Question

during Heaton Company’s first two years of operations, it reported absorption costing net operating income as follows: Year 1 Year 2 Sales (@ $60 per unit) $ 1,020,000 $ 1,620,000 Cost of goods sold (@ $35 per unit) 595,000 945,000 Gross margin 425,000 675,000 Selling and administrative expenses* 299,000 329,000 Net operating income $ 228,000 508,000 * $3 per unit variable; $248,000 fixed each year. The company’s $35 unit product cost is computed as follows: Direct materials $ 7 Direct labor 10 Variable manufacturing overhead 3 Fixed manufacturing overhead ($330,000 ÷ 22,000 units) 15 Absorption costing unit product cost $ 35 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 22,000 22,000 Units sold 17,000 27,000 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

1) Under variable costing, fixed manufacturing overhead is considered as period cost and not included in unit product cost. Under absorption costing, fixed manufacturing overhead is considered as product cost.

Calculation of Unit Product cost under Variable Costing (Amounts in $)

Direct Materials	7
Direct Labor	10
Variable manufacturing overhead	3
Unit Product Cost (7+10+3)	20

Therefore unit product cost for both years under variable costing is $20 per unit.

2) Variable Costing Income Statement (Amounts in $)

	Year 1	Year 2
Sales (A)	1,020,000 (17,000*$60)	1,620,000 (27,000*$60)
Variable Cost of goods sold	340,000 (17,000*$20)	540,000 (27,000*$20)
Variable selling and administrative cost	51,000 (17,000*$3)	81,000 (27,000*$3)
Total Variable costs (B)	391,000	621,000
Contribution Margin (C = A-B)	629,000	999,000
Fixed Manufacturing Overhead	330,000	330,000
Fixed selling and administrative cost	248,000	248,000
Total Fixed Costs (D)	578,000	578,000
Net Operating Income (C-D)	51,000	421,000

Therefore under variable costing, net operating income is $51,000 and $421,000 for year 1 and year 2 respectively.

3) Reconciliation of operating income under both costing methods (Amounts in $)

	Year 1	Year 2
Net Operating Income as per Absorption Costing	126,000	346,000
Less: Fixed Manufacturing Overhead Deferred under absorption	75,000 (5,000*$15)	0
Add: Fixed Manufacturing Overhead Released	0	75,000
Net Operating Income as per Variable Costing	51,000	421,000

Ending Inventory for year 1 = Units produced - Units sold

= 22,000 - 17,000 = 5,000 units

Fixed manufacturing deferred under absorption costing is equal to ending inventory multiplied by fixed manufacturing overhead per unit. The beginning inventory for year 2 is 5,000 units which will results in fixed manufacturing overhead released in year 2.