The Z-Watch Company

The assignment:

The Z-Watch Company

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:

1. Prepare income statements under variable (contribution margin) and traditional (absorption) costing for the year ended December 31, 2008.

2. What is Z-Watch’s operating income under each costing method (in percentage terms)?

3. Explain the difference in operating income between the two methods.

4. Which costing method would you recommend to the CFO? Why?

Here's an example of a contribution format income statement:

Beta Sales Company

Contribution Format Income Statement

For Year Ended December 31, 200X

Sales $ 462,452

Less Variable Costs:

Cost of Goods Sold $ 230,934

Sales Commissions $ 58,852

Delivery Charges $ 13,984

Total Variable Costs $ 303,770

Contribution Margin $ 158,682 34%

Less: Fixed Costs:

Advertising $ 1,850

Depreciation $ 13,250

Insurance $ 5,400

Payroll Taxes $ 8,200

Rent $ 9,600

Utilities $ 17,801

Wages $ 40,000

Total Fixed Costs $ 96,101

Net Operating Income $ 62,581

You can tell at a glance that the Beta Company's contribution margin for the year was 34 percent. This means that, for every dollar of sales, after the costs that were directly related to the sales were subtracted, 34 cents remained to contribute toward paying for the direct costs and for profit.