Question

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

	Year 1			Year 2
Sales (@ $63 per unit)	$	1,197,000		$	1,827,000
Cost of goods sold (@ $46 per unit)		874,000			1,334,000
Gross margin		323,000			493,000
Selling and administrative expenses*		305,000			335,000
Net operating income	$	\18,000\		$	158,000

* $3 per unit variable; $248,000 fixed each year.

The company’s $46 unit product cost is computed as follows:

Direct materials	$	10
Direct labor		11
Variable manufacturing overhead		5
Fixed manufacturing overhead ($480,000 ÷ 24,000 units)		20
Absorption costing unit product cost	$	46

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 operatons 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:

Variable Costing System

1) Product Cost refers to the costs used to fabricate/make/produce a product.

2) Under Variable Costing System, product cost includes only following variable manufacturing costs:

- Cost of direct material used

- Direct labor cost

- Variable manufacturing overheads.

3) Under this system, fixed costs are not considered in product cost and for valuation of closing stock of finished goods. Fixed costs are treated as period cost in this system.

4) The value of finished goods and work in process is also comprised only of Manufacturing Variable Costs.

5) Selling and administrative expenses are not included because these are not the expenses incurred in production department. These expenses relate to selling and admin department.

Part 1 – Unit Product Cost under variable costing system for both years

Unit Product Cost	Year 1	Year 2
Direct Materials	$10	$10
Direct Labor	$11	$11
Variable Overhead	$5	$5
Unit Product Cost	$26	$26

Part 2 --- Income Statement using variable costing system

Income Statement (Using Variable Costing)
	Year 1	Year 2
Sales (@ $63 per unit)	$1,197,000	$1,827,000
Variable Costs:
Variable Cost of Goods Sold (@ $26 per unit)	$494,000	$754,000
Add: Variable Selling and administrative expense (@ $3 per unit)	$57,000	$87,000
Total Variable Cost	$551,000	$841,000
Contribution Margin (Sales - Total Variable Costs)	$646,000	$986,000
Fixed Costs:
Fixed Manufacturing Overhead	$480,000	$480,000
Fixed Selling and Administrative Expense	$248,000	$248,000
Total Fixed Costs	$728,000	$728,000
Net Operating Income	($82,000)	$258,000

Part 3 – Reconciliation the variable and absorption costing net operating income

Reconciliation the variable and absorption costing net operating income
	Year 1	Year 2
Net Operating Income as per Variable Costing	-$82,000	$258,000
Add or (Deduct) the Fixed Manufacturing Overhead cost deferred or released from the Inventory (Since variable cost does not include fixed manufacturing cost in product cost but the absorption costing includes)
Ending Inventory of Year 1 and Beginning Inventory of Year 2 (5000 Units x $20 Fixed Overhead Per Unit	$100,000	-$100,000
Net Operating Income as per Absorption Costing	$18,000	$158,000

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