Explain the impact of just in time (JIT) manufacturing and inventory control system on the variable and absorption costing income statements of the companies.

A company using both variable and absorption costing usually finds a difference in net operating income figures produced by the income statements prepared under these two costing methods. This difference may be confusing especially for those who do not fully understand these two costing approaches. The difference in the net operating income under variable and absorption costing can largely be reduced by using a system called just in time (JIT) manufacturing and inventory control system. This system encourages companies to eliminate all types of inventory (materials, work-in-process and finished goods). When inventories are reduced, the difference in the net operating income figure is automatically reduced. Adoption of just in time (JIT) does not change the computation of unit product cost but eliminates the inventories. When inventories are eliminated, the difference in net operating income is automatically eliminated because they are the root cause of the difference.

Example:

The following data relates to two manufacturing companies – company A and company B. Company A uses traditional manufacturing system and company B uses a strict just in time (JIT) manufacturing system. Company B does not manufacture a unit unless an order is received for it.

Company A Company B
Sales price per unit $40 $60
Manufacturing expenses:
Direct materials  $15  $15
Labor  $5 $10
Factory overhead:
   Variable $2  $10
   Fixed – (A: 7,500/m B: $9,375/m )  $3  $5
 ——-  ——-
 Total manufacturing expenses  $25 $40
 ——-  ——-
 Opening inventory  500 Units 0
 Production  2,500 Units  1875 Units
————– ————–
Available for sale 3,000 Units 1875 Units
 Closing inventory  300 Units  0
————– ————–
 Sales 2,700 Units 1,875 Units
 ————–  ————–
Marketing and admin expenses:
   Variable (per unit sold) $5 $8
   Fixed $5000 $4,000

Now we will prepare income statements of both the companies under variable costing and absorption costing methods and observe the impact of just in time (JIT) manufacturing system on the company B’s net operating income figure.

Absorption costing:

Company A Company B
Sales revenue 108,000 112,500
———- ———-
Less cost of goods sold (COGS):
Opening inventory 12,500  0
Cost of goods manufactured 62,500  75,000
———- ———-
Cost of goods available for sale 75,000 75,000
Closing inventory 7,500  0
———- ———-
 Cost of goods sold (COGS) 67,500  75,000
 ———- ———-
 Gross margin (sales – COGS)  40,500  37,500
 ———- ———-
 Less marketing and administration exp:
 Variable 13,500  15,000
 Fixed  5,000 4,000
 ———- ———-
 Total marketing and administration exp. 18,500  19,000
 ———-  ———-
 Net operating income  22,000  18,500
 ———-  ———-

Variable costing:

Company A Company B
Sales revenue 108,000 112,500
———- ———-
Less variable cost of goods sold (VCOGS):
Opening inventory 11000  0
Cost of goods manufactured  55,000  65,625
———- ———-
Cost of goods available for sale 66,000  65,625
Closing inventory  6,600  0
———- ———-
 Variable cost of goods sold (VCOGS)  59,400  65,625
 ———- ———-
 Gross contribution margin (Sales – VCOGS)  48,600  46,875
 Less variable marketing and admin. exp 13,500  15,000
———- ———-
Contribution margin 35,100 31,875
 ———- ———-
Less fixed expenses:
    Manufacturing  7,500 9,375
    Marketing and administration 5,000 4,000
———- ———-
 Total fixed expenses  12,500 13,375
———- ———-
 Net operating income  22,600  18,500
 ———-  ———-

Company A’s net operating income is different under two costing methods because it does not follow just in time (JIT) system (maintains inventory).

Company B’s net operating income is same under both the costing methods because it follows just in time (JIT) system (does not maintain inventory).

The change in inventory during the period is responsible for the difference in net operating income. Company B does not maintain any inventory hence no change in inventory. When inventory does not change the operating income remains same under variable costing and absorption costing.

In our example company B’s opening and closing inventory is zero, but in practice it may not always be possible. Companies using just in time method may have some opening and closing inventories. The concept of just in time is to maintain minimum inventory. When inventories are minimized, confusion of operating income difference between variable and absorption costing is automatically minimized.

Important points to remember:

  1. The change in inventory is the reason of difference in the net operating income figure under variable costing and absorption costing.
  2. The difference in the net operating income figure can be minimized or eliminated by adopting  just in time manufacturing system.
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