“This is illogical,” said Mike Rafferty, president of XYZ Company. “Unit sales this year were the same as last year, but our bottom line profits have more than doubled. Who made the accounting mistake�”the people or the computer?”

The income statements to which Mr. Rafferty was referring are shown below (based on the absorption costing method):

XYZ Company Income Statement – Absorption Method
Year 1 Year 2
Sales (40,000 units each year) $1,253,000 $1,253,000
Cost of goods sold 840,000 720,000
Gross margin 413,000 533,000
Selling and administrative expense 335,000 335,000
Net operating income $78,000 $198,000

XYZ Production Data
Year 1 Year 2
Production in units 40,000 50,000
Sales in units 40,000 40,000
Variable manufacturing cost per unit produced $6 $6
Variable selling and administrative expense per unit sold $1 $1
Fixed manufacturing overhead costs (total) $600,000 $600,000

The income statements above report net operating income for the first two years of operation. During the first year, the company produced and sold 40,000 units. During the second year, the company also sold 40,000 units, but it increased production as shown below:

XYZ Company applies fixed manufacturing overhead costs to its product on the basis of each year’s production and so a new fixed manufacturing overhead rate is computed each year.

Explain how activity-based costing may or may not be useful for XYZ in preparing variable and absorption-based income statements.

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