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Activity-based costing for variable or absorption costing

"This is illogical," said Mike Rafferty, president of XYZ Company. "Unit sales this year were the same as last year, but our bottom line profits have more than doubled. Who made the accounting mistake´┐Ż"the people or the computer?"

The income statements to which Mr. Rafferty was referring are shown below (based on the absorption costing method):

XYZ Company Income Statement - Absorption Method
Year 1 Year 2
Sales (40,000 units each year) $1,253,000 $1,253,000
Cost of goods sold 840,000 720,000
Gross margin 413,000 533,000
Selling and administrative expense 335,000 335,000
Net operating income $78,000 $198,000

XYZ Production Data
Year 1 Year 2
Production in units 40,000 50,000
Sales in units 40,000 40,000
Variable manufacturing cost per unit produced $6 $6
Variable selling and administrative expense per unit sold $1 $1
Fixed manufacturing overhead costs (total) $600,000 $600,000

The income statements above report net operating income for the first two years of operation. During the first year, the company produced and sold 40,000 units. During the second year, the company also sold 40,000 units, but it increased production as shown below:

XYZ Company applies fixed manufacturing overhead costs to its product on the basis of each year's production and so a new fixed manufacturing overhead rate is computed each year.

Explain how activity-based costing may or may not be useful for XYZ in preparing variable and absorption-based income statements.

Solution Preview


Here is the issue: The cost per unit changed between the two year because of the fixed overhead per unit. That is, the way the $600,000 was spread to the units, the COGS in the two years differed by $3 per unit. So, even though fixed costs were the same in each year, those costs were spread over fewer units last year and so the cost per unit was higher. See this schedule for an ...

Solution Summary

Your tutorial is 247 words and identifies the core issue with a schedule and then explains why ABC will not help the profit fluctuation issue.