Jokkomok Industries Company’s Cost Behavior

Jokkomok Industries

Absorption Costing Income Statement

For the first quarter ending 31st March 2014:

Amount in $
Sales (25,000 * 100) 2,500,000
Less cost of sales
Opening inventory 0
Add: cost of goods produced (25,000 * 72) 1,800,000
Goods available for sale 1,800,000
Less: closing inventory 0
Cost of goods sold 1,800,000
(1,800,000)
Gross profit margin (2,500,000 – 1,800,000) 700,000
Less selling and administrative expenses
Variable selling and administrative expenses
Fixed selling and administrative expenses 300,000
(300,000)
Net operating income (700,000 – 300,000) 400,000

Contribution Margin Costing Income Statement

For the first quarter ending 31st March 2014:

Amount in $
Sales (25,000 * 100) 2,500,000
Less variable expenses
The variable cost of goods sold
Beginning inventory 0
Add variable manufacturing costs (25,000 * $0 per unit) 0
Cost of goods available for sale 0
Less ending inventory 0
The variable cost of goods sold 0
Variable selling and administrative expenses 0
(0)
Contribution margin ($2,500,000 –$0) 2,500,000
Less fixed expenses:
Fixed manufacturing overhead 0
Fixed selling and administrative expenses 300,000
(300,000)
Net operating income 2,200,000

Absorption Costing Income Statement

For the second quarter ending 30th June 2014:

Amount in $
Sales (25,000 * 100) 2,500,000
Less cost of sales
Opening inventory 0
Add: cost of goods produced (50,000 * 72) 3,600,000
Goods available for sale 3,600,000
Less: closing inventory (25,000 * 72) (1,800,000)
Cost of goods sold 1,800,000
Gross profit margin (2,500,000 – 1,800,000) 700,000
Less selling and administrative expenses:
Variable selling and administrative expenses 0
Fixed selling and administrative expenses 300,000
(300,000)
Net operating income (700,000 – 300,000) 400,000

Contribution Margin Income Statement

For the second quarter ending 30th June 2014:

Amount in $
Sales (25,000 * 100) 2,500,000
Less variable expenses
The variable cost of goods sold
Beginning inventory 0
Add variable manufacturing costs (50,000 *$0) 0
Cost of goods available for sale 0
Less ending inventory 0
The variable cost of goods sold 0
Variable selling and administrative expenses 0
(0)
Contribution margin (2,500,000 –0) 2,500,000
Less fixed expenses:
Fixed manufacturing overhead 0
Fixed selling and administrative expenses 300,000
(300,000)
Net operating income 2,200,000

Estimation of production cost per unit

Quarter 1

Absorption Costing

Production cost per unit:

= 1,800,000 / 25,000

= $72

Contribution Margin: The production cost per unit in this case is $0 because it is not indicated whether there are variable costs of production or not.

Quarter 2

Absorption Costing

Production cost per unit:

= 1,800,000 / 25,000

= $72 (since the variable cost per unit remained constant)

Contribution Margin: The production cost per unit in this case is $0 because it is not indicated whether there are variable costs of production or not.

Discussion

The improvement of the performance for the second quarter

Based on the calculations shown above, it can be established that Mr. Rosen ensured that the number of units produced during the period increased. The production reached the full capacity in the second quarter. However, the volume of sales did not improve. This implies that there were closing inventory. A high balance of closing inventory has an effect of increasing stock handing cost. Therefore, increasing the units produced has the effect of increasing operating costs. Further, there was no improvement in net income during the period. The two approaches that were used to prepare the income shows that there were no changes in the net operating income. Thus, the performance of the company did not improve in the second quarter of the year.

Suggestions for reporting in the future

At the moment, it can be observed that the cost of goods sold is reported as a single value. In the future, the management of Jokkomok Enterprises needs to break down the cost of goods sold into various components. For instance, the cost can be separated into direct materials, direct labor, and variable manufacturing overhead. This will assist in the preparation of the contribution margin cost statement. Besides, it will aid in cost control and improve internal reporting (Atrill & McLaney, 2009).

The candidate for the CEO position

Mr. Rosen should not be seriously considered for the position of a CEO. A person eyeing this position should be able to recommend a holistic change in the entire manufacturing and selling process and not just in one area. For instance, a suggestion that focuses on increasing in production should be supported by a corresponding increase in sales. Sales can be increased through aggressive advertisement and promotional activities. The bottom line of Jokkmok Industries can also be improved through cost reduction. Therefore, Mr. Rosen should not be seriously considered for the position of a CEO of Jokkmok Industries because he lacks adequate skills that can assist in improving the overall performance of the company.

Three shortcomings of the absorption approach for internal decision-making

Despite being widely used across the globe, absorption costing has a number of shortcomings. A major drawback of this approach is that it does not give accurate results because the allocation, apportionment, and absorption of costs using this approach are based on budgeted values. These values are arrived at after taking into account operations of the previous years and future plans of the company. However, business environment does change. Therefore, there is a tendency that the budgeted values would not be exactly the same as the actual values. This causes variance which calls for adjustments at year end. The second drawback of this approach is that it does not provide adequate information that can be used for managerial decision making. It is worth mentioning that under absorption costing, the fixed overhead production cost is included in the cost of a unit produced. This makes the cost per unit of output to appear high and reduces the ability of the company to generate more revenue. For instance, if the variable cost per unit is $40 while the fixed overhead is $10 per unit, then the total cost per unit under absorption costing is $50. If a buyer wants to purchase a unit at $45, the company will miss the opportunity because the price ($45) is lower than the cost per unit ($50). Such scenarios calls for the use of other approaches such as marginal costing technique. Therefore, it is apparent that absorption costing is not suitable for cost-volume-profit analysis. The final drawback of this approach is that it is less suitable in cases where the company produces irregular volumes. In scenarios where the production and sales fluctuate, the fixed production overhead and the variable costs will also fluctuate. However, only the variable should fluctuate as the volume of production changes. The fixed overhead should remain constant irrespective of the volume of production (Drury, 2012). This makes the approach unsuitable when analyzing the per unit cost of production.

References

Atrill, P. & McLaney, E. (2009). Management accounting for decision makers. UK: Financial Times/Prentice Hall.

Drury, C. (2012). Management and cost accounting. United States of America: Cengage Learning.

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