Question

There must be something wrong with these financial statements! exclaimed Ezra Hart, president of Olivers Inc. (Olivers or the Company). They just dont make sense. We sold the same number of units this year as we did last year, yet our profits have tripled! Who messed up the calculations?

Olivers is a wand manufacturer and has been in business for 250 years. Sales forecasting has been relatively easy to do in the past since Olivers has had long-term, single-sourcing relationships with most of its customers. In 2022, however, there was a threat of a strike at one of Olivers major raw materials suppliers. For that reason, Olivers management decided to purchase more raw materials and produce more components in 2022 than required, in anticipation of raw materials shortages in 2023. Manufacturing equipment was typically operated below capacity, so this boost in production was possible without incurring significant increased fixed manufacturing costs. The income statement and production reports to which Hart was referring are shown below:

2021 2022

Sales (40,000 units each year) $6,000,000 6,000,000

Cost of goods sold 4,032,000 3,456,000

Gross margin 1,968,000 2,544,000

Selling and administrative expenses 1,587,000 1,587,000

Operating Income $381,000 $957,000

	2021	2022
Production in units	40,000	50,000
Sales in units	40,000	40,000
Variable manufacturing cost per unit produced	$50	$50
Variable selling and administrative expense per unit sold	$15	$15
Fixed manufacturing overhead costs (total)	$2,150,000	$2,150,000

Olivers uses absorption costing and applies fixed manufacturing overhead costs to its only product on the basis of each years production. Hart would like you to explain why the operating income for 2022 was higher than for 2021 under absorption costing, even though the number of units sold was the same each year. He wants to understand the difference between the two costing methods and provide a brief discussion of the advantages and disadvantages of variable over absorption costing for internal reporting purposes.

Perhaps preparing an income statement under variable costing may be helpful in understanding the situation. Should the company continue to overproduce in coming years to boost operating income?