You are working as a loan officer at TransPacific Bank and are analyzing a loan

Question

You are working as a loan officer at TransPacific Bank and are analyzing a loan request for a client when you come across the following footnote in the client's report:

"Inventories are priced at the lower of cost or market of materials plus other direct (variable) costs. Fixed overheads of $4.2 Million this year and $3.0 million last year are excluded from inventories. Omitting such overhead resulted in a reduction in net income (after taxes) of $720,000 for this year. Our tax rate is 40 percent"

In preparing to present the loan application to the bank's loan committee, write bried statement in nontechnical terms describing what this footnote means and how it affects the bank's evaluation of the financial condition of the borrower.

Explanation / Answer

A Variable Cost is a cost that varies ,in total ,in direct proportion to changes in the level of activity. The activity can be expressed in many ways ,such as Units produced ,units sold, miles driven etc.Under variable costing , only Variable Costs are considered.

On the other hand , Fixed Cost is a cost that remains constant regardless of a change in the level of activity. Under absorption costing , both fixed and variable costs are considered.

The above situation arises when the current year’s production exceed sales because a portion of the fixed costs would be deferred to other years.

Hence, the total costs under absorption Costing would be lesser than the total Costs under Variable Costing.

This would naturally reduce the Net Income calculated under Variable Costing.

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