Income Comparison of Variable and Absorption Costing:
Learning Objectives:
- Prepare income statements using
variable costing and absorption costing.
- Why net operating income usually
different under variable and absorption costing methods?
The income statements prepared under
absorption costing
and
variable costing
usually produce different
net
operating income figures. This difference can be quite large. Here
we will explain the basic reason of this difference in income. The explanation for this difference needs two separate income statements
one under
absorption costing and other under
variable costing. We will prepare
two income statements that will produce different income figures and then
explain the reasons of difference. Consider the following example:
Example:
Following data relates to a manufacturing
company:
| Number of
units produced each year |
6,000 |
|
|
| Variable
cost per unit: |
|
| Direct
materials |
$2 |
| Direct labor |
$4 |
| Variable Manufacturing Overhead |
$1 |
| Variable selling and Administrative expenses |
$3 |
| |
|
| Fixed
costs per year: |
|
| Fixed manufacturing overhead |
$30,000 |
| Fixed selling and administrative expenses |
$10,000 |
| |
|
| Units in beginning inventory |
0 |
| Units
produced |
6,000 |
| Units Sold |
5,000 |
| Units in ending inventory |
1,000 |
| Selling price per unit |
$20 |
|
|
| Selling and administrative expenses: |
|
| Variable per unit |
$3 |
| Fixed per year |
$10,000 |
|
Required:
-
Prepare income statements using:
a. Absorption costing system
b. Variable costing system
-
Prepare a reconciliation schedule
|
Absorption Costing
Income Statement
|
| Sales (5,000
units×$20 per unit) |
$100,000 |
| |
---------- |
|
Less cost of goods sold: |
|
| Beginning inventory |
$0 |
| Add Cost of goods manufactured (6,000 units×$12per unit) |
$72,000 |
| |
---------- |
| Goods available for sale |
$72,000 |
| Less ending inventory |
$12,000 |
| |
---------- |
| Cost of goods sold |
$60,000 |
| |
---------- |
| Gross Margin ($100,000 – $60,000) |
$40,000 |
|
---------- |
| Less selling and administrative expenses |
|
| Variable
selling and administrative expenses (5,000 ×
3) |
$15,000 |
| Fixed selling
and administrative expenses |
$10,000 |
| |
--------- |
| |
$25,000 |
| |
---------- |
| Net operating income ($40,000
– $25,000) |
$15,000 |
| |
======== |
| |
|
|
Variable Costing
Income Statement
|
| Sales ($5,000units×$20 per unit)
|
$100,000 |
|
------------ |
| Less variable expenses: |
|
| Variable
cost of goods sold: |
|
| Beginning inventory |
$0 |
| Add variable manufacturing costs (6,000 units×$7 per unit) |
$42,000 |
| |
----------- |
| Goods available for sale |
$42,000 |
| Less ending inventory (1,000 units×$7 per unit) |
$7,000 |
| |
--------- |
| Variable
cost of goods sold |
$35,000 |
variable selling and administrative expenses
(5,000 units × $3 per unit) |
$15,000 |
|
--------- |
|
50,000 |
|
---------- |
| Contribution margin ($100,000 −
$50,000) |
50,000 |
|
---------- |
| Less fixed expenses: |
|
| Fixed manufacturing overhead |
$30,000 |
| Fixed selling and administrative expenses |
$10,000 |
|
--------- |
|
$40,000 |
|
--------- |
| Net operating
Income ($50,000 − $40,000) |
$10,000 |
|
======= |
|
|
|
The income statements prepared above have
different
net operating
income figures. Now we will explain why
net operating
income is different under both the costing systems.
Explanation:
Several points can be noted from the income
statements prepared above:
Under
absorption costing if inventories increase then some of the fixed
manufacturing costs of the current period will not appear on the income
statement as part of
cost of goods sold. Instead, these costs are deferred to
a future period and are carried on the balance sheet as part of the inventory
account. Such a deferral of cost is known as
fixed manufacturing overhead
deferred in inventory. The process involved can be explained by referring
to income statements prepared above. During the current period 6,000 units
have been
produced but only 5,000 units have been sold leaving 1,000 unsold units in the ending
inventory. Under the absorption costing system each unit produced was
assigned $5 in fixed overhead cost. Therefore each unit going into inventory
at the end of the period has $5 in fixed manufactured overhead cost attached
to it, or a total of $5,000 for 1,000 units (1,000 ×
$5). This fixed manufacturing overhead cost of the current period deferred in
inventory to the next period, when hopefully these units will be taken out of
inventory and sold. This deferral of $5,000 of fixed manufacturing overhead
costs can be clearly seen by analyzing the ending inventory under the
absorption costing method:
| Variable manufacturing costs
(1000units × $7 per unit) |
$7,000 |
| Fixed manufacturing overhead costs (1,000 × $5 per unit) |
$5,000 |
| |
--------- |
| Total ending
inventory value |
$12,000 |
| |
======= |
In summary, under absorption costing, of the
$30,000 in fixed manufacturing overhead costs incurred during the period,
only $25,000 (5,000 $ per unit) has been included in the cost of goods
sold. The remaining $5000 (1000 units not sold $5 per unit) has been
deferred in inventory to the next period.
Under variable costing method the entire
$30,000 in fixed manufacturing overhead costs has been treated as an expense
of the current period (see the bottom portion of the variable costing income
statement).
The ending inventory figure under the variable
costing method is $5,000 lower than it is under the absorption costing
method. The reason is that under variable costing, Only the variable
manufacturing costs are assigned to units of product and therefore included
in the inventory:
Variable manufacturing costs (1000units × $7 per unit)
$7,000 The $5,000 difference in ending inventories
explains the difference in net operating income reported between the two
costing methods. Net operating is $5,000 higher under absorption costing
since, as explained above, $5,000 of fixed manufacturing overhead cost has
been deferred in inventory to the next period under that costing method.
Hopefully, when the units relating to this $5,000 fixed cost will be
sold in the next period the cost attached to these units will be included in
the cost of goods sold of the next period. This is called
fixed manufacturing
overhead cost released
from inventory. The absorption
costing system makes no distinction between fixed and variable costs;
therefore, it is not well suited for CVP computations, which are important
for good planning and control. To generate data for
cost volume profit
(CVP) analysis, it would be necessary to spend considerable time
reworking and reclassifying costs on the absorption statement.
The variable costing approach to costing units
of product works very well with the contribution approach to the income
statement, since both concepts are based on the idea of classifying costs by
behavior. The variable costing data could be immediately used in
cost volume profit (CVP) calculations. |
