Impact of Just In Time (JIT) Inventory Methods on Variable and Absorption Costing System:
- Why net operating income figure under variable costing and absorption costing systems are almost same when companies use just in time manufacturing and inventory control system?
Variable costing and absorption costing produce different net operating income figures whenever the number of units produced is different from the number of units sold. In other words, whenever there is a change in the number of units in inventory. Absorption costing net operating income figure can be erratic, sometimes moving in a direction that is opposite from the movement in sales.
When companies use just in time (JIT) methods, these problems are reduced. The erratic movement of net operating income under absorption costing and the difference in net operating income between absorption and variable costing occur because of changes in the number of units in inventory. Under just in time (JIT) goods are produced to customers’ orders and the goal is to eliminate finished goods inventory entirely and reduce work in process inventory to almost nothing. If there is very little inventory, the changes in inventories will be very small and both variable costing and absorption costing will show basically the same net operating income figure. In that case, absorption costing net operating income will move in the same direction as movement in sales.
Of course the cost of a unit of product will still be different between variable and absorption costing. But when just in time (JIT) is used, the differences in net operating income will largely disappear.