Question

NEW MEXICO CORPORATION

…… had the following operating data for its first two years of operations: Variable costs per unit: Direct materials $ 5.00 Direct labor 3.00 Variable overhead 1.50 Fixed costs per year: Overhead $90,000 Selling and administrative 17,200 The company produced 30,000 units the first year and sold 25,000. In the 2nd year, it produced 25,000 units and sold 30,000 units. The selling price per unit each year was $15.

Required: 1. What are absorption and variable costing? How are they different and when are they used?

2. Prepare a comparative income statement (side by side) for the years 1 and 2, using absorption costing. Has the firm performance, as measured by income, improved or declined from Year 1 to Year 2?

3. Prepare comparative income statements for both years using variable costing. Has firm performance, as measured by income, improved or declined from Year 1 to Year 2?

4. Reconcile the difference between the income(s) shown between the two statements for each of the years.

5. Which method do you think more accurately measures performance? Why?

Answer 1

1) In accounting, absorption (full) costing and variable (direct) costing are two different methods of applying costs of production to products or services. The difference among the two accounting methods is in the treatment of fixed manufacturing overhead costs. Under the variable costing method, fixed manufacturing overhead costs fixed are expensed during the period in which they are incurred. On contrary under the absorption costing method, fixed manufacturing overhead costs are expensed when the good is sold

2) Absorption-costing Income Statement

	Year 1	Year 2
Sales	$375,000	$450,000
Minus: Cost of goods sold
Variable ($9.50 per unit)	$285,000	$237,500
Fixed	$90,000	$90,000
Less: Ending Inventory	$62,500	$0
Cost of goods sold	$312,500	$327,500
Gross Profit	$62,500	$122,500
Minus: Selling &administrative expenses	$17,200	$17,200
Operating income	$43,300	$105,300

3) Variable-costing Income Statement

	Year 1	Year 2
Sales	$375,000	$450,000
Minus:
Beginning Inventory	$0	$47,500
Variable Expenses ($9.50 per unit)	$285,000	$237,500
Ending Inventory	-$47,500	$0
Contribution Margin	$137,500	$165,000
Fixed cost
Overhead expenses	$90,000	$90,000
Selling &administrative expenses	$17,200	$17,200
	$107,200	$107,200
Operating Income	$30,300	$57,800

4) In the absorption costing income statement, Cost of good sold in year 2 is higher in comparison to Cost of good sold in year 2 because of ending inventory. In the variable costing income statement, the Contribution Margin in year 2 is higher than year 1 because of beginning inventory

5) In my opinion the variable costing method id better because it gives better signals related to the performance, thus provides more relevant information for management decision making.