Question: The Hurley Hat Company manufactures baseball hats. Hurley’s primary customers are sporting goods stores that supply uniforms to youth baseball teams. Following is Hurley’s income statement for 2018:

In 2018, Hurley produced and sold 200,000 baseball hats. Of the Cost of Goods Sold, \(150,000 is fixed; 80% of the Selling and Administrative Expenses are fixed. There were no beginning inventories on January 1, 2018. The company is considering two options to increase sales.

Option 1: The company is operating at 100,000 hats below full production capacity and is considering increasing advertising to increase sales to the production capacity level in 2019. The marketing director predicts that an additional \)100,000 expenditure for advertising would increase sales to 300,000 hats per year.

Option 2: The sales manager has been negotiating with buyers for several national sporting goods retailers and recommends the company expand production capacity to 400,000 hats in order to secure long-term contracts beginning in 2019. The expansion is expected to increase fixed manufacturing costs by \(200,000 per year. Additionally, the retailers are requesting a higher-quality hat, and the changes to the hat materials and manufacturing process would increase variable manufacturing costs by \)1 per hat for the additional 200,000 hats. (The original 200,000 hats manufactured and sold would not be affected by this change.)

Requirements

1. Use the data from the 2018 income statement to prepare an income statement using variable costing. Assume no beginning or ending inventories. Calculate the contribution margin ratio. Round to two decimal places.

2. Prepare an absorption costing income statement assuming the company pursues Option 1 and increases advertising and production and sales increase to 300,000 hats.

3. Refer to the original data. Prepare an absorption costing income statement assuming the company pursues Option 2 and increases capacity and sales and production increases to 400,000 total hats.

4. Which option should the company pursue? Explain your reasoning.

Step by step solution

01

Calculation of contribution margin ratio

Particulars	Year 1
Net sales revenue	$1,500,000
Less: Variable cost$\left(\mathbf{\$}\mathbf{700}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{150}\mathbf{,}\mathbf{000}\right)$	$550,000
Less: Variable selling and administrative expenses$\left(\mathbf{\$}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{20}\mathbf{\%}\right)$	$100,000
Contribution Margin	$850,000
Contribution Margin Ratio (Contribution margin/sales revenue)	$850,000/$1,500,000*100 =56.67%

02

Income statement as per absorption costing assuming the company pursues option 1.

$$\begin{gathered} \mathbf{Unitsalesprice}\mathbf{=}\frac{\mathbf{SalesPrice}}{\mathbf{Numberofunits}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}}{\mathbf{200}\mathbf{,}\mathbf{000}} \\ \mathbf{=}\mathbf{\$}\mathbf{7}\mathbf{.}\mathbf{50} \\ \mathit{V}\mathit{a}\mathit{r}\mathit{i}\mathit{a}\mathit{b}\mathit{l}\mathit{e}\mathbf{ }\mathbf{COGS}\mathbf{=}\frac{\mathbf{Variable}\mathbf{ }\mathbf{cost}}{\mathbf{Numberofunits}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{550}\mathbf{,}\mathbf{000}}{\mathbf{200}\mathbf{,}\mathbf{000}} \\ \mathbf{=}\mathbf{\$}\mathbf{2}\mathbf{.}\mathbf{75} \end{gathered}$$

Particulars	Year 1
Net sales revenue$\left(\mathbf{\$}\mathbf{7}\mathbf{.}\mathbf{5}\mathbf{\times }\mathbf{300}\mathbf{,}\mathbf{000}\mathbf{hats}\right)$	$2,250,000
Less: Cost of goods sold$\left(\mathbf{\$}\mathbf{2}\mathbf{.}\mathbf{75}\mathbf{\times }\mathbf{300}\mathbf{,}\mathbf{000}\right)\mathbf{+}\mathbf{\$}\mathbf{150}\mathbf{,}\mathbf{000}$	$975,000
Gross profit	$1,275,000
Selling and administrative cost$\left(\mathbf{\$}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{100}\mathbf{,}\mathbf{000}\right)$	$600,000
Operating Income	$675,000

03

 Step 3: Income statement as per absorption costing assuming the company pursues option 2.

Particulars	Year 1
Net sales revenue$\left(\mathbf{\$}\mathbf{7}\mathbf{.}\mathbf{5}\mathbf{\times }\mathbf{400}\mathbf{,}\mathbf{000}\mathbf{hats}\right)$	$3,000,000
Less: Cost of goods sold$\left(\mathbf{\$}\mathbf{2}\mathbf{.}\mathbf{75}\mathbf{\times }\mathbf{200}\mathbf{,}\mathbf{000}\right)\mathbf{+}\left(\mathbf{\$}\mathbf{3}\mathbf{.}\mathbf{75}\mathbf{\times }\mathbf{200}\mathbf{,}\mathbf{000}\right)\mathbf{+}\left(\mathbf{\$}\mathbf{150}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{200}\mathbf{,}\mathbf{000}\right)$	$1,650,000
Gross profit	$1,350,000
Variable selling and administrative costdata-custom-editor="chemistry" $\left(\mathbf{\$}\mathbf{0}\mathbf{.}\mathbf{50}\mathbf{\times }\mathbf{400}\mathbf{,}\mathbf{000}\mathbf{hats}\right)\mathbf{+}\mathbf{\$}\mathbf{400}\mathbf{,}\mathbf{000}$	$600,000
Operating Income	$750,000

04

Decision making

The company should choose option 2 because operating income under option 2 is higher than that in option 1.

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