Impact of change in production on variable and absorption costing SOLVED

AJX company manufactures and sells a single product. Company sold the same number of units this year as it did last year but generated different profit for two years.  The president asks for the explanation of difference in net operating income for two years.
The income statements of two years are as follows:

	Year 1	Year 2
Sales (40,000 units)	$2,500,000	$2,500,000
Less cost of goods sold	$1,680,000	$1,440,000
	————-	————-
Gross margin	820,000	1,060,000
Less selling and administrative expenses	700,000	700,000
	————-	————-
Net operating income	120,000	360,000
	————-	————-

Sales, production and production for two years are as follows:

	Year 1	Year 2
Production in units	40,000	50,000
Sales in units	40,000	40,000
Variable production cost per unit	$12	$12
Fixed manufacturing overhead cost	$1,200,000	$1,200,000

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

1. Calculate unit product cost for both the years under absorption costing and direct costing (variable costing).
2. Prepare a contribution margin format income statement for two 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 just in time (JIT) manufacturing and inventory control methods.

Solution:

(1) Computation of unit product cost:

	Year 1	Year 2
Unit product cost under variable costing	$12	$12
Unit product cost under absorption costing	$12+$30*=$42	$12+$24**=$36
*1,200,000 / 40,000 **1,200,000 / 50,000

(2) Variable costing income statement:

	Year 1	Year 2
Sales	2,500,000	2,500,000
	———	———-
Less variable cost of goods sold:
Beginning inventory	0	0
Variable cost of goods manufactured	480,000	600,000
	———-	———-
Cost of goods available for sale	480,000	600,000
Less ending inventory	0	120,000
	———-	———-
Cost of goods sold	480,000	480,000
	———-	———-
Gross contribution margin	2,020,000	2,020,000
Less variable selling and administrative expenses	160,000	160,000
	———-	———-
Contribution margin	1,860,000	1,860,000
	———-	———-
Less fixed costs:
Fixed manufacturing overhead expenses	1,200,000	1,200,000
Fixed selling and administrative expenses	540,000	540,000
	———-	———-
Total fixed expenses	1,740,000	1,740,000
	———-	———-
	120,000	120,000
	———-	———-

(3) Reconciliation of net operating income:

	Year 1	Year 2
Variable costing income statement	120,000	120,000
Fixed manufacturing overhead deferred in inventory	0	240,000
	———-	———-
	120,000	360,000
	———-	———-

(4) Just in time manufacturing method:

If the company had been using just in time manufacturing and inventory control methods in year 2 the difference in net operating income under variable costing and absorption costing would have been very little to zero. The central idea of just in time manufacturing is to eliminate inventories.  For better understanding of the impact of JIT read our article variable and absorption costing with just in time (JIT) manufacturing system.

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