Exercise-8 (variable and absorption costing – constant sales, change in production)

Learning objective:
This exercise illustrates how the net operating income gets impacted when sales remain constant but production changes.

AJX Company manufactures and sells only a single product. The company sold exactly the same number of units this year as it did last year but showed a different net operating income figure. The president of AJX is a little bit confused about these results and asks for the explanation of why it happened.

A condensed absorption costing income statement for year-1 and-2 is given below:

The sales and production data for year-1 and-2 was as follows:

Variable selling and administrative expenses of AJX are $4.00 per unit sold sold. A new manufacturing overhead rate is computed each year.

Required:

1. Calculate unit product cost for both the years under absorption costing and variable costing system.
2. Prepare a contribution margin format income statement for both the years.
3. Reconcile the net operating income figures for each year under two costing methods.
4. Explain how operations would have different in year-2 if the company had been using a just in time (JIT) manufacturing and inventory control method.

Solution:

(1) Computation of unit product cost:

Year-1:

• Unit product cost under variable costing: $12
• Unit product cost under absorption costing: $12 + $30* = $42

*$1,200,000/40,000 units

Year-2:

• Unit product cost under variable costing: $12
• Unit product cost under absorption costing: $12 + $24* = $36

*$1,200,000/50,000 units

(2) Variable costing income statement:

*Units sold during the period x Per unit variable marketing and administrative expenses
= 40,000 x $4.00
= $160,000

(3) Reconciliation of net operating income:

The production was increased by 10,000 units in Year-2 that caused a buildup of closing inventory and a deferral of a portion of fixed manufacturing overhead to the next period. This deferral relieved Year-2 of $240,000 [= 10,000 units x (1,200,000 units/$50,000)] of cost that it otherwise would have borne. Hence, the net operating income in Year-2 was $240,000 higher than it was in Year-1, even though the company sold the same number of units each year.

Conclusively, we can say that the profit increased in Year-2 without any increase in sales revenue or reduction in manufacturing costs. This is a general criticism of the absorption or traditional costing system. The reconciliation schedule for Year-1 and Year-2 can be prepared as follows:

*Units in closing inventory x Per unit fixed manufacturing overhead
= 10,000 units x (1,200,000 units/$50,000)
= $240,000

(4) The use of just in time manufacturing in Year-2:

Under just in time (JIT) manufacturing and inventory control method, production would have been geared to sales and inventories would not have been built up in Year-2. Since no fixed manufacturing overhead would have been deferred in inventory to the next periods, the net operating income for year-2 would have been $120,000 under absorption costing approach – the same as in Year 1.

With production geared to sales under JIT system, the entire $1,200,000 in fixed manufacturing overhead would have been expensed in year-2, rather than having $240,000 of it deferred to next periods. Hence, the net operating income figure would have been about the same for each year under both variable costing and absorption costing.