Question

Explain the difference between variable costing and absorption costing income statements. Provide income statements in both variable costing and absorption costing formats for an initial period and its successive period in a case where all manufactured products within the two periods are sold by the end of the second period, but number of units sold in the first period is less than the number of units manufactured in this period. What is the interesting observation in comparing the two types of income statements

Answer 1

Difference between variable costing and absorption costing income statements: The only reason for the difference in net operating income (loss) between absorption costing and variable costing is the deferred fixed manufacturing overhead cost to next period through ending inventory under absorption costing. That is, under variable costing, entire fixed manufacturing overhead cost is considered as period cost and so charged to income statement. However, under the absorption costing, fixed mfg. overhead cost is considered as product cost and so a portion of it will be deferred to next reporting period through ending inventory. If number of units produced and sold are same, net operating income reported under both methods will be same.

Let us assume the data for first 2 years of operations as below: Selling price per unit $59 $21 $17 Direct material cost per unit Direct labor cost per unit Variable mfg. overhead per unit Variable sell. & admin. per unit so Fixed manufacturing overhead Fixed sell. & admin. expenses $320,000 $90,000 Units in beginning inventory Number of units produced Number of units sold Units in ending inventory Year-1 0 50,000 40,000 10,000 Year-2 10,000 40,000 50,000

Under variable costing, unit product cost shall consider only variable mfg. costs incurred to produce the number goods. Therefore, Year-1 Year-2 Direct material cost per unit $21 Direct labor cost per unit $17 $17 Variable mfg. overhead per unit Unit product cost $42 $42 $21 $4 $4 Variable Costing Income Statement Year-1 Year-2 Sales Revenue $2,360,000 $2,950,000 [40000 units x $59; 50000 units x $59] Variable Expenses: Variable Manufacturing costs $1,680,000 $2,100,000 [40000 units x $42; 50000 units x $42] Variable Selling and Admin. Expenses $120,000 $150,000 (40000 units x $3; 50000 units x $3] Total Variable Expenses $1,800,000 $2,250,000 Contribution Margin $560,000 $700,000 (Sales Revenue - Total Variable Expenses] Fixed Expenses: Fixed Manufacturing costs $320,000 $320,000 [Fully charged as expense] Fixed Selling and Admin. Expenses $90,000 $90,000 [Fully charged as expense] Total Fixed Expenses $410,000 $410,000 Net Operating Income $150,000 $290,000 (Contribution margin - Total Fixed Expenses]

Under absorption costing, unit cost of goods manufactured shall consider both variable and fixed manufacturing costs incurred to produce the number goods. Therefore, Direct material cost per unit Direct labor cost per unit Variable mfg. overhead per unit Fixed mfg. overhead per unit Product cost per unit Year-1 $21.00 $17.00 $4.00 $6.40 $48.40 Year-2 $21.00 $17.00 $4.00 $8.00 $50.00 [Ref: NOTE] NOTE: For Year-1, $320000 / 50000 units produced = $6.4; For Year-2, $320000 / 40000 units produced = $8. Absorption Costing Income Statement Year-1 Sales Revenue $2,360,000 Cost of Goods Sold $1,936,000 Gross Profit $424,000 Marketing & Admin. Expenses $210,000 Net Operating Income $214,000 Year-2 $2,950,000 [40000 units x $59; 50000 units x $59] $2,484,000 [40000 units x $48.40; (10000 units x $48.40) + (40000 units x $50.00)] $466,000 [Sales Revenue - Cost of Goods Sold] $240,000 ((40000 x $3) + $90000; (50000 x $3) + $90000] $226,000

Reconciliation between net incomes reported under absorption versus variable costing: Net income as per variable costing Add: Fixed mfg. costs in ending inventory Less: Fixed mfg. costs in beginning inventory Net income as per absorption costing Year-1 $150,000 $64,000 $0 $214,000 Year-2 $290,000 (Ref: Part-(d)] $0 (10000 units x $6.40; 0 units x $8] $64,000 [Year-1's fixed mfg. costs in end. Inventory] $226,000 --> Matched with Part-2B]