Question

Under full costing, how does increasing production increase income? Does this work under variable costing? Why or why not?

Answer 1

Full (Absorption) costing could result in an increase in net income if a company increases its production and its inventory. This occurs because fixed manufacturing overhead is allocated to more production units—some of which will be reported as inventory.

But the same will not be work under Variable costing because

The reason behind this is that all the fixed manufacturing costs are expensed in the same year, in which they are incurred. (treated as period costs i.e not allocated to products )

  Example: (for showing the difference)

Let’s say a company ‘A’ manufactures 1000 pieces of pencil each year. The cost associated with manufacturing one such pencil is as follows:

Expenses	Cost
Direct Materials Cost (Per Unit)	$1.00
Direct Labor Cost (Per Unit)	$0.50
Variable Manufacturing Cost Per Unit	$0.80
Fixed Manufacturing Cost Per Year	$1,000.00
Fixed Manufacturing Cost Per Unit	$1.00

per unit product cost of each pencil can be calculated as follows under absorption costing as well as variable costing.

Per Unit Cost	Absorption Costing	Variable Costing
Direct Materials Cost	$1.0	$1.0
Direct Labour Cost	$0.5	$0.5
Variable Manufacturing Cost	$0.8	$0.8
Fixed Manufacturing Cost	$1.0	–
Total	$3.3	$2.3

RESULTING DIFFERENCE IN NET INCOME

If the Company A sell a total of 800 pencils each year with per unit sale price of $5, the net income difference based on different costing methods would be as follows:

Income Statement	Absorption Costing	Variable Costing
Sales (800 * $5)	$4,000.0	$4,000.0
Less:
Cost of goods sold
Total Units Manufactured (1000)	-$3,250.0	-$2,250.0
Plus Ending Inventory (1000-800)	$650.0	$450.0
Gross Profit	$1,400.0	$2,200.0
Less: Fixed Costs, incl. SG&A	$0.0	-$1,000.0
Operating Income	1400	1200
Less: Tax @ 20%	-$280.0	-$240.0
Net Income	$1,120.0	$960.0

This is how the income lower under variable costing.