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

Sales $400,000
Less variable cost of goods sold $160,000
————
Gross contribution margin $240,000
Less variable selling and administrative expenses $60,000
 ————
Contribution margin  $180,000
Less fixed expenses:
Fixed manufacturing overhead $150,000
Fixed selling and administrative expenses $40,000  $190,000
 ———— ————
 Net operating loss  $(10,000)
————

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

Units produced during the first month of operation 50,000
Units sold during the first month of operation 40,000
Variable unit cost:
Direct materials $2.00
Direct labor 1.60
Variable manufacturing overhead expenses 0.40
Variable selling and administrative expenses 1.50

Required:

  1. What costing method was used by the accounting service providers to prepare income statement of Fine Producers Inc? Can an absorption costing income statement show a profit rather than loss? Support your answer with computations.
  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:

Accounting service providers 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:

Net profit (loss) under variable costing method $(10,000)
Fixed manufacturing overhead to be deferred in inventory under absorption costing system. $30,000*
———
Net operating income if absorption costing is adopted $20,000
———

 *10,000 units × $3.00

(2) Income statements for second month:

Absorption costing:

Sales (60,000 Units × $10) $600,000
Less cost of goods sold:
Beginning finished goods inventory 70,000
Direct materials 100,000
Direct labor  80,000
Manufacturing overhead  170,000
 ———-
Cost of goods manufactured 350,000
———-
Cost of goods available for sale 420,000
Less ending finished goods inventory 0 420,000
 ———-  ———-
Gross profit $180,000
Add selling and administrative expenses:
Fixed 40,000
Variable (60,000 × 1.50 ) 90,000  $130,000
 ———- ———-
Net operating income $50,000
———-

Variable costing:

Sales (60,000 Units × $10) $600,000
Less cost of goods sold:
Beginning finished goods inventory 40,000
Direct materials 100,000
Direct labor 80,000
Variable manufacturing overhead 20,000
 ———-
Cost of goods manufactured 200,000
———-
Cost of goods available for sale 240,000
Less ending finished goods inventory 0 240,000
 ———-  ———-
Gross contribution margin  360,000
Less variable selling and admin. expenses 90,000
———-
Contribution margin 270,000
Less fixed costs:
Manufacturing overhead  150,000
Selling and administrative 40,000  190,000
 ———- ———-
Net operating loss 80,000
———-

(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.

Net operating income under variable costing $80,000
Less fixed manufacturing overhead released from inventory $30,000*
———
Net operating income under absorption costing $50,000
———

*10,000 units × $3.00

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