Solutions
CHAPTER 10
CRITICISMS OF ABSORPTION COST SYSTEMS:
INCENTIVE TO OVER-PRODUCE
P 10-1: Solution to Federal Mixing (10 minutes) [Explaining absorption versus variable costing]
Variable costing writes off to income all fixed manufacturing costs incurred during the year. Absorption costing prorates the fixed overheads between units in inventory and units sold based on machine hours.
Absorption costing net income is higher than under variable costing by $1.2 million. This means that inventories under absorption costing are higher by $1.2 million.
The ending work-in-process inventory contains 20,000 more machine hours than the beginning inventory (90,000 – 70,000 machine hours). From the data given, the fixed overhead rate applied to products is $60 per machine hour. Or,
$1.2 million = (90,000 – 70,000) × fixed overhead rate
Fixed overhead rate =
= $60
P 10–2: Solution to Xerox (15 minutes)
[Incentives to over produce]
By building inventories and using absorption costing, Xerox shifts some of its fixed manufacturing costs from cost of goods sold to inventories. This decreases cost of goods sold and increases net income as long as average unit costs are decreasing. This is a short-term strategy to boost accounting earnings and earnings will reverse as soon as inventories are depleted. This strategy is unlikely to mislead the stock market. Since the higher inventories must be disclosed as part of the financial statements, the market is not likely to be fooled by such over production.
Note: In May, 2000 Richard Thoman was replaced as CEO. The previous CEO, Paul Allaire returned as CEO and Anne Mulcahy was promoted to president and chief operating officer. Paul Allaire described the change as, "We are grateful for Rick's contributions in leading the company through a period of major repositioning. However, both Rick and the board felt it best for the company to move forward with an experienced Xerox team that will lead Xerox
CRITICISMS OF ABSORPTION COST SYSTEMS:
INCENTIVE TO OVER-PRODUCE
P 10-1: Solution to Federal Mixing (10 minutes) [Explaining absorption versus variable costing]
Variable costing writes off to income all fixed manufacturing costs incurred during the year. Absorption costing prorates the fixed overheads between units in inventory and units sold based on machine hours.
Absorption costing net income is higher than under variable costing by $1.2 million. This means that inventories under absorption costing are higher by $1.2 million.
The ending work-in-process inventory contains 20,000 more machine hours than the beginning inventory (90,000 – 70,000 machine hours). From the data given, the fixed overhead rate applied to products is $60 per machine hour. Or,
$1.2 million = (90,000 – 70,000) × fixed overhead rate
Fixed overhead rate =
= $60
P 10–2: Solution to Xerox (15 minutes)
[Incentives to over produce]
By building inventories and using absorption costing, Xerox shifts some of its fixed manufacturing costs from cost of goods sold to inventories. This decreases cost of goods sold and increases net income as long as average unit costs are decreasing. This is a short-term strategy to boost accounting earnings and earnings will reverse as soon as inventories are depleted. This strategy is unlikely to mislead the stock market. Since the higher inventories must be disclosed as part of the financial statements, the market is not likely to be fooled by such over production.
Note: In May, 2000 Richard Thoman was replaced as CEO. The previous CEO, Paul Allaire returned as CEO and Anne Mulcahy was promoted to president and chief operating officer. Paul Allaire described the change as, "We are grateful for Rick's contributions in leading the company through a period of major repositioning. However, both Rick and the board felt it best for the company to move forward with an experienced Xerox team that will lead Xerox