Question

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

	Year 1			Year 2
Sales (@ $61 per unit)	$	1,159,000		$	1,769,000
Cost of goods sold (@ $38 per unit)		722,000			1,102,000
Gross margin		437,000			667,000
Selling and administrative expenses*		306,000			336,000
Net operating income	$	\131,000\		$	331,000

* $3 per unit variable; $249,000 fixed each year.

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

Direct materials	$	10
Direct labor		11
Variable manufacturing overhead		4
Fixed manufacturing overhead ($312,000 ÷ 24,000 units)		13
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	24,000	24,000
Units sold	19,000	29,000

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

Solution- 1:

Unit Product Cost (variable costing Method
Cost	Year 1	Year 2
Direct Material	10	10
Direct Labor	11	11
Variable Manufacturing overhead	4	4
Unit Product Cost	25	25

- Remember that Fixed Manufacturing overheads (Depreciation and Wages & Salaries) will be treated as Period expense and will not be considered as part of product variable cost under Marginal Costing technique.

- Variable portion of Selling expense will not be considered as part of unitproduct cost since unit product cost takes care of the cost till production not the selling cost.

Solution - 2:

Net Operating Income under Year 1 and Year 2 (Variable Costing):

Working Note:

- Sales revenue will be calculated for only Sold units (Year 1 and Year 2- 19000 units, 29,000 units)

- Variable Selling overheads are not part of unit product cost.

- Fixed Manufacturing overheads and fixed selling overheads will be considered as period expense under Variable costing.

Solution-3:

We have already calculated Unit Product cost in Solution 1 above and net Operating Inceome under Solution 2, Let's make the stock register for 2 years as well:

Inventory Statement
	Year 1	Year 2
Opening Stock	0	5000
Add: Actual Production	24000	24000
Less: Sale	19000	29000
Closing Stock	5000	0

It should be noted that Closing stock for Year 1 will become opening Stock for Year 2.

Now we have all the Inputs to answer question 3. Reconcilation between income under both the approaches will look like below:

Reconciliation
Net Operating Income	Year 1	Year 2
Under Absorbtion Costing	131000	331000
Under Marginal Costing	66000	396000
Difference	65000	-65000

- It should be noted that Under Absorbtion costing, Closing stock valuation will be having the part of fixed Manufacturing overheads in year 1. Due to this Absorbtion costing will show higher income. In our question, Year 1 closing stock is 5000 units and fixed manufacturing overhead per unit is $13 per unit. Total Manufacturing overheads sitting inclosing stock is 5000 * 13= $ 65,000 which is a gap between both the incomes

- Next year same difference is reversed since there is no closing stock left. Under Absorbtion costing, all the overheads will be charged in current year since there is no closing stock left