Income Comparison of Variable  and Absorption Costing:

Learning Objectives:

1. Prepare income statements using variable costing and absorption costing.
2. 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:

1. Prepare income statements using:
   a. Absorption costing system
   b. Variable costing system
2. 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.

 

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