Chapter 6, Problem 3E

Sims Company, a manufacturer of table computers, begin operations on January 1, 2015. Its cost and sales information for this year follows.

Manufacturing cost
Direct materials	$40 per unit
Direct labor	$60 per unit
Overhead costs for the year
Variable overhead	$3,000,000
Fixed overhead	$7,000,000
Selling and administrative costs for the year
Variable	$ 770,000
Fixed	$4,250,000
Production and sales for the year
Units produced	100,000 units
Units sold	70,000 units
Sales price per units	$350 per unit

1. Prepare the income statement for the year using variable costing.
2. Prepare the income statement for the year using absorption costing.
3. Under what circumstance (s) is reported income identical under both absorption costing and variable costing?

To determine

Concept introduction:

Variable Costing Income Statement:

In Variable Costing Income Statement, all the variable expenses are subtracted from total Income to derive the contribution margin and then all fixed expenses are subtracted to arrive at the net profit or loss.

Absorption Costing Income Statement:

Absorption costing is the traditional method of Income statement preparation. Under absorption costing both variable and fixed costs are considered as cost of production and allocated to the units lying in the finished stock inventory.

Requirement 1:

To prepare:

The variable costing Income statement.

Answer to Problem 3E

Sims Company Income Statement(Variable Costing) For the year ended
	$	$
Sales (70, 000*$350)		24, 500, 000
Variable Production Costs
Direct Materials(70, 000*$40)	2, 800, 000
Direct labor(70, 000*60)	4, 200, 000
Variable Overhead (70, 000*30)	2, 100, 000
Total Variable Production Cost		9, 100, 000
Gross Contribution margin		15, 400, 000
Variable Selling and administrative expense		770, 000
Contribution Margin		14, 630, 000
Less. Fixed expenses
Fixed production cost	7, 000, 000
Fixed selling and administrative expense	4, 250, 000
Total Fixed Cost		11, 250, 000
Net Operating Income		3, 380, 000

Explanation of Solution

From the total Revenue, variable production cost has been subtracted to derive the gross contribution. The variable overhead for each unit produced has been derived by the following method-

$\frac{TotalvariableOverhead}{Totalunitsproduced}=\frac{3,000,000}{100,000}=\$30$

Then variable selling and administration expenses have been deducted to arrive at the contribution margin. Then total fixed expenses are deducted from contribution margin to derive the Net Income under Variable costing.

Thus, the Income statement under variable costing has been prepared.

To determine

Concept introduction:

Variable Costing Income Statement:

In Variable Costing Income Statement, all the variable expenses are subtracted from total Income to derive the contribution margin and then all fixed expenses are subtracted to arrive at the net profit or loss.

Absorption Costing Income Statement:

Absorption costing is the traditional method of Income statement preparation. Under absorption costing both variable and fixed costs are considered as cost of production and allocated to the units lying in the finished stock inventory.

Requirement 2:

To prepare:

The absorption costing Income statement.

Answer to Problem 3E

Sims Company Income Statement(Absorption Costing) For the year ended
	$	$
Sales (70, 000*$350)		24, 500, 000
Cost of goods sold
Direct Materials(70, 000*$40)	2, 800, 000
Direct labor(70, 000*60)	4, 200, 000
Variable Overhead (70, 000*30)	2, 100, 000
Fixed Overhead (70, 000*70)	4, 900, 000
Total Cost of goods sold		14, 000, 000
Gross Profit		10, 500, 000
Operating expenses
Variable Selling and administrative expense	770, 000
Fixed selling and administrative expense	4, 250, 000
Total Operating expenses		5, 020, 000
Net Operating Income		5, 480, 000

Explanation of Solution

From the total Revenue, total production cost both fixed and variable costs have been subtracted to derive the gross profit.

The variable overhead for each unit produced has been derived by the following method-

$\frac{TotalvariableOverhead}{Totalunitsproduced}=\frac{3,000,000}{100,000}=\$30$

The fixed overhead for each unit produced has been derived by the following method-

$\frac{TotalfixedOverhead}{Totalunitsproduced}=\frac{7,000,000}{100,000}=\$70$

Then total selling and administration expenses have been deducted to arrive at the net profit.

Thus, the Income statement under absorption costing has been prepared.

To determine

Concept introduction:

Variable Costing Income Statement:

In Variable Costing Income Statement, all the variable expenses are subtracted from total Income to derive the contribution margin and then all fixed expenses are subtracted to arrive at the net profit or loss.

Absorption Costing Income Statement:

Absorption costing is the traditional method of Income statement preparation. Under absorption costing both variable and fixed costs are considered as cost of production and allocated to the units lying in the finished stock inventory.

Requirement 3:

To identify:

The circumstances under which the income under absorption costing and variable costing would be identical.

Answer to Problem 3E

The circumstances under which the income under absorption costing and variable costing would be identical are

a. when there is no opening inventory sold during the year.

b. when the total units produced are sold during the given period.

Explanation of Solution

a. If last period inventory is brought forward, the inventory cost under variable cost and absorption costing would be different as variable costing inventory would include only variable costs of production whereas inventory under absorption costing would include the fixed overhead cost.

So, when this inventory is sold, a difference in net income where the income under absorption costing would be less than income under variable costing by the amount of fixed production overhead included in the cost of inventory.

In the given example, there is no opening inventory

b. When the total units produced are sold during the year, the total cost of goods sold under both the methods will be same. When there will be no closing inventory, all the fixed production expenses would be charged to the income statement under absorption costing and will not be deferred for next year.

Thus, the circumstances under which income under variable costing and absorption costing would be similar have been identified.