Problem:
The Z-Watch Company manufactures trendy, high-quality moderately priced watches. As Z-Watch?s senior financial analyst, you are asked to recommend a method of inventory costing to the chief financial officer (CFO). The CFO will use your recommendation to construct Z-Watch?s 2008 income statement. The following data are for the year ended December 31, 2008:
Beginning inventory, January 1, 2008 85,000 units
Ending inventory, December 31, 2008 34,500 units
2008 sales are 345,400 units
Selling price (to distributor) $22.00 per unit
Variable manufacturing cost per unit, including. direct materials $5.10 per unit
Variable operating cost per unit sold $1.10 per unit sold
Fixed Manufacturing Overhead $1,440,000
Denominator-level machine-hours 6,000
Standard production rate 50 units per machine-hour
Fixed operating costs $1,080,000
Assume costs per unit are the same for units in beginning inventory and units produced during the year. Also, assume the prices and unit costs did not change during the year.
Prepare the following to assist the CFO of Z-Watch:
Question 1. Prepare income statements under variable (contribution margin) and traditional (absorption) costing for the year ended December 31, 2008.
Question 2. What is Z-Watch?s operating income under each costing method (in percentage terms)?
Question 3. Explain the difference in operating income between the two methods.
Question 4. Which costing method would you recommend to the CFO? Why?