Miller Corporation produces a single product. The company had the following results for its first two years of operation:??Year 1Year 2?Sales$1,200,000$1,200,000?Cost of goods sold800,000680,000?Gross margin400,000520,000?Selling and administrative expenses300,000300,000?Net operating income$100,000$220,000In 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 manufacturing overhead rate is computed each year). Variable selling
and administrative expenses are $2 per unit sold.Required:a. Compute the unit product cost for each year under absorption costing and under variable costing.b. Prepare a contribution format income statement for each year using variable costing.c. Reconcile the variable costing and absorption costing income figures for each year.d. Explain why the net operating income for Year 2 under absorption costing was higher than the net operating income for Year 1, although the same number of units were sold in each year.
What will be an ideal response?
a. Cost per unit under absorption costing:
| ? | ? | Year 1 | Year 2 |
| ? | Variable production cost | $5 | $5 |
| ? | Fixed manufacturing overhead cost: | ? | ? |
| ? | ($600,000 ÷ 40,000 units) | 15 | ? |
| ? | ($600,00 ÷ 50,000 units) | ? | 12 |
| ? | Unit product cost | $20 | $17 |
Cost per unit under variable costing:
| ? | ? | Year 1 | Year 2 |
| ? | Variable costing unit product cost | $5 | $5 |
b. Income statements for each year under variable costing:
| ? | ? | Year 1 | Year 2 |
| ? | Sales | $1,200,000 | $1,200,000 |
| ? | Cost of goods sold ($5 per unit × 40,000 units) | 200,000 | 200,000 |
| ? | Variable selling and administrative expense ($2 per unit × 40,000 units) | 80,000 | 80,000 |
| ? | Contribution margin | 920,000 | 920,000 |
| ? | Fixed expenses: | ? | ? |
| ? | Fixed manufacturing overhead | 600,000 | 600,000 |
| ? | Fixed selling and administrative expense | 220,000 | 220,000 |
| ? | Net operating income | $100,000 | $100,000 |
c. Reconciliation
Year 1:
Units in ending inventory = Units in beginning inventory + Units produced ? Units sold
= 0 units + 40,000 units ? 40,000 units = 0 units
Year 2:
Units in ending inventory = Units in beginning inventory + Units produced ? Units sold
= 0 units + 50,000 units ? 40,000 units = 10,000 units
Manufacturing overhead deferred in (released from) inventory = Fixed manufacturing overhead in ending inventory ? Fixed manufacturing overhead in beginning inventory = ($12 per unit × 10,000 units) ? ($15 per unit × 0 units) = $120,000
| c. | ? | Year 1 | Year 2 |
| ? | Net operating income under variable costing | $100,000 | $100,000 |
| ? | Fixed manufacturing overhead deferred in inventory in Year 2 | ? | 120,000 |
| ? | Net operating income under absorption costing | $100,000 | $220,000 |
d. The increase in production in Year 2, in the face of level sales, caused a buildup of inventory and a deferral of a portion of the overhead costs of Year 2 to the next year. This deferral of cost relieved Year 2 of $120,000 of fixed manufacturing overhead. Income for Year 2 was $120,000 higher than income of Year 1, even though the same number of units was sold each year. By increasing production and building up inventory, the company was able to increase profits without increasing sales. This is a major criticism of the absorption costing approach.
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