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Absorption costing does not distinguish between variable and fixed costs. All manufacturing costs are included in the cost of goods sold.

Saxon, Inc.

Absorption Costing Income Statement

For the Year Ended December 31

1	Sales		$1,200,000.00
2	Cost of goods sold:
3	Beginning inventory	$0.00
4	Cost of goods manufactured	800,000.00
5	Ending inventory	(160,000.00)
6	Total cost of goods sold		640,000.00
7	Gross profit		$560,000.00
8	Selling and administrative expenses		289,000.00
9	Income from operations		$271,000.00

Under variable costing, the cost of goods manufactured includes only variable manufacturing costs. This type of income statement includes a computation of manufacturing margin.

Saxon, Inc.

Variable Costing Income Statement

For the Year Ended December 31

1	Sales		$1,200,000.00
2	Variable cost of goods sold:
3	Beginning inventory	$0.00
4	Variable cost of goods manufactured	560,000.00
5	Ending inventory	(112,000.00)
6	Total variable cost of goods sold		448,000.00
7	Manufacturing margin		$752,000.00
8	Variable selling and administrative expenses		224,000.00
9	Contribution margin		$528,000.00
10	Fixed costs:
11	Fixed manufacturing costs	$240,000.00
12	Fixed selling and administrative expenses	65,000.00
13	Total fixed costs		305,000.00
14	Income from operations		$223,000.00

This is the Question

The production manager for Saxon, Inc. is worried because the company is not showing a high enough profit. Looking at the income statements on the Absorption Statement panel and the Variable Statement panel, he notices that the income from operations is higher on the absorption cost income statement. He is considering manufacturing another 10,000 units, up to the companys capacity for manufacturing, in the coming year. He reasons that this will boost income from operations and satisfy the companys owner that the company is sufficiently profitable. Although the total units manufactured changes, assume that total fixed costs, unit variable costs, unit sales price, and the sales levels are the same. Complete questions (1)-(4) that follow. If the answer is zero, enter "0".

1. Use the income statements on the Absorption Statement and Variable Statement panels to complete the following table for the original production level. Then prepare similar income statements at a production level 10,000 units higher and add that information to the table. Assume that total fixed costs, unit variable costs, unit sales price, and the sales levels are the same at both production levels.

Income From Operations
Original Production Level-Absorption	Original Production Level-Variable	Additional 10,000 Units-Absorption	Additional 10,000 Units-Variable
?	?	?	?

2. What is the change in income from operations from producing 10,000 additional units under absorption costing?

3. What is the change in income from operations from producing 10,000 additional units under variable costing?

4. What would be your recommendation to the production manager?

a)Produce the extra 10,000 units. Income from operations will be increased, and the production manager will receive praise for creating higher profits.

b)Produce the extra 10,000 units. It's always a good idea to have extra units on hand and keep the factory operating at capacity, even if all the units are not sold.

c)Do not produce the extra 10,000 units. Income from operations does not change under absorption costing when the additional units are produced.

d)Do not produce the extra 10,000 units. The increase in income from operations under absorption costing is due to fixed manufacturing costs being held in inventory, and the additional inventory will lead to higher handling, storage, financing, and obsolescence costs.

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