Polk Company Builds Custom Fishing Lures For Sporting Goods

Polk Company Builds Custom Fishing Lures For Sporting Goods Stores In

Polk Company produces custom fishing lures for sporting goods stores, incurring various costs during its first year of operations in 2012. These costs include variable costs such as direct materials, direct labor, variable manufacturing overhead, and variable selling and administrative expenses. Additionally, fixed manufacturing overhead and fixed selling and administrative expenses are incurred annually regardless of production volume. The company sells its lures at a unit price of $25, with sales totaling 80,000 units and production reaching 95,000 units in 2012. This report focuses on calculating the manufacturing costs per unit under both variable and absorption costing methods and preparing corresponding financial statements to analyze cost behavior and profitability.

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Introduction

Cost accounting plays a crucial role in providing management with relevant information for decision-making, cost control, and profitability analysis. The choice between variable (direct) costing and absorption (full) costing significantly influences the reporting of product costs and net income, especially when production volume fluctuates relative to sales. This paper examines Polk Company's costs during its inaugural year, calculating unit costs under both costing methods, and presents income statements accordingly to shed light on cost structures and financial performance.

Variable Costing Analysis

Under variable costing, only direct costs and variable manufacturing overhead are included in product costs. Fixed manufacturing overhead and fixed selling and administrative expenses are treated as period costs. The variable manufacturing cost per unit is derived from direct materials, direct labor, and variable manufacturing overhead. According to the data, direct materials cost is $7.50, direct labor is $2.45, and variable overhead is $5.75 per unit. Summing these gives:

  • Variable manufacturing cost per unit = $7.50 + $2.45 + $5.75 = $15.70

This cost represents the expense associated with producing each unit under the variable cost approach. It is important to note that variable costing facilitates the analysis of contribution margin and variable expenses in relation to production and sales volume.

Variable Costing Income Statement

Using the provided data on sales volume (80,000 units at $25 each), revenues amount to $2,000,000. Variable costs include the manufacturing costs for the units sold, calculated as:

  • Variable manufacturing cost = 80,000 units × $15.70 = $1,256,000
  • Variable selling and administrative expenses = 80,000 units × $3.90 = $312,000

Gross profit under variable costing is then:

  • Revenue - Variable costs = $2,000,000 - ($1,256,000 + $312,000) = $432,000

Fixed manufacturing overhead ($234,650) and fixed selling and administrative expenses ($240,100) are considered period costs and subtracted from the gross profit to determine net income:

  • Net income = $432,000 - ($234,650 + $240,100) = -$42,750

Thus, Polk's net income for 2012 under variable costing is a loss of $42,750, reflecting the fixed costs spread over the period.

Absorption Costing Analysis

Under absorption costing, fixed manufacturing overhead is allocated to each unit produced, making total product costs inclusive of all manufacturing expenses. The fixed overhead per unit is calculated by dividing total fixed manufacturing overhead by units produced:

  • $234,650 / 95,000 units = approximately $2.47 per unit

The total manufacturing cost per unit then becomes:

  • $7.50 (materials) + $2.45 (labor) + $5.75 (variable overhead) + $2.47 (fixed overhead) = $18.17

The total cost of goods sold (COGS) for 80,000 units sold is:

  • 80,000 units × $18.17 = $1,453,600

Revenue remains the same at $2,000,000. The gross profit under absorption costing is calculated as:

  • Revenue - COGS = $2,000,000 - $1,453,600 = $546,400

Recognizing fixed selling and administrative expenses of $240,100, the net income again results in a loss:

  • Net income = $546,400 - ($312,000 + $240,100) = -$5,800 (approx.)

Note: Minor discrepancies in net income figures may arise from rounding; the essential conclusion remains that absorption costing shows a lower net loss compared to variable costing, primarily because fixed manufacturing overhead costs are allocated to inventory instead of being expensed in the period.

Discussion and Implications

The choice of costing method influences reported profitability and managerial decision-making. Variable costing provides clearer insights into the contribution margin, focusing exclusively on costs that vary with production and sales volume. This method is advantageous for evaluating the impact of volume changes and making decisions about pricing, discontinuing products, or identifying profitable segments.

Absorption costing, mandated by generally accepted accounting principles (GAAP) for external reporting, incorporates fixed manufacturing overhead into product costs. This method can smooth income fluctuations across periods and align with tax reporting but may obscure the actual variable costs associated with producing specific units. The higher net income reported under absorption costing when inventory increases may lead to misleading conclusions about operational performance, especially in periods with fluctuating production levels.

The analysis indicates that Polk Company’s net income would be higher under absorption costing due to fixed overhead being spread over all units produced, including unsold inventory, as opposed to the variable costing approach, which expenses fixed costs entirely in the period. Therefore, managerial decisions should consider the context; for internal decision-making, variable costing offers more pertinent insights, whereas external financial statements adhere to absorption costing conventions.

Conclusion

In summary, the application of both costing methods reveals different perspectives on Polk Company's costs and profitability. The variable costing approach emphasizes the variable costs directly attributable to production and sales, providing valuable insights for short-term decision-making. Conversely, absorption costing allocates fixed manufacturing overhead to inventory, affecting net income calculations when inventory levels change. Management must understand the implications of each method to interpret financial results accurately and make strategic choices aligned with operational realities and reporting requirements.

References

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