Suggested languages for you:

Americas

Europe

Problem 25

# The Tomlinson Company manufactures trendy, high-quality, moderately priced watches. As Tomlinson's senior financial analyst, you are asked to recommend a method of inventory costing. The CF0 will use your recommendation to prepare Tomlinson's 2017 income statement. The following data are for the year ended December 31,2017 : Assume standard costs per unit are the same for units in beginning inventory and units produced during the year. Also, assume no price, spending, or efficiency variances. Any production-volume variance is written off to cost of goods sold. 1\. Prepare income statements under variable and absorption costing for the year ended December 31 2017 2\. What is Tomlinson's operating income as percentage of revenues under each costing method? 3\. Explain the difference in operating income between the two methods. 4\. Which costing method would you recommend to the CF0? Why?

Expert verified
In summary, the primary difference between variable and absorption costing is the treatment of fixed manufacturing overhead. Variable costing includes only variable costs in the cost of goods sold, while absorption costing includes both variable and fixed manufacturing overhead. Generally, absorption costing results in a higher cost of goods sold, lower gross margin, and lower operating income than variable costing. To make a recommendation, we would need more information regarding Tomlinson Company's specific financial goals and context. However, if cost control is prioritized, variable costing might be the better choice; if adherence to GAAP and better allocation of fixed manufacturing overhead is desired, absorption costing should be used.
See the step by step solution

## Step 1: Understand the key differences between variable and absorption costing

Variable costing includes only variable costs (direct materials, direct labor, and variable manufacturing overhead) in the cost of goods sold, while absorption costing also includes fixed manufacturing overhead. This difference affects the calculation of cost of goods sold, gross margin, and operating income in the income statements.

## Step 2: Prepare the income statements under variable and absorption costing

Unfortunately, there is not enough data provided in the exercise to create income statements for Tomlinson Company under variable and absorption costing. The data provided needs to include amounts for revenue, direct materials, direct labor, variable manufacturing overhead, fixed manufacturing overhead, and other expenses, in order to complete this step.

## Step 3: Calculate the operating income as a percentage of revenues

Once you have prepared the income statements using both costing methods, you can calculate the operating income as percentage of revenues for both methods by dividing the operating income by the revenue for each method and multiplying the result by 100. Operating Income percentage (Variable Costing) = (Operating Income_VC / Revenue) * 100 Operating Income percentage (Absorption Costing) = (Operating Income_AC / Revenue) * 100

## Step 4: Explain the difference between the two methods

The primary difference between variable and absorption costing is the inclusion of fixed manufacturing overhead in the cost of goods sold under absorption costing. This results in a higher cost of goods sold and a lower gross margin in absorption costing when compared to variable costing. In turn, this impacts the operating income, which will also be lower under absorption costing. The difference between the two methods lies in the way fixed manufacturing overhead is accounted for: in variable costing, it is treated as a period expense, while in absorption costing, it is included in the cost of goods sold and allocated to the inventory.

## Step 5: Recommend a costing method and justify the recommendation

After analyzing the differences between variable and absorption costing, noting the impact on the income statements and operating income percentages, and considering the company's context and financial goals, we can make a recommendation. For example, if the CFO wants to emphasize cost control and better understand the impact of variable costs on the company's gross margin and operating income, it might be more appropriate to recommend variable costing. On the other hand, if the company wants to adhere to Generally Accepted Accounting Principles (GAAP) and better allocate fixed manufacturing overhead to product costs, absorption costing would be the better choice. In any case, your recommendation should be clear and justified based on the analysis conducted in previous steps.

We value your feedback to improve our textbook solutions.

## Access millions of textbook solutions in one place

• Access over 3 million high quality textbook solutions
• Access our popular flashcard, quiz, mock-exam and notes features

## Join over 22 million students in learning with our Vaia App

The first learning app that truly has everything you need to ace your exams in one place.

• Flashcards & Quizzes
• AI Study Assistant
• Smart Note-Taking
• Mock-Exams
• Study Planner