Problem-4 (Constant production and change in sales – variable and absorption costing)

Fine Producers suffered a loss for the first month of operations. Following is the income statement of Fine Producers prepared by an accounting service providing firm.

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The loss created a serious problem because company was planning to use the statement to encourage investors to purchase the stock of the company. Some other relevant data is given below:

  • Units produced during the first month: 50,000 units
  • Units sold during the first month: 40,000 units

Variable costs:

  • Direct materials: $2.00 per unit
  • Direct labor: $1.60 per unit
  • Variable manufacturing overhead: $0.40 per unit
  • Variable selling and administrative expenses: $1.50 per unit

Required:

  1. What costing method was used by the accounting firm for preparing income statement of Fine Producers? Can an absorption costing income statement show a profit rather than loss? Support your answer by preparing a reconciliation schedule.
  2. Prepare company’s income statement using variable costing and absorption costing for the second month if 60,000 units were sold in the second month and there were no closing inventories.
  3. Reconcile the second month’s net operating income under both the costing approaches.

Solution:

(1) Costing method used by accounting firm:

Accounting firm used variable costing method to prepare income statement of Fine Producers.

Yes, an income statement prepared on the basis of absorption costing can show a profit rather than loss because a portion of fixed manufacturing overhead cost would be absorbed by ending finished goods inventory. Under absorption costing, this absorbed fixed cost would be deferred to the next period and would reduce the burden of current period.

The net operating loss for the first month of operation under variable costing is $10,000 and the cost to be absorbed under absorption costing system is $30,000*. It results in a net operating profit of $20,000 (30,000 – $10,000). The computations are shown below:

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 *Fixed manufacturing overhead/Units manufactured

= $150,000/50,000 units

= $3.00 per unit

(2) Income statements for second month:

a. Absorption costing:

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*Unit product cost under absorption costing: Direct materials + Direct labor + Variable manufacturing overhead + Fixed manufacturing overhead

= $2.00 + $1.60 + $0.40 + $3.00

= $7.00

**Units manufactured in second month: Units sold + Units in ending inventory – Units in beginning inventory

= 60,000 units + 0 units – 10,000 units

= 50,000 units

b. Variable costing:

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*Unit product cost under variable costing: Direct materials + Direct labor + Variable manufacturing overhead

= $2.00 + $1.60 + $0.40

= $4.00

(3) Reconciliation:

If the company sells 60,000 units in second month, the sales of the second month will be more than production. In that case, the fixed manufacturing overhead cost deferred in inventory in first month will be released from inventory in the second month and the net operating income under absorption costing will be less than the net operating income under variable costing.

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