Exercise-4 (Variable and absorption costing ending inventory, external reports)

The production and sales data of Albari company for the year 2016 is as follows:

Variable costs per unit:

• Direct materials: $20
• Direct labor: $10
• Variable manufacturing overhead: $4
• Variable selling and administrative expenses: $8

Fixed costs per year:

• Fixed manufacturing overhead: $180,000
• Fixed selling and administrative expenses: $600,000

During the year 2016, Albari company manufactured 30,000 units out of which 25,000 units were sold. At the end of 2016,  the finished goods inventory account showed a balance of $170,000.

Required:

1. What costing method is used by Albari to compute finished goods inventory?
2. Should company use $170,000 finished goods inventory figure for external reports? if not what is the correct amount in dollars that the company should use for external reporting purpose?

Solution:

(1) Costing method used:

The ending inventory figure of $170,000 shows that the company is using variable costing for finished goods inventory because the company has not included fixed manufacturing cost in its ending inventory. The following calculation proves that:

Variable cost per unit:

Ending inventory under variable costing: $34 × 5,000 = $170,000

(2) Finished goods inventory figure for external reports:

For external reporting purposes, company must use finished goods inventory figure computed on the basis of absorption costing system. It is computed as follows:

Absorption cost per unit:

* $180,000/30,000 units = $6.00

Ending inventory under absorption costing: $40 × 5,000 = $200,000