Absorption Costing Discussion paper

What denominator level is Smart Safety using to allocate fixed manufacturing costs to the bicycle helmets?

The denominator level that is being used appears to be master-budget utilization. Master budget capacity results in a higher cost per unit, because the fixed costs are spread over expected demand for the budgeted year of 52,000 units, which is presumably less than available capacity. Using practical capacity as the denominator level spreads fixed costs over capacity available, which reduces the cost per unit and eliminates the need to have to recalculate cost per unit each year. In addition, it highlights used and unused capacity for management decisions, such as what to do with unused capacity, or whether they should downsize, etc. Smart Safety has a in 2014, because they utilized more capacity than was budgeted. As a result, fixed costs were over allocated due to the higher cost per unit, giving Smart Safety a favorable production-volume variance. It looks like they reduced the production level in 2015, given the lack of additional demand for their product in 2014. The president should use practical capacity as their denominator level for allocating fixed costs, so he can make better production and costing decisions in the long run.

How is Smart Safety disposing of any favorable or at the end of the year?

The favorable production-volume variance of $260,000 in 2014, is being inventoried rather than expensed to cost of goods sold in the current period. This means it is added to ending inventory, reducing cost of goods sold, and increasing operating income. An unfavorable production-volume variance would have increased cost of goods of goods sold under this method, and decreased operating income. Under absorption costing, all fixed manufacturing costs are allocated to the unit cost of the product and inventoried, so when inventory is increasing, as it does when there is a favorable production-volume variance, operating income will also increase under this costing method. This is true regardless of whether the company is operating at capacity. There was no beginning inventory at the start of 2014, and production increased by $405,600. Smart Safety was not able to sell the additional inventory, so the costs were not deducted in Cost of Goods Sold; they were instead left on the balance sheet. Smart safety starts 2015 with $405,600 of inventory, and brought production back down to 2013 levels. They had zero inventory on hand at the end of 2015, so all fixed costs incurred in 2014 were expensed in 2015, which explains the significant decrease in operating income. Had the additional units been sold in 2014, then 2015 would have a higher operating income, but not enough inventory to meet demand.


Horngren, C. T., Datar, S. M., Rajan, M. V. Cost Accounting. [VitalSource Bookshelf]. Retrieved from https://online.vitalsource.com/#/books/97813234844…


STUDENT 2: Chris

Hello Class, I hope everyones week was/is productive. With absorption costing, manufacturing costs are absorbed by the units produced. This simply means that the cost of a finished product will also include direct expense cost and fixed/variable manufacturing overhead cost. This appears to be the method that Smart Safety is using when preparing their income statement.

In the years 2013, 2014, and 2015, the operating cost were $0, $260,000, and $41,600 respectively. Furthermore, the units sold those years were $52,000 for the first two, and $62,400 in the last. We see that the operating income decreased in the third, which is the year that they sold more units. The prior years had the same number of sales for both years ($52,000), but in the case of 2014, the operating income was $260,000. What does this mean? Well, in the first year the company broke even at $52,000. The second year, they produced more than 52,000 units, which was 62,400, leaving 10,400. This caused an over absorption of production (10,400 x 25 = $260,000). In other words, the fixed manufacturing cost that correlated with those units are not recorded on the income statement and cause an overstatement in operating cost. The following year reflects a transfer of beginning inventory and a sale of related to beginning inventory. Now, the fixed manufacturing overhead cost will be recorded and an understatement of that portion is seen in 2015.

Also, in regards to the over absorption, the company also appears to dispose all against cost of goods sold. When they are producing more units, instead of the budgeted 52,000, it causes a favorable production variance ((62,4000 52,000) x 25 = 260,000). When the $260,000 amount was written off against cost of goods sold, it caused a positive effect by increasing the gross margin by 56%. This why the manager stated, Then in our second year, we sold the same volume and had a positive operating income.

It appears that the company is using 52,000 as its denominator level, which is their fixed manufacturing overhead, which formulates to fixed manufacturing cost divided by budgeted production units (1,300,000/52,000). This number comes out to $25. The information presented seems to suggest that the company cannot make a profit by only producing 52,000 units and should therefore, more.

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