MA35 Problem: Direct vs. Absorption Costing – Northway Corporation

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MA35 Problem: Direct vs. Absorption Costing – Northway Corporation

 

 Northway Corporation is a manufacturer of a synthetic element. Jim Northway, president of the company,has been eager to get the operating results for the just completed fiscal year. He was surprised when theincome statement revealed that income before taxes had dropped to $360,000 from $750,000 even thoughsales volume had increased 100,000 kilograms. This drop in net income had occurred even though Northway had implemented the following changes during the past 12 months to improve the profitabilityof the company:

• In response to a 10% increase in production cost

s, the sales price of the company's product was

increased by 12%. This action took place on December 1, 20x3.• The management of the selling and administrative

departments were given strict instructions tospend no more in fiscal 20x4 than in fiscal 20x3. Northway's accounting department prepared and distributed to top management the comparative incomestatements presented below. The accounting staff also prepared related financial information in theaccompanying schedule to assist management in evaluating the company's performance. Northway uses

the FIFO inventory method for finished goods.

 NORTHWAY CORPORATION Statements of Operating Income for the years ended November 30, 20x3 and 20x4 ($000 omitted)20x3 20x4

Sales revenue $9,000 $11,200Cost of goods sold 6,750 9,340Gross margin 2,250 1,860Selling and administrative expenses 1,500 1,500

Operating Income

$ 750 $ 360 

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 NORTHWAY CORPORATION Selected Operating and Financial Data for 20x3 and 20x420x3 20x4

Sales price $ 10/kg $11.20/kgMaterial cost $1.50/kg $ 1.65/kgDirect labour cost $2.50/kg $ 2.75/kgVariable overhead cost $1.00/kg $ 1.10/kgTotal fixed overhead costs $3,000,000 $3,300,000Selling and administrative costs (all fixed) $1,500,000 $1,500,000Sales volume 900,000 kg 1,000,000 kgBeginning inventory 300,000 kg 600,000 kgUnits produced 1,200,000 kg500,000 kg 

 Required -

a Explain to Jim Northway why Northway Corporation's operating income decreased in the currentfiscal year despite the sales price and sales volume increases. b A member of the Northway's accounting department has suggested that the company adoptvariable (direct) costing for internal reporting purposes.i. Prepare an operating income statement through income before taxes for the year ended November 30, 20x4, for Northway Corporation using the variable (direct) costingmethod.ii. Present a numerical reconciliation of the difference in operating income using theabsorption costing method as currently employed by Northway and the variable (direct)costing method as proposed.

 

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