Question

Jorgansen Lighting, Inc., manufactures heavy-duty street lighting systems for municipalities. The company uses variable costing for internal management reports and absorption costing for external reports to shareholders, creditors, and the government. The company has provided the following data:

	Year 1	Year 2	Year 3
Inventories
Beginning (units)	210	160	200
Ending (units)	160	200	220
Variable costing net operating income	$290,000	$279,000	$260,000

The company’s fixed manufacturing overhead per unit was constant at $560 for all three years.

Required:

1. Calculate each year’s absorption costing net operating income. (Enter any losses or deductions as a negative value.)

2. Assume in Year 4 that the company’s variable costing net operating income was $260,000 and its absorption costing net operating income was $290,000.

a. Did inventories increase or decrease during Year 4?

b. How much fixed manufacturing overhead cost was deferred or released from inventory during Year 4?

Answer 1

The company has provided the following data:

	Year 1	Year 2	Year 3
Inventories
Beginning (units)	210	160	200
Ending (units)	160	200	220
Variable costing net operating income	$290,000	$279,000	$260,000

The company’s fixed manufacturing overhead per unit was constant at $560 for all three years.

1. Calculate each year’s absorption costing net operating income

	Year 1	Year 2	Year 3
Variable costing net Operating income	$290,000	$279,000	$260,000
Add(deduct) fixed manufacturing overhead deferred in(released from) inventory under absorption costing	28000	-22400	11200
Absorption costing net Operating income	318000	256600	271200

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**The difference between the two method is how they account for fixed manufacturing overhead. Absorption costing include FMOH as a product cost where as variable costing does not.

**The inventory level are correlated to the operating income that calculated in each method

>>when unit produced more than units sold that the unit inventory increase, Absorption costing income is greater than variable costing income.

Because, absorption costing assign per unit fixed manufacturing cost to ending inventory and shown in the balance sheet on end.

>>When units produced less than unit sold that is ending inventory decreased than opening inventory, Then absorption costing income is less than variable costing income.

*so the difference in the income is coming from difference in units multiplied with fixed MFOH cost per units.

Workings note:
	Year 1	Year 2	Year 3
Add(deduct) fixed manufacturing overhead deferred in(released from) inventory under absorption costing	=(210-160)*560 =50*560=28000	=(160-200)*560 =-40*560= -22400	=(200-220)*560 =20*560 = 11200

2. Assume in Year 4 that the company’s variable costing net operating income was $260,000 and its absorption costing net operating income was $290,000.

a. Did inventories increase or decrease during Year 4?

The net income under absorption costing is greater than the net income under variable costing that means the inventories increase during the year as the difference in the net income under absorption costing and variable costing arises due to the fixed manufacturing overhead. In variable costing all the fixed manufacturing is taken while in absorption costing fixed manufacturing overhead is calculated on the basis of the number of units sold and in this case the net income under absorption costing is greater than net income under variable costing which means the number of units sold must be less than the units produced.

So, the answer is Increases

b. How much fixed manufacturing overhead cost was deferred or released from inventory during Year 4?

As the net income under absorption costing is greater than variable costing that means the fixed manufacturing overhead must be deferred in inventory

So here,

Net income under absorption costing= Net income under variable costing+Fixed manufacturing overhead cost deferred in inventory

$290000 = $260000 + Fixed manufacturing overhead cost deferred in inventory

Fixed manufacturing overhead cost deferred in inventory = 290000 - 260000 = $20000