Lesson 3 Sample Problem #2

ACA 212 Strategic Cost Management
Sample problem #2 Profit (loss) calculation, normal capacity is not equal to actual production
Hunts Corporation has the following standard costs and production data in 2019:
Unit sales price P200
Unit variable cost of production 120
Unit fixed overhead 20
Unit variable expenses 10
Unit fixed expenses 5
Beginning inventory 4,000 units
Normal capacity 20,000 units
The fixed expenses are also based on normal capacity.
Required: Determine the operating income under absorption costing and variable under each of
the following cases:
Solutions/Discussions
Case A – Sales (22,000 units) > Production (21,000 units), with volume variance
1. First, compute the volume variance because the actual production is not equal to the
normal capacity.
Normal capacity in units 20,000
– Actual capacity in units 21,000
Volume variance in units (1,000) F
X Standard fixed overhead rate P20
Volume variance in pesos P20,000 F
Volume variance represents the ability of the business to meet its normal capacity.
Volume variance is related to fixed overhead since it is constant per total amount but
changes per unit. In short, fixed overhead is not controlled on its total amount but is
controlled in relation to volume (i.e., production). Over the years, a business would have
developed its average capacity (i.e., normal capacity) that settles at the middle of ups and
downs of production levels. If normal capacity is greater than actual capacity, there is an
under-absorbed capacity and it is an unfavorable variance.
If normal capacity is less than actual capacity, there is an over-absorbed capacity and it is a
favorable variance.
A cost variance is the difference between the actual costs and standard costs. If actual
costs are greater than standard costs, the cost variance is unfavorable. Unfavorable
variances are added to standard cost of goods sold, while favorable variances are deducted
from standard cost of goods sold, while favorable variances are deducted from standard
costs of goods sold to get the actual cost o goods sold. That is why unfavorable cost
variance is also called debit variance, while favorable cost variance is called credit variance.
Volume variance is included only in the absorption costing income statement. Since
volume variance relates to fixed overhead which is a product cost under the absorption
method, the volume variance is considered. Under the variable costing, however, the fixed
overhead is a period cost, an expense and is not subject to variance analysis.
2. The computation of profit (loss), with volume variance, is shown below:
Absorption Variable
Sales (22,000 x P200) P4,400,000 P4,400,000
Variable CGS (22,000 x P120) (2,640,000) (2,640,000)
Fixed Overhead (22,000 x P20) ( 440,000) ( 400,000)
Volume Variance 20,000 F
Variable expenses (22,000 x P10) ( 220,000) ( 220,000)
Fixed expenses ( 100,000) ( 100,000)
Profit (loss) P1,020,000 P1,040,000
Note the favorable volume variance is added because the profit is computed directly.
The normal treatment, though, for a favorable cost variance is to deduct it from the
standard cost of goods sold. Also note the volume variance is treated only under the
absorption costing method.
The difference in profit of P20,000 is accounted for as follows:

Production P21,000 units
Sales (22,000)
Change in inventory 1,000 units
x Standard fixed overhead rate P20
Change in profit P20,000
Case B – Sales (15,000 units) < Production (18,000 units), with capacity variance
1. First, compute the capacity variance because the actual production is not equal to the
normal capacity.
Normal capacity 20,000 units
– Actual capacity 18,000
2. The profit (loss) is computed as follows:

Absorption Variable
Sales P3,000,000 P3,000,000
Variable CGS (1,800,000) (1,800,000)
Fixed Overhead ( 300,000) ( 400,000)
Volume Variance ( 40,000) U
Variable expenses ( 150,000) ( 150,000)
Fixed expenses ( 100,000) ( 100,000)
Profit (loss) P 610,000 P 550,000
Note that the unfavorable volume variance is deducted from profit. The normal
treatment of an unfavorable variance is an addition to the standard cost o goods sold.
Using direct method of computation, an increase in cost of goods sold is a deduction
from profit.
The difference in operating profit of P60,000 is accounted for as follows:
Production P18,000 units
Sales (15,000)
The Normal Capacity

Normal capacity refers to the average production level of the business over a long
range of time. Assume the following levels of production for a business which has
been operating in the last seven years:
Year 1 45,000 units Year 5 60,000 units
Year 2 35,000 Year 6 35,000
Year 3 50,000 Year 7 50,000
Year 4 25,000 Year 8 (estimated) 75,000
The normal capacity of the business is 42,000 units. It is the average production level
of the business in the last seven years. the company’s normal capacity is set based on
past experience in relation to production. Normal capacity rests in the middle level of
a company’s production and is therefore stable in the long run. It is preferred to be
used as denominator in computing the fixed and fixed expenses rates.

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ACA 212 Strategic Cost Management

The fixed expenses are also based on normal capacity.

The difference in profit of P20,000 is accounted for as follows:

2. The profit (loss) is computed as follows:

The Normal Capacity

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