Chapter 7, Problem 1PB

Absorption and variable costing income statements

During the first month of operations ended July 31, YoSan Inc. manufactured 2,400 flat panel televisions, of which 2,000 were sold. Operating data for the month are summarized as follows:

Instructions

1. 1. Prepare an income statement based on the absorption costing concept.
2. 2. Prepare an income statement based on the variable costing concept.
3. 3. Explain the reason for the difference in the amount of operating income reported in (1) and (2).

To determine

Calculate the income statement according to the absorption costing concept for Y Incorporation.

Explanation of Solution

Absorption Costing

Absorption costing is compulsory under Generally Accepted Accounting Principles (GAAP) for financial statements which are circulated to the external users. The cost of goods manufactured includes direct materials, direct labor, and factory overhead costs under absorption costing. Fixed factory overhead and variable factory overhead included as a part of factory overhead.

Variable Costing

Variable costing is the method that is used by the management (managers) for decision making purposes. The cost of goods manufactured includes direct materials, direct labor, and variable factory overhead. Fixed factory overhead is treated as period (fixed) expense.

Calculate the income statement according to the absorption costing concept for the Y Incorporation as shown below:

Y Incorporation
Absorption costing income statement
for the month ended July, 31
Particulars	$	$
Sales		2,150,000
Less: Cost of goods sold
Cost of goods manufactured	1,824,000
Ending inventory (2)	(304,000)
Total cost of goods sold		1,520,000
Gross profit		630,000
Less: Selling and administrative expenses		300,000
Income from operations		330,000

Table (1)

Working note (1):

Calculate the value of ending inventory per unit.

$\begin{array}{c}\text{Ending inventory =}\frac{\text{Cost of good sold}}{\text{Units manufactured}}\\ =\frac{\$1,824,000}{\text{2,400 Units}}\\ =\$760\end{array}$

Working note (2):

Calculate the value of ending inventory

$\begin{array}{c}\text{Ending inventory = }\left[\begin{array}{l}\text{Units manufactured }\times \\ \text{Ending inventory rate per unit (1)}\end{array}\right]\\ =400\text{ Units}\times \text{\$760}\\ \text{=\$304,000}\end{array}$

Conclusion

Therefore, income from operations under absorption costing concept of Y Incorporation is $330,000.

To determine

Calculate the income statement according to the variable cost concept for the Y Incorporation.

Explanation of Solution

Calculate the income statement according to the variable costing concept for the Y Incorporation as shown below:

Y Incorporation
Variable costing income statement
for the month ended July, 31
Particulars	$	$
Sales		2,150,000
Less: Variable cost of goods sold
Variable cost of goods manufactured (3)	1,536,000
Ending inventory (5)	(256,000)
Total variable cost of goods sold		1,280,000
Manufacturing margin		870,000
Less: Variable selling and administrative expenses		204,000
Contribution margin		666,000
Less: Fixed costs
Fixed manufacturing costs	288,000
Fixed selling and administrative expenses	96,000
Total fixed cost		384,000
Income from operations		282,000

Table (2)

Working note (3):

1. Calculate cost of goods manufactured

$\begin{array}{c}\text{Cost of goods manufactured = }\left[\begin{array}{l}\text{Total manufacturing cost}-\\ \text{Fixed manufacturing cost}\end{array}\right]\\ =\$1,824,000-\$288,000\\ =\$1,536,000\end{array}$

Working note (4):

Calculate the value of ending inventory per unit.

$\begin{array}{c}\text{Ending inventory =}\frac{\text{Cost of good sold}}{\text{Units manufactured}}\\ =\frac{\$1,536,000}{\text{2,400 Units}}\\ =\$640\end{array}$

Working note (5):

Calculate the value of ending inventory

$\begin{array}{c}\text{Ending inventory = }\left[\begin{array}{l}\text{Units manufactured }\times \\ \text{Ending inventory rate per unit (4)}\end{array}\right]\\ =400\text{ Units}\times \text{\$640}\\ \text{=\$256,000}\end{array}$

Conclusion

Therefore, income from operations under variable costing concept of Y Incorporation is $282,000.

To determine

Identify the reason for the difference between in the amount of income from operations reported in absorption costing income statement and variable costing income statement.

Explanation of Solution

The difference between the absorption and variable costing income from operations of $48,000 $\left(\$330,000–\$282,000\right)$ can be explained as follows:

Increase in inventory = 400 units $\left(2,400\text{ Units}-2,000\text{ Units}\right)$

Fixed factory overhead per unit = $4$\left(\frac{\$288,000}{2,400\text{ Units}}\right)$

$\begin{array}{c}\begin{array}{l}\text{Difference in income}\\ \text{ from operations}\end{array})\text{=}\left(\begin{array}{l}\text{Increase in inventory}\times \text{Fixed }\\ \text{factory overhead per unit}\end{array}\right)\\ \text{=}4\text{00}\text{units }\times \text{\$120}\text{per unit}\\ \text{=}\text{\$48,000}\end{array}$

Under absorption costing method, the fixed factory overhead cost included in the cost of goods sold is coordinated with the incomes. As an effect, 400 units that were produced, but unsold include fixed factory overhead cost, which is not involved in the cost of goods sold.

Under variable costing, all of the fixed factory overhead cost is subtracted in the period in which it is incurred, regardless of the amount of inventory change. Therefore, when inventory rises, the absorption costing income statement will have a higher income from operations than the variable costing income statement.