Question

Absorption vs. Variable

Operating income is one of the most important items reported by a company. Depending on the decision-making needs of management, operating income can be determined using absorption costing or variable costing.

Select whether the following characteristics are most often associated with absorption costing or variable costing.

Required under generally accepted accounting principles (GAAP)	Absorption Costing
Often used for internal use in decision making	Variable Costing
Cost of goods manufactured includes only variable manufacturing costs	Variable Costing
Used in reports prepared for external users	Absorption Costing
Fixed factory overhead costs are not part of cost of goods manufactured	Variable Costing
Both fixed and variable factory costs are included in cost of goods sold and inventory	Absorption Costing

Absorption Statement

Absorption costing does not distinguish between variable and fixed costs. All manufacturing costs are included in the cost of goods sold.

Saxon, Inc. Absorption Costing Income Statement For the Year Ended December 31
Sales		$1,125,000
Cost of goods sold:
Cost of goods manufactured	$800,000
Ending inventory	(200,000)
Total cost of goods sold		(600,000)
Gross profit		$525,000
Selling and administrative expenses		(275,000)
Operating income		$250,000

Variable Statement

Under variable costing, the cost of goods manufactured includes only variable manufacturing costs. This type of income statement includes a computation of manufacturing margin.

Saxon, Inc. Variable Costing Income Statement For the Year Ended December 31
Sales		$1,125,000
Variable cost of goods sold:
Variable cost of goods manufactured	$560,000
Ending inventory	(140,000)
Total variable cost of goods sold		(420,000)
Manufacturing margin		$705,000
Variable selling and administrative expenses		(210,000)
Contribution margin		$495,000
Fixed costs:
Fixed manufacturing costs	$240,000
Fixed selling and administrative expenses	65,000
Total fixed costs		(305,000)
Operating income		$190,000

Method Comparison

Review the income statements on the Absorption Statement and Variable Statement, then complete the following table. The company’s sales price per unit is $75, and the number of units in ending inventory is 5,000. There was no beginning inventory.

Item	Amount
Number of units sold
Variable sales and administrative cost per unit	$
Number of units manufactured
Variable cost of goods manufactured per unit	$
Fixed manufacturing cost per unit	$

Manufacturing Decisions

Whenever the units manufactured differ from the units sold, finished goods inventory is affected. In analyzing operating income, such increases and decreases could be misinterpreted as operating efficiencies or inefficiencies. Each decision-making situation should be carefully analyzed in deciding whether absorption or variable costing reporting would be more useful.

All costs are controllable in the long run by someone within a business. For a given level of management, costs may be controllable costs or noncontrollable costs.

The production manager for Saxon, Inc. is worried because the company is not showing a high enough profit. Looking at the income statements on the Absorption Statement and the Variable Statement, he notices that the operating income is higher on the absorption cost income statement. He is considering manufacturing another 10,000 units, up to the company’s capacity for manufacturing, in the coming year. He reasons that this will boost operating income and satisfy the company’s owner that the company is sufficiently profitable. Although the total units manufactured changes, assume that total fixed costs, unit variable costs, unit sales price, and the sales levels are the same. Complete questions (1)-(4) that follow. If the answer is zero, enter "0".

1. Use the income statements on the Absorption Statement and Variable Statement to complete the following table for the original production level. Then prepare similar income statements at a production level 10,000 units higher and add that information to the table. Assume that total fixed costs, unit variable costs, unit sales price, and the sales levels are the same at both production levels.

Operating Income
Original Production Level-Absorption	Original Production Level-Variable	Additional 10,000 Units-Absorption	Additional 10,000 Units-Variable
$	$	$	$

2. What is the change in operating income from producing 10,000 additional units under absorption costing?

$______________

3. What is the change in operating income from producing 10,000 additional units under variable costing?

$______________

Answer 1

Item	Amount
Number of units sold ($1125000/$75)	15000
Variable sales and administrative cost per unit ($210000/15000)	$    14.00
Number of units manufactured (15000 + 5000)	20000
Variable cost of goods manufactured per unit ($560000/20000)	$    28.00
Fixed manufacturing cost per unit ($240000/20000)	$    12.00

1.

Operating Income
Original Production Level-Absorption	Original Production Level-Variable	Additional 10,000 Units-Absorption	Additional 10,000 Units-Variable
$                2,50,000	$                1,90,000	$               3,10,000	$               1,90,000

Saxon, Inc.
Absorption Costing Income Statement
For the Year Ended December 31
Sales (15000 x $75)		1125000
Cost of goods sold:
Beginning inventory	0
Cost of goods manufactured [(30000 x $28) + $240000]	1080000
Ending inventory [$1080000 x 15000/30000]	-540000
Total cost of goods sold		540000
Gross profit		585000
Selling and administrative expenses ($210000 + $65000]		275000
Income from operations		310000
Saxon, Inc.
Variable Costing Income Statement
For the Year Ended December 31
Sales (15000 x $75)		1125000
Variable cost of goods sold:
Beginning inventory	0
Variable cost of goods manufactured (30000 x $28)	840000
Ending inventory (15000 x $28)	-420000
Total variable cost of goods sold		420000
Manufacturing margin		705000
Variable selling and administrative expenses (15000 x $14)		210000
Contribution margin		495000
Fixed costs:
Fixed manufacturing costs	240000
Fixed selling and administrative costs	65000
Total fixed costs		305000
Income from operations		190000

2. Change in operating income from producing 10,000 additional units under absorption costing: Increase $60000

$310000 - $250000 = $60000

3. Change in operating income from producing 10,000 additional units under variable costing: $0

$190000 - $190000 = $0