Chapter 7, Problem 3PB

Absorption and variable costing income statements for two months and analysis

During the first month of operations ended July 31, Head Gear Inc. manufactured 6,400 hats, of which 5,200 were sold. Operating data for the month are summarized as follows:

During August, Head Gear Inc. manufactured 4,000 hats and sold 5,200 hats. Operating data for August are summarized as follows:

Instructions

1. 1. Using the absorption costing concept, prepare income statements for (a) July and (b) August.
2. 2. Using the variable costing concept, prepare income statements for (a) July and (b) August.
3. 3.
   1. A. Explain the reason for the differences in the amount of operating income in (1) and (2) for July.
   2. B. Explain the reason for the differences in the amount of operating income in (1) and (2) for August.
4. 4. Based on your answers to (1) and (2), did Head Gear Inc. operate more profitably in July or in August? Explain.

To determine

Compute the income statement according to the absorption costing concept of the H Incorporation for the month of July.

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 of the H Incorporation as shown below:

H Incorporation
Absorption costing income statement for the month ended
July 31
Particulars	$	$
Sales		104,000
Less: Cost of goods sold
Cost of goods manufactured	97,280
Inventory on July 31$\left(1,200\text{Units}\times \text{\$15}\text{.20(1)}\right)$	(18,240)
Total cost of goods sold		79,040
Gross profit		24,960
Less: Selling and administrative expenses		16,120
Income from operations		8,840

Table (1)

Working note (1):

Calculate the value of ending inventory per unit.

$\begin{array}{c}\text{Ending inventory =}\frac{\text{Cost of good manufactured}}{\text{Units manufactured}}\\ =\frac{\$97,280}{6,400\text{ Units}}\\ =\$15.20\end{array}$

Conclusion

Therefore, income from operations under absorption costing concept of H Incorporation for the month ended July 31 is $8,840.

To determine

Compute the income statement according to the absorption costing concept of the H Incorporation for the month ended August.

Explanation of Solution

Calculate the income statement according to the absorption costing concept of the H Incorporation as shown below:

H Incorporation
Absorption costing income statement for the month ended
August 31
Particulars	$	$
Sales		104,000
Less: Cost of goods sold
Cost of goods manufactured	18,240
Inventory on August, 1$\left(1,200\text{Units}\times \text{\$15}\text{.20(1)}\right)$	66,560
Total cost of goods sold		84,800
Gross profit		19,200
Less: Selling and administrative expenses		16,120
Income from operations		3,080

Table (2)

Conclusion

Therefore, income from operations under absorption costing concept of H Incorporation for the month ended August, 31 is $3,080.

To determine

Compute the income statement according to the variable cost concept of the H Incorporation for the month ended July, 31.

Explanation of Solution

Calculate the income statement according to the variable costing concept of the H Incorporation as shown below:

H Incorporation
Variable costing income statement for the month ended
July 31
Particulars	$	$
Sales		104,000
Less: Variable cost of goods sold
Variable cost of goods manufactured	81,920
Inventory on July, 31 $\left(1,200\text{Units}\times \text{\$12}\text{.80(2)}\right)$	(15,360)
Total variable cost of goods sold		66,560
Manufacturing margin		37,440
Less: Variable selling and administrative expenses		10,920
Contribution margin		26,520
Less: Fixed costs
Fixed manufacturing costs	15,360
Fixed selling and administrative expenses	5,200
Total fixed cost		20,560
Income from operations		5,960

Table (3)

Working note (2):

Calculate the value of ending inventory per unit.

$\begin{array}{c}\text{Ending inventory =}\frac{\text{Cost of good manufactured}}{\text{Units manufactured}}\\ =\frac{\$81,920}{6,400\text{ Units}}\\ =\$12.80\end{array}$

Conclusion

Therefore, income from operations under variable costing concept of H Incorporation for the month ended July, 31 is $5,960.

To determine

Compute the income statement according to the variable cost concept of the H Incorporation for the month ended August, 31.

Explanation of Solution

Calculate the income statement according to the variable costing concept of the H Incorporation as shown below:

H Incorporation
Variable costing income statement for the month ended
August 31
Particulars	$	$
Sales		104,000
Less: Variable cost of goods sold
Variable cost of goods manufactured	15,360
Inventory on August, 1$\left(1,200\text{Units}\times \text{\$12}\text{.80(2)}\right)$	51,200
Total variable cost of goods sold		66,560
Manufacturing margin		37,440
Less: Variable selling and administrative expenses		10,920
Contribution margin		26,520
Less: Fixed costs
Fixed manufacturing costs	15,360
Fixed selling and administrative expenses	5,200
Total fixed cost		20,560
Income from operations		5,960

Table (4)

Conclusion

Therefore, income from operations under variable costing concept of H Incorporation for the month ended August, 31 is $5,960.

To determine

Identify the reason for the difference between the amount of income from operations reported in absorption costing income statement and variable costing income statement for the month ended July, 31.

Explanation of Solution

The difference between the absorption and variable costing income from operations of $2,880 $\left(\$8,840–\$5,960\right)$ can be explained as follows:

Increase in inventory = 1,200 units $\left(\text{5,200 Units}-4,000\text{ Units}\right)$

Fixed factory overhead per unit = $2.4$\left(\frac{\$15,360}{\text{6,400 Units}}\right)$

$\begin{array}{c}\begin{array}{l}\text{Difference in income}\\ \text{ from operations}\end{array})\text{=}\left(\begin{array}{l}\text{Increase in inventory}\times \text{Fixed }\\ \text{factory overhead per unit}\end{array}\right)\\ \text{=}1,2\text{00}\text{units }\times \text{\$2}\text{.4}\text{per unit}\\ \text{=}\text{\$2,080}\end{array}$

Under absorption costing method, the fixed factory overhead cost included in the cost of goods sold is coordinated with the incomes. As an effect, 1,200 units that were produced, but unsold includes 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.

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 for the month ended August, 31.

Explanation of Solution

The difference between the absorption and variable costing income from operations of $2,880 $\left(\$5,960–\$3,080\right)$ can be explained as follows:

Increase in inventory = 1,200 units $\left(\text{5,200 Units}-4,000\text{ Units}\right)$

Fixed factory overhead per unit = $2.4$\left(\frac{\$15,360}{\text{6,400 Units}}\right)$

$\begin{array}{c}\begin{array}{l}\text{Difference in income}\\ \text{ from operations}\end{array})\text{=}\left(\begin{array}{l}\text{Increase in inventory}\times \text{Fixed }\\ \text{factory overhead per unit}\end{array}\right)\\ \text{=}1,2\text{00}\text{units }\times \text{\$2}\text{.4}\text{per unit}\\ \text{=}\text{\$2,080}\end{array}$

Under absorption costing method, the fixed factory overhead cost included in the cost of goods sold is coordinated with the incomes. As an effect, 1,200 units that were produced, but unsold includes 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.

To determine

Describe whether H Incorporation operates more profitability in July or August.

Explanation of Solution

Based on variable costing concept, the H Incorporation was equally profitable in July and August. Sales and variable cost per unit were the same for both the month and under both concept. The combined income from operations reported based on absorption concept for July and August $\left(\$8,840+\$3,080=\$11,920\right)$ is same in the variable cost concept $\left(\$5,960+\$5,960=\$11,920\right)$. Hence, the equal profitability in July and August based on variable cost concept, and the difference between the two concepts are also equal.