Question

Using variable and absorption costing, making decisions

The 2018 data that follow pertain to Mike’s Magnificent Eyewear, a manufacturer of swimming goggles. (Mike’s Magnificent Eyewear had no beginning Finished Goods Inventory in January 2018.)

Number of goggles produced 245,000

Number of goggles sold 230,000

Sales price per unit \( 28

Variable manufacturing cost per unit 10

Sales commission cost per unit 2

Fixed manufacturing overhead 1,960,000

Fixed selling and administrative costs 260,000

Requirements:

1. Prepare both conventional (absorption costing) and contribution margin (variable costing) income statements for Mike’s Magnificent Eyewear for the year ended December 31, 2018.
2. Which statement shows the higher operating income? Why?
3. Mike’s Magnificent Eyewear’s marketing vice president believes a new sales promotion that costs \)40,000 would increase sales to 235,000 goggles. Should the company go ahead with the promotion? Give your reasoning.

Short answer

1. Operating profit as per absorption and variable costing is $1,580,000 and $1,460,000 respectively.
2. Income statements as absorption costing has higher operating income because proportionate allocation of fixed cost.
3. Yes, companies should go ahead as it increases operating income.

Step-by-step solution

Calculation of unit product cost using variable and absorption costing (1) : 

Particulars	Absorption costing	Variable Costing
Variable manufacturing overhead	$10	$10
Fixed manufacturing overhead ($1,960,000/245,000)	$8	-
Total unit product cost	$18	$10

Income statement absorption costing format 

Particulars	Absorption Costing
Net sales revenue ($28x230,000)	$6,440,000
Less: Cost of goods sold ($18x230,000)	$4,140,000
Gross profit	$2,300,000
Variable selling and administrative cost ($2x230,000)	$460,000
Fixed selling and administrative cost	$260,000
Operating Income	$1,580,000

Income statement variable costing format

Particulars	Variable Costing
Net sales revenue ($28x230,000)	$6,440,000
Less: Cost of goods sold
Variable cost of goods sold ($10x230,000)	$2,300,000
Variable selling and administrative cost ($2x230,000)	$460,000
Contribution margin	$3,680,000
Less: Fixed costs
Fixed costs of goods sold	$1,960,000
Fixed selling and administrative cost	$260,000
Operating Income	$1,460,000

 Profitability Analysis (2): 

Operating income is higher under absorption costing because proportionate fixed cost allocated to while calculating operating income because units sold are less than the units produced.

Operating income if the company goes ahead with the promotion (3): 

Particulars	Variable Costing
Net sales revenue ($28x235,000)	$6,580,000
Less: Cost of goods sold
Variable cost of goods sold ($10x235,000)	$2,350,000
Variable selling and administrative cost ($2x235,000)	$470,000
Contribution margin	$3,760,000
Less: Fixed costs
Fixed costs of goods sold	$1,960,000
Fixed selling and administrative cost($260,000 + $40,000)	$300,000
Operating Income	$1,500,000

Yes, the company should go ahead with the promotion because it will increase the operating profit.