Question

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3. The Miller Company had the following results for its first year of operations: Year 1 Sales $1,200,000 Cost of goods sold 800,000 GM 400,000 SG&A 300.000 Operating Income $100,000 In Year 1, the company produced and sold 40,000 units of its only product; in Year 2, the company again sold 40,000 units, but increased production to 50,000 units. The company's variable production cost is $5 per unit, and its fixed manufacturing overhead cost is $600,000 a year. Fixed manufacturing overhead costs are applied to the product on the basis of each year's unit production (i.e., a new fixed overhead rate is computed each year). Variable selling and administrative expenses are $2 per unit sold. a. Prepare an income statement for Year 2 under absorption costing. b. Explain why the operating income for Year 2 under absorption costing differs from the operating income for Year 1.

Answer 1

Income statement for Year 2 under absorption costing Sales Less: Cost of Goods Sold Gross margin Less: Selling and Administrative expense Operating Income $ $ $ $ $ 1,200,000 (680,000) 520,000 (300,000) 220,000 Working Notes: Cost of Goods Sold for Year 2 $ 200,000 Variable production cost ( 40000 * $5) Absrobed Fixed Maufacturing overhead (40000 * $ 12 ) Cost of Goods Sold $ $ 480,000 680,000 Fixed manufacturing oerhead rate = Total Fixed overhead/Total Production = $ 600000 / 50000 = $ 12 per unit. Selling and administrative expenses will be same in the year 2, as they depend upon the number of units sold.

b) In the year 1, there is total production units is equal to total units sold, hence there is no under or over absorption of manufacturing overhead. However, in the year 2, Production is 50000 units and Units sold is 40000. In such a situation under absorption of manufacturing overhead arises. Therby Operating income in the year 2 differs from the operating income in the year 1. Difference in Operating Income from year 1 to year 2 = $ 220000 - $ 100000 = $ 120000 $ 120000 comes as follows Total fixed manufacturing overhead Less: fixed manufacturing overhead absorbed Underabsorbed fixed overhead $ $ $ 600,000 (480,000) 120,000