RAYCO INC.

These statements cant be right, said Ben Yoder, president of Rayco Inc.
Our sales in the second quarter were up by 25% over the first quarter, yet
these income statements show a precipitous drop in the net operating
income for the second quarter. Those accounting people have fouled
something up. Mr. Yoder was referring to the following statements
(absorption costing basis):

After studying the statements briefly, Mr. Yoder called in the controller to see
if the mistake in the second quarter could be located before the figures were
released to the press. The controller stated, Im sorry to say that those
figures are correct, Ben. I agree that sales went up during the second
quarter, but the problem is in production. You see, we budgeted to produce
15,000 units each quarter, but a strike on the west coast among some of our
suppliers forced us to cut production in the second quarter back to only
9,000 units. Thats what caused the drop in the net operating income.
Mr. Yoder was confused by the controllers explanation. He replied, This
doesnt make sense. I ask you to explain why net operating income dropped
when sales went up and you talked about production! So what if we had to
cut back production? We still were able to increase sales by 25%. If sales go
up, then net operating income should go up. If your statements cant show a
simple thing like that, then its time for some changes in your department!
Budgeted production and sales for the year, along with actual production and
sales for the first two quarters, are given below:

The companys plant is heavily automated, and fixed manufacturing

overhead amounts to $180,000 each quarter. Variable manufacturing costs
are $8 per unit. The fixed manufacturing overhead is applied to units of
product at a rate of $12 per unit (based on the budgeted production shown
above).
Any under applied or over applied overhead is closed directly to cost of
goods sold for the quarter. The company had 4,000 units in inventory to start
the first quarter and uses the FIFO inventory flow assumption. Variable
selling and administrative expenses are $5 per unit.
Required:
1. What characteristic of absorption costing caused the dropped in net
operating income for the second quarter and what could the controller
have said to explain the problem?
Under absorption costing, the net operating income of a particular
period is dependent on both production and sales. Since under
absorption costing treats fixed manufacturing overhead as a product
cost, along with direct materials, direct labor, and variable overhead a
portion of fixed manufacturing overhead is assigned to each unit as it
is produced. If units of product are unsold at the end of a period, then
the fixed manufacturing overhead cost attached to those units is
carried with them into the inventory account and deferred to a future
period. When these units are later sold, the fixed manufacturing
overhead cost attached to them is released from the inventory account
and charged against income as part of cost of goods sold.
For this reason the controllers explanation was accurate. He should
have pointed out however that the reduction of the production resulted
in a large amount of under applied overhead which is added to the cost
of goods sold in the second quarter. By producing fewer units than
planned, the company was not able to absorb all the fixed
manufacturing overhead incurred during the quarter.
2. Prepare a contribution format variable costing income statement for
each quarter? See Schedule 1

3. Reconcile the absorption costing and the variable costing net operating
income figures for each quarter? See Schedule 2
4. Identify and discuss the advantages and disadvantages of using
variable costing method for internal reporting purposes?
The advantages of using the variable costing method for internal
reporting purposes include the following:

Variable costing supports forecasting and very helpful in decision

making purposes.
Profits vary directly with sales volume and are not affected by
changes in inventory levels. When sales go up, net operating
income goes up. When sales go down, net operating income
goes down. When sales are constant, net operating income is
constant.
Facilitates the analysis of cost volume profit relationships and
aids the easy determination of break-even point and total profit
for a given volume of production and sales.

The disadvantages of using the variable costing method is that it may

not be acceptable to external reporting purposes and adds record
keeping cost.

5. Assume that the company had introduced Lean Production at the

beginning of the second quarter, resulting in zero ending inventory
(Sales and production during the first quarter remain the same.
Under Lean Production, goods are produced to customers orders and
the goal is to eliminate finished goods inventories entirely and reduce
work in process inventory to almost nothing.
Because of this the company would have produced only enough units
during the quarter to facilitate sales needs.
a. How many units would have been produced during the second
quarter under Lean Production?

b. Starting with the third quarter, would you expect any difference
between the net operating income reported under absorption costing
and under variable costing? Explain why there would or would not be
any difference?
Starting the Third Quarter, there will be little or no difference between
the incomes reported under variable costing and under absorption
costing. The inconsistent movement of net operating income under
absorption costing and the difference in net operating income between
absorption and variable costing occur because of changes in the
number of units in inventory. There will be no shifting of fixed
manufacturing overhead cost between periods under absorption
costing.