Question

During Heaton Company’s first two years of operations, it reported absorption costing net operating income as follows:

	Year 1			Year 2
Sales (@ $62 per unit)	$	992,000		$	1,612,000
Cost of goods sold (@ $38 per unit)		608,000			988,000
Gross margin		384,000			624,000
Selling and administrative expenses*		298,000			328,000
Net operating income	$	86,000		$	296,000

* $3 per unit variable; $250,000 fixed each year.

The company’s $38 unit product cost is computed as follows:

Direct materials	$	9
Direct labor		11
Variable manufacturing overhead		4
Fixed manufacturing overhead ($294,000 ÷ 21,000 units)		14
Absorption costing unit product cost	$	38

Forty percent of fixed manufacturing overhead consists of wages and salaries; the remainder consists of depreciation charges on production equipment and buildings.

Production and cost data for the first two years of operations are:

	Year 1	Year 2
Units produced	21,000	21,000
Units sold	16,000	26,000

Required:

1. Using variable costing, what is the unit product cost for both years?

2. What is the variable costing net operating income in Year 1 and in Year 2?

3. Reconcile the absorption costing and the variable costing net operating income figures for each year.

Answer 1

Unit product cost under variable costing: ($)

Direct material	9
Direct Labor	11
Variable Manufacturing	4
Variable selling	3
Total unit cost	27

The difference in net income is due to the fixed cost element in closing stock. It is understood by following reconciliation:

	Year 1	Year 2
Net Income as per Absorption costing	86,000	296000
Less: Fixed Cost element in Ending inventories (14×(21000-16000)	(70,000)	Nil
Add: Fixed Cost element in Begining Inventory	NIL	70,000
Net income as per Variable Costing	16,000	366,000