Absorption costing vs variable costing and a pricing decision
Waihopai Ltd produces a single product. Budgeted production and sales for the year are 20,000 units. Variable manufacturing cost is $24 per unit. Fixed manufacturing overhead is $300,000 per year, absorbed on the basis of units produced. Variable selling cost is $6 per unit and fixed selling and administration cost is $120,000 per year. The selling price is $60 per unit. Actual production was 22,000 units and sales were 19,000 units; there is no opening inventory. The sales manager proposes cutting the price to $52 to increase volume, arguing that 'the product costs $45, so $52 still gives a good margin'. A customer offers to buy 2,000 units at $40, and idle capacity exists.
1. Calculate the product cost per unit under absorption costing and under variable costing, and reconcile the difference in reported profit.
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Absorption cost per unit
Fixed overhead rate = 300,000 / 20,000 = $15 per unit. Product cost = 24 + 15 = $39.
Variable cost per unit = $24.
Profit reconciliation
Absorption costing: closing inventory (3,000 units) carries 3,000 x 15 = $45,000 of fixed overhead deferred. Absorption profit exceeds variable costing profit by $45,000.
Workings:
- Variable costing contribution = 19,000 x (60 - 24 - 6) = 19,000 x 30 = $570,000; less fixed costs 300,000 + 120,000 = $420,000; profit = $150,000.
- Absorption costing: sales 19,000 x 60 = 1,140,000; cost of goods sold 19,000 x 39 = 741,000; gross profit 399,000; less variable selling 114,000 and fixed selling 120,000; profit = $165,000.
Difference = 165,000 - 150,000 = $15,000, which equals 3,000 units x $15 fixed overhead in closing inventory... note the reconciliation must use the actual overhead rate; using budgeted rate gives $45,000 only if production equals budget. Here actual fixed overhead absorbed = 22,000 x 15 = $330,000 against actual $300,000, creating a $30,000 over-absorption that also affects profit. The key exam point is that the difference is explained by fixed overhead in inventory plus any over/under-absorption.
2. Evaluate the sales manager's claim that 'the product costs $45, so $52 gives a good margin'.
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Error in the claim
The $45 figure appears to add variable manufacturing $24 + fixed overhead $15 + variable selling $6 = $45. That mixes product and period costs and treats fixed cost per unit as if it were variable. At a selling price of $52, contribution per unit = 52 - 24 - 6 = $22. Whether $52 is profitable depends on volume and total fixed costs, not on a unit cost that changes with volume.
Break-even at $52
Required units = fixed costs 420,000 / 22 = 19,091 units. Current sales are 19,000, so at $52 the company makes a small loss unless volume rises above 19,091. At $60, contribution is $30 and break-even is 14,000 units - comfortably met.
Conclusion: The price cut is only justified if it lifts sales above 19,091 units and does not cannibalise existing sales. The manager's reasoning is flawed because it treats fixed overhead per unit as a relevant cost for a pricing decision.
3. Advise whether the 2,000-unit order at $40 should be accepted, and explain how absorption costing could mislead this decision.
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Relevant (incremental) analysis
Idle capacity exists, so fixed costs do not change. Incremental revenue = 2,000 x 40 = $80,000. Incremental variable cost = 2,000 x (24 + 6) = $60,000 (assuming selling cost is incurred; if not, only $48,000). Incremental contribution = $20,000 (or $32,000).
Absorption cost trap
Absorption product cost is $39 (or $45 including selling). At $40 the order appears to yield only $1 per unit, or a loss of $5 if $45 is used, so absorption costing suggests rejection. But the $15 fixed overhead per unit is not incremental - it is incurred regardless. Using it as a relevant cost overstates the cost of the order.
Advice: Accept, provided (a) the order does not displace full-price sales, (b) no additional fixed costs or special selling costs arise, and (c) the price does not undermine future pricing. The contribution of $20,000 improves profit. Disclose the basis of the decision to avoid criticism that the order is 'below cost'.