Rayco Suggested Solutions

CLASS CASE 4: RAYCO INC.
Statement of the Problem: The cause of the sudden drop in the net operating income of Rayco Inc.
during the 2nd quarter contrary to increase in sales.
1. What characteristic of absorption costing caused the drop in net operating income for the
second quarter and what could the controller have said to explain the problem.
Absorption costing is a costing method that includes all manufacturing costs — direct
materials, direct labor, and both variable and fixed manufacturing overhead in the cost of a
unit of product. It is also referred to as the full cost method because it treats all cost of
production as product costs or inventoriable costs. Supposing a product will not be sold at the
end of a particular period, fixed manufacturing overhead cost will be carried as a part of total
inventory. Only when the product is already sold that the portion of fixed manufacturing
overhead manufacturing cost will be recognized as a portion of the cost of goods sold.
Additionally, absorption costing is a conventional costing method which is required for both
external financial reporting and tax reporting.
As far as the case of Rayco Inc., the controller’s explanation is accurate however, the controller
should point out that the reduced production results in a large amount of underapplied
overhead which bloats second quarter cost of goods sold. The strike caused the reduction in
production as planned hence resulted into absorption of the entire fixed manufacturing
overhead incurred during the quarter.
2. Prepare a contribution margin format income statement.

3. Reconcile the absorption costing and the variable costing net operating income figures for
each quarter.
First a schedule of inventory production and sales in unit is prepared and shown below to
reconcile the net operating income based on absorption costing with the net operating income
based on variable costing.
4. Identify and discuss the advantages and disadvantages of using the variable costing method
for internal reporting purposes.
The main advantage in using the variable costing method for internal reporting purposes is
the integration of CVP (Cost-Volume-Profit) Analysis. With the employment of CVP analysis,
several advantages will likewise flow to the company. First, the use of Variable Costing Method
necessitates the preparation of Variable Income Statement format wherein costs are classified
by means of its behavior thereby identifying what costs are variable and fixed in relation to
production. This identification facilitates the second advantage of projecting how much units
must be produced to hit a target. Though this would need a close collaboration with the Sales
Department, at least both production and sales efforts are geared towards one goal. Thirdly,
the separation of fixed and variable expenses allows the management to exercise control on
fixed expense. Management may develop practices to save like in the case utilities, supplies
and the like.
The disadvantage of using variable costing method is that it does not report on inventory
levels. The determination particularly of ending inventory levels must be anticipated especially
if the company is operating on a limited warehouse space. Inability to know this will eventually
impact company’s cost efficiencies. Second, a new categorization of the company’s chart of
accounts will be performed to identify easily whether the cost is variable or fixed hence
requiring additional efforts and man hours which may turn into possible increase in employee
costs. Lastly, this categorization will not be aligned with the external reporting requirements
by the regulatory bodies as external reporting wise, financial statements must be prepared
based on applicable accounting standards.
5. Assume that the company had introduced Lean Production at the beginning of the second
quarter, resulting in zero ending inventory. (Sales and production during the first quarter
remain the same).
a. How many units would have been produced during the second quarter under Lean
Production?
Units generated in lean manufacturing correspond to sales and customer demand. As a

result, the corporation would have only manufactured enough units throughout the quarter
to fulfill sales demands. The results are displayed below.
Units Sold 15,000units

Less: Inventory Beginning the Quarter (7,000)units
Units Produced under Lean Production 8,000units
Furthermore, if lean production is implemented, net income for the second quarter will be
computed as follows:
*Overhead rates are based on 15,000 units produced each quarter. Assuming only 8,000
units are produced, then underapplied fixed manufacturing OH will be:
7,000 units x $12.00 per unit $ 84,000.00
b. Starting with the third quarter, would you expect any difference between the net operating
income reported under absorption costing and under variable costing? Explain why there
would or would not be any difference.
By third quarter, there will be minimal or no difference in the income recorded under the
absorption costing and the income reported under the variable costing. It is to be noted
that the balance of the initial inventory is typically the reason why the net revenue for the
two approaches varies. Since the firm has implemented Lean manufacturing, and it was
previously determined that the quantity of items to be produced during the second quarter
amounts to the difference between actual sales and beginning inventory, ending inventory
should be to zero. As a result, there will be little or no stocks on hand and no means to
move fixed production overhead expenses among both timeframes.
Submitted by:
Ronil John Garganian MBAT1

Geraldine Alisbo MBAT1

Rayco Suggested Solutions

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CLASS CASE 4: RAYCO INC.

2. Prepare a contribution margin format income statement.

Units generated in lean manufacturing correspond to sales and customer demand. As a

Units Sold 15,000units

7,000 units x $12.00 per unit $ 84,000.00

Ronil John Garganian MBAT1

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