Also, in
regards to the “over absorption”, the company also appears to dispose all
production volume variance against cost of goods sold. When they are producing
more units, instead of the budgeted 52,000, it causes a favorable production
variance ((62,4000 – 52,000) x 25 = 260,000). When the $260,000 amount was
written off against cost of goods sold, it caused a “positive” effect by
increasing the gross margin by 56%. This why the manager stated, “Then in our
second year, we sold the same volume and had a positive operating income”.

It
appears that the company is using 52,000 as its denominator level, which is
their fixed manufacturing overhead, which formulates to fixed manufacturing
cost divided by budgeted production units (1,300,000/52,000). This number comes
out to $25. The information presented seems to suggest that the company cannot
make a profit by only producing 52,000 units and should therefore, more.

Reference:

https://www.investopedia.com/terms/a/absorptioncos…

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