Impact of (just in time) JIT

Impact of JIT Inventory Methods

When companies use JIT methods for controlling their operations, the distortions of income that can occur under absorption costing largely (or completely) disappear.

1. The cause of distortions in net operating income

Erratic movements in net operating income under absorption costing and the differences in net operating income between absorption and variable costing can be traced to changing levels of inventory. When inventory levels are constant or negligible, absorption costing and variable costing methods yield the essentially same net operating income.

2. The JIT solution

Under an ideally functioning JIT system, goods are produced strictly to customers’ orders. Finished goods inventories almost disappear and work in process inventories are kept to a minimum. With little or no inventories, fixed manufacturing overhead costs cannot be shifted between periods under absorption costing. As a result, both variable and absorption costing will show essentially the same net operating income figure, and the net operating income under absorption costing will move in the same direction as movements in sales.

Absorption Costing (External reporting) and Income Taxes

Absorption costing is required for external reporting for a company. A company that attempts to use variable costing on its external financial reports runs the risk that its auditors may not accept the financial statements as conforming to generally accepted accounting principles (GAAP). Tax law on this issue is cleat cut. A company must use absorption costing for its external reports; a manager can also use variable costing income statements for internal reports. No particular accounting problems are created by using both costing methods- the variable costing method for internal reports and the absorption costing method for external reports. Top executives are typically evaluated based on the earnings reported to shareholders on the company’s external financial reports.

 

Format Differences Under Two Methods

 

Format (Technical) Differences

 

Absorption costing makes a primary classification of costs according to manufacturing and nonmanufacturing functions, emphasizing the gross margin (that is, Sales COGS) available to cover all fixed and variable selling and administrative expenses.

 

Direct costing makes a primary classification of costs into variable and fixed categories, emphasizing the contribution margin (that is, sales ? variable costs) available to cover all fixed costs. 

 

Report Formats

 

The formats for profit reporting under direct costing and absorption costing are different.

 

Absorption Costing

 

Revenues ………………………… ***

Less cost of goods sold ………….. ***                            

 

Gross margin ………………..…… ***

 

Less selling and administration expenses:

 

Variable ………………………..  ***

 

Fixed …………………………... ***

 

Net operating income (NOI)            ***


 

Variable Costing

 

Revenues ………………………… ***

Less variable cost:

Manufacturing cost …………..….. ***                            

Selling and administration cost ….. ***

 

Contribution margin (CM) ....….… ***

 

Less fixed costs:

 

Manufacturing costs …………..  ***

Selling and administration costs.. ***

 

Net operating income (NOI)            ***

 

 

The figures under the two approaches will not always be the same.

  

Interpretation of the Difference

 

The difference between the two income measurement approaches is essentially the difference in the timing of the charge to expense for fixed factory overhead cost. In the absorption costing method, fixed factory overhead is first charged to inventory; thus, it is not charged to expense until the period in which the inventory is sold and included in cost of goods sold (an expense).  In contrast, in the variable costing method, fixed factory overhead is charged to expense immediately, and only variable manufacturing costs are included in product inventories.  Therefore, if inventories increase during a period (i.e., production exceeds sales), the variable costing method will generally report less operating income than will the absorption costing method; when inventories decrease, the opposite effect will take place.