Profit Centers: Comparison of Variable and Full Costing (Underapplied Overhead) Mark Hancock Inc. manufactures a specialized surgical instrument called the HAN-20. The firm has grown rapidly in recent years because of the product’s low price and high quality. However, sales have declined this year primarily due to increased competition and a decrease in the surgical procedures for which the HAN-20 is used. The firm is concerned about the decline in sales and has hired a consultant to analyze the firm’s profitability. The consultant was provided the following information:
Top management at Hancock explained to the consultant that a difficult business environment for the firm in 2018 and 2019 had caused the firm to reduce its price and production levels and reduce its fixed manufacturing costs in response to the decline in sales. Even with the price reduction, there was a decline in sales in both years. This led to an increase in inventory in 2018, which the firm was able to reduce in 2019 by further reducing the level of production. In both years, Hancock’s actual production was less than the budgeted level so that the overhead rate for fixed overhead, calculated from budgeted production levels, was too low, and a production volume variance was calculated to adjust cost of goods sold for the underapplied fixed overhead (the calculation of the production volume variance is explained fully in Chapter 15 and reviewed briefly below). The production volume variance for 2018 was determined from the fixed overhead rate of $175 per unit ($700,000/4,000 budgeted units). Because the actual production level was 200 units short of the budgeted level in 2018 (4,000 − 3,800), the amount of the production volume variance in 2018 was 200 × $175 = $35,000. The production volume variance is underapplied because the actual production level is less than budgeted, and the production volume variance is therefore added back to cost of goods sold to determine the amount of cost of goods sold in the full costing income statement. The full costng income statement for 2018 is shown below:
Required
1. Using the full costing method, prepare the income statement for 2019. 2. Compute operating income for each period under variable costing, and explain the difference in operating income from that obtained in requirement 1. 3. Write a brief memo to the firm to explain the difference in operating income between variable costing and full costing.