Federal Mixing (FM) is a division of Federal Chemicals, a large diversified chem
ID: 2575947 • Letter: F
Question
Federal Mixing (FM) is a division of Federal Chemicals, a large diversified chemical company. FM provides mixing services for both outside customers and other Federal divisions. FM buys or receives liquid chemicals and combines and packages them according to the customer’s specifications. FM computes its divisional net income on both a fully absorbed and variable costing basis. For the year just ending, it reported: Net Income Absorption Costing $13,800,000 Variable Costing $12,600,000 Difference $1,200,000 Overhead is assigned to products using machine hours. There is no finished goods inventory at FM, only work-in-process (WIP) inventory. As soon as a product is completed, it is shipped to the customer. The beginning inventory based on absorption costing was valued at $6.3 million and contained 70,000 machine hours. The ending WIP inventory based on absorption costing was valued at $9.9 million and contained 90,000 machine hours. Write a short nontechnical note to senior management explaining why variable costing and absorption costing net income amounts differ.
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Explanation / Answer
Answer:
There is a difference in calculation methods used in variable costing and Absorption costing which leads to an effect on the income calculation resulting in difference. Variable costing writes off the entire amount of fixed manufacturing costs occurred during the year from the Income where as absorption costing divides the fixed manufacturing costs between units remaining in inventory and units sold based on machine hours.
Absoption costing method income is higher pointing to the fact that inventory under it is more then variable costing. ending work in progress inventory contains 20000 more mac. hrs. than the starting inventory (90000-70000).
fixed OH rate applicable is
1.2 million = (90000-70000) * Fixed OH rate
Fixed OH rate = 1200000/20000
Fixed OH rate = $60
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