Question

Skelter Corporation, which has only one product, has provided the following data concerning its most recent month of operations:

Selling price	$	121
Units in beginning inventory		400
Units produced		5,600
Units sold		5,800
Units in ending inventory		200
Variable costs per unit:
Direct materials	$	33
Direct labor	$	49
Variable manufacturing overhead	$	1
Variable selling and administrative expense	$	4
Fixed costs:
Fixed manufacturing overhead	$	140,000
Fixed selling and administrative expense	$	52,200

The company produces the same number of units every month, although the sales in units vary from month to month. The company's variable costs per unit and total fixed costs have been constant from month to month. The company uses LIFO costing.

Required:

Assume the company uses variable costing for internal management purposes. How much is net operating income when variable costing is used?

For financial reporting purposes, the company uses absorption costing. How much is net operating income when absorption costing is used?

Explain the difference in the net operating income numbers computed in parts a and b. Your answer should show the reason for the dollar amount of difference by stating the difference(s) in particular. It is not sufficient to state a general rule that income is higher or lower when either of the methods is used.

Answer 1

PART A: NET OPERATING INCOME - VARIABLE COSTING

PART B: NET OPERATING INCOME - ABSORPTION COSTING

Fixed Manufacturing overhead = $140,000 / 5600 units = $25 per unit

PART C: REASON FOR THE DIFFERENCE IN NET OPERATING PROFIT

In Variable costing system, the stock is valued at variable manufacturing cost ($83) whereas in absorption costing system it is valued at full manufacturing cost ($108). Therefore, in absorption costing system we should calculate fixed manufacturing cost per unit for the purpose of valuing stock.

The difference in profit is due to stock valuation. The difference in profit is the fixed cost inside the net stock. When there is no stock, the profit under variable costing system is equal to the profit under absorption costing system. When there is net closing stock, absorption costing system has more profit. When there is net opening stock, absorption costing system has less profit.

In this problem, it has net opening stock.

Units in beginning inventory = 400 units

Units in ending inventory = 200 units

Therefore, net opening stock = 400 - 200 = 200 units.

Absorption costing system has less profit compared to variable costing system. The difference is due to the presence of fixed manufacturing overhead in stock.

Check:

Difference of net operating profit under both system

Net operating profit under Variable costing system = $5000

Net operating profit under Absorption costing system = $0

Difference = $5000

Reason for the difference = Net opening stock * fixed manufacturing overhead per unit

                                               = 200 units * $25

                                               = $5000

All the best...