Gomez Electric - Inventory Costing

Executive Summary

Companies use standard cost to determine costs involved in manufacturing their products. Though this method tended to slightly distort the resulting unit cost, the distortion was very minor. Nevertheless when a company manufactures more than it sells and year-after-year it accumulates unsold inventory, it could completely distort the view of the company’s income.

In ourcase, Gomez electronics followed a full costing method to record costs for their products. Full costing is a process in which costs like direct labor, Materials, Variable manufacturing overheads and fixed Manufacturing overheads are added to the each products cost. The problem with this approach is that when fixed overheads are added to the product, and the product is not sold during the currentyear, the cost of goods sold for the following year increases (as it includes fixed costs from the previous year), resulting in reduced profits or sometimes losses for that year.

A solution to this problem would be to treat fixed overheads as period expenses. By doing this the company can more accurately report the inventory cost in the current year, and thus avoid transferring fixed costs tothe next period, which in turn helps management in making decisions. The following table portrays the company’s income statement under both, full costing and the direct costing methods:

| Full Costing | Direct Costing |
| | |
Sales | 997,000.00 | 997,000.00 |
| | |
Standard COGS | 753,250.00 | 699,000.00 |
Total variances | (2,700.00) | (6,200.00) |
Total FixedOverhead | - | 54,400.00 |
Actual Gross Margin | 241,050.00 | 237,400.00 |
| | |
Selling, general, and
administrative expenses | 165,300.00 | 165,300.00 |
| | |
Net Income | 75,750.00 | 72,100.00 |
| | |

The difference of $ 3,650.00 is caused by the treatment of fixed cost. Under full costing, a fixed cost is added to a products cost whereas in directcosting fixed cost are treated as period expenses.

Gomez currently manufactures 3 models of CD players A, B and C. The Company is currently required to evaluate whether to accept a new order, if accepted the company would make a sale of 5000 units with a contribution margin of 15.13%.

Ultimately, the direct cost method provides greater clarity in cost of production, managing costs andsubsequently aids the internal decision making process, whereas full costing method may result in inappropriate decisions, as it include no relevant costs.

Finally, if the order was accepted, Gomez electronics would need to increase their production volume. This could be achieved through increasing production hours through managing multiple shifts in Department 3, or via delivering the 5000 units in sixmonths instead of the requested five months.
Question 1
Income statements for the period July 1 through December 31, 2002.
| Full Costing | Direct Costing |
| Budgeted Sales & Budgeted Production Volume | Actual Sales & Actual Production Volume | Budgeted Sales & Budgeted Production Volume | Actual Sales & Actual Production Volume |
| | | | |
Sales |1,108,000.00 | 997,000.00 | 1,108,000.00 | 997,000.00 |
| | | | |
Standard COGS | 835,500.00 | 753,250.00 | 777,000.00 | 699,000.00 |
Standard Gross Margin | 272,500.00 | 243,750.00 | 331,000.00 | 298,000.00 |
| | | | |
Variances | | | | |
Direct Labour | - | (3,400.00) |- | (3,400.00) |
Direct Material | - | (2,600.00) | - | (2,600.00) |
Variable mfg. Overhead | - | (200.00) | - | (200.00) |
Fixed mfg. Overhead | - |...