Income Comparison of Variable and Absorption Costing:
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.
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