Sensitivity of income to production levels under absorption costing*

Hansel has devised a more advanced (wicked?) witchit, to be known as a ‘widget’. His company plans production of this product for the coming year (year 1). Sales are expected to be 20,000 units at a price of 20/unit. Material and labour costs are production-related and variable: combined, they’re forecast to be 10/unit. Production overhead costs are all fixed and are estimated at 100,000 in total.

There are no widget-related inventories at the start of year 1. All units started will be completed in the year. The company continues to use absorption costing when costing products.

Required

(a) Hansel asks you to calculate expected gross profit on the new widget line if:

(i) production is set equal to sales of 20,000 units; and

(ii) production is set at 25,000 units, 5,000 higher than sales.

(b) Why is expected gross profit under

(a) (ii) greater than expected gross profit under (a)(i)? Is the company better off by producing more units than it expects to sell?

(c) Hansel looks ahead to year 2. Suppose production strategy

(a) (ii) is followed in year 1 (i.e. production of 25,000 widgets exceeds sales by 5,000 units) but in year 2, sales show no growth (they remain at 20,000 units) so production is cut to 15,000 units to clear stocks. There’s no change in sale price, unit costs or total production overhead.

Calculate the widget line’s expected gross profit in year 2. Why is it different from the expected gross profit figures you calculated under

(a) (i) and

(a) (ii)?

Check figures:

(a) (ii) Expected gross profit 120,000

(c) Expected gross profit in year 2 80,000

* Problem assignment draws on material in the appendix to this chapter.

AppenedixLO1