So during 2007 there was a drop of 20000 units in

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So, during 2007, there was a drop of 20,000 units in inventory levels (matching the 20,000 more units sold than produced). The smaller the denominator level, the larger is the budgeted fixed cost allocated to each unit of production, and, when those units are sold (all the current production is sold, and then some), the larger is the cost of each unit sold, and the smaller is the operating income. Normal utilization capacity is the smallest capacity of the three, hence in this year, when production was less than sales, the absorption-costing based operating income is the smallest when normal capacity utilization is used as the denominator level. 4. Reconcilation Theoretical Capacity Operating Income Practical Capacity Operating Income $40,000 Decrease in inventory level during 2007 20,000 Fixed mfg cost allocated per unit under practical capacity fixed mfg. cost allocated per unit under theoretical capacity ($12 $10) $2 Additional allocated fixed cost included in COGS under practical capacity = 20,000 units $2 per unit = $40,000 More fixed manufacturing costs are included in inventory under practical capacity, so, when inventory level decreases (as it did in 2007), more fixed manufacturing costs are included in COGS under practical capacity than under theoretical capacity, resulting in a lower operating income.
9-38 9-37 (20 35 min.) Effects of denominator-level choice. 1. Normal capacity utilization. Givens denoted* Actual Costs Incurred (1) Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level (2) Flexible Budget: Same Budgeted Lump Sum (as in Static Budget) Regardless of Output Level (3) Allocated: Budgeted Input Allowed for Actual Output × Budgeted Rate (4) $130,000 $120,000* $120,000* 70,000 hrs.* × $2.00 a = $140,000 $10,000 U* $20,000 F* Spending variance Never a variance Prodn. volume variance Production,volume,variance = Error! $20,000 = ($120,000 X) X = $140,000 Budgeted fixed manufacturing,overhead rate per unit = $140,000 70,000 machine-hours = $2 per machine-hour Denominator level = $120,000 $2 = 60,000 machine-hours
9-39 2. Practical capacity. Givens denoted* Actual Costs Incurred (1) Same Lump Sum (as in Static Budget) Regardless of Budgeted Output Level (2) Flexible Budget: Same Lump Sum (as in Static Budget) Regardless of Budgeted Output Level (3) Allocated: Budgeted Input Allowed for Actual Output × Budgeted Rate (4) $130,000 $120,000* $120,000* 70,000* × $1.20 a = $84,000 $10,000 U* $36,000 U* Spending variance Never a variance Prodn. volume variance Production-volume,variance = Error! $36,000 = ($120,000 X) X = $84,000 Budgeted manufacturing,overhead rate per unit = $84,000 70,000 machine-hours = $1.20 per machine-hour Denominator level = $120,000 $1.20 = 100,000 machine-hours

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