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