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Jorgansen Lighting, Inc., manufactures heavy-duty street lighting systems for municipalities. The...

Question:

Reconciliation of Absorption and Variable Costing Net Operating Incomes

Jorgansen Lighting, Inc., manufactures heavy-duty street lighting systems for municipalities. The company uses variable costing for internal management reports and absorption costing for external reports to shareholders, creditors, and the government. The company has provided the following data:

Year 1 Year 2 Year 3
Inventories:
Beginning (units) 200 170 180
Ending (units) 170 180 220
Variable costing net operating income $1,080,400 $1,032,400 $996,400

The company's fixed manufacturing overhead per unit was constant at $560 for all three years.

Required:

1. Determine each year's absorption costing net operating income. Present your answer in the form of a reconciliation report.

2. In Year 4, the company's variable costing net operating income was $984,400 and its absorption costing net operating income was $1,012,400. Did inventories increase or decrease during Year 4? How much fixed manufacturing overhead cost was deferred or released from inventory during Year 4?

Variable costing:

Variable costing is primarily used for management reporting purposes while absorption costing is used for external reporting purposes. The difference between the two is the treatment of fixed manufacturing overhead. Under variable costing, the fixed manufacturing overhead is recognized outright in the income statement while under the absorption costing, portion of the fixed overhead will be deferred since absorption costing recognizes fixed overhead as part of product cost.

Answer and Explanation:

Year 1 Year 2 Year 3
Variable Costing and Costing Net Operating Incomes. $1,080,400 $1,032,400 $996,400
Add (deduct) fixed manufacturing overhead deferred in (released from) inventory under absorption costing. ($16,800) 5,600 22,400
Absorption costing net operating income. $1,063,600 $1,038,000 $1,018,800

At year 1, since beginning inventory is greater than ending inventory, we are sure that the number of units sold is greater than the number of units produced. If number of units sold is greater then we can assume that the fixed overhead recognized in the income statement is greater under the absorption costing method than the variable costing method. Thus net income in absorption costing is lower than net income in variable costing method. To compute:

  • Absorption costing net operating income (year 1) = variable costing operating income + ((ending inventory - beginning inventory) x fixed overhead cost per unit))
  • Absorption costing net operating income (year 1) = $1,080,400 + ((170- 200) x $560))
  • Absorption costing net operating income (year 1) = $1,080,400 + (-30 x $560))
  • Absorption costing net operating income (year 1) = $1,080,400 - 16,800
  • Absorption costing net operating income (year 1) = $1,063,600

At year 2, the opposite will happen since the beginning inventory is lesser than the ending inventory.

  • Absorption costing net operating income (year 2) = variable costing operating income + ((ending inventory - beginning inventory) x fixed overhead cost per unit))
  • Absorption costing net operating income (year 2) = $1,032,400 + ((180- 170) x $560))
  • Absorption costing net operating income (year 2) = $1,032,400 + (10 x $560))
  • Absorption costing net operating income (year 2) = $1,032,400+ 5,600
  • Absorption costing net operating income (year 2) = $1,038,000

At year 3, the same scenario will happen as year 2:

  • Absorption costing net operating income (year 3) = variable costing operating income + ((ending inventory - beginning inventory) x fixed overhead cost per unit))
  • Absorption costing net operating income (year 3) = $996,400 + ((220- 180) x $560))
  • Absorption costing net operating income (year 3) = $996,400 + (40 x $560))
  • Absorption costing net operating income (year 3) = $996,400 + 22,400
  • Absorption costing net operating income (year 3) = $1,018,800

Question 2

a. *Answer: i. increase

Since absorption costing income is greater than variable costing income, we can conclude that the inventory increased during year 4. Why is this so? Note that the difference between the two is due to the fixed overhead cost. Fixed overhead cost is constant in variable costing while fixed overhead cost in absorption costing will vary depending on the number of units sold. Therefore if the absorption costing income is higher, the number of units sold is lesser than the number of units produced resulting to an increase in inventory at year-end.

b. The amount of fixed manufacturing overhead deferred in the inventory amounted to $28,000 ($1,012,400 - $984,400).


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