6.5: Analysis of variable and absorption costing

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Sales were 15,000 units in each of the three variable costing and three absorption costing income statements just presented. It was the number of units produced that varied among the three pairs of statements.

The three variable costing income statements at the different levels of production were exactly the same, each yielding operating income of $100,000, as shown in the following comparative statements.

Comparative Variable Costing Income Statements
	15,000 units		20,000 units		10,000 units
Sales		$750,000		$750,000		$750,000
Variable cost of goods sold		375,000		375,000		375,000
Manufacturing margin		$375,000		$375,000		$375,000
Variable selling and administrative expenses		75,000		75,000		75,000
Contribution margin		$300,000		$300,000		$300,000
Fixed costs:
$\ \quad \quad$Fixed manufacturing costs	$150,000		$150,000		$150,000
$\ \quad \quad$Fixed selling and administrative expenses	50,000		50,000		50,000
$\ \quad \quad\quad \quad$Total fixed costs		200,000		200,000		200,000
Operating income		$100,000		$100,000		$100,000

The number of units manufactured during the period – 15,000; 20,000; and 10,000; respectively — does not affect operating income under the variable costing approach. This is as it should be, since production affects inventory, which is a balance sheet rather than an income statement account. When more units are produced (20,000) than sold (15,000), ending inventory is 5,000 units higher than beginning inventory. When fewer units are produced (10,000) than sold (15,000), ending inventory is 5,000 units lower than beginning inventory. Yet regardless of changes in inventory, operating income remains constant for a given level of sales because variable cost of goods sold and fixed manufacturing costs are identical for all three variable costing scenarios.

Under absorption costing, however, operating income changes when the company’s inventory balance changes. The results from the three absorption income statements presented earlier are shown again, as follows.

Comparative Absorption Costing Income Statements
	15,000 units	20,000 units	10,000 units
Sales	$750,000	$750,000	$750,000
Cost of goods sold	575,000	487,500	575,000
Gross profit	$175,000	$262,500	$175,000
Selling and administrative expenses	125,000	125,000	125,000
Operating income	$50,000	$137,500	$50,000

When all units manufactured (15,000) are sold (15,000), operating income under absorption costing is the same as it is under variable costing, $100,000. Under both costing methods, $150,000 of fixed factory overhead costs is deducted to arrive at operating income. It just appears in two different line items. Under variable costing, the flat amount of $150,000 follows the contribution margin line. Under absorption costing, the $150,000 is included in cost of goods sold. The fixed cost per unit is $10, determined by dividing the $150,000 total fixed factory overhead cost by the number of units produced, 15,000. The $10 per unit is then multiplied by 15,000, the number of units sold.

Variable costing fixed manufacturing costs	$150,000 fixed factory overhead
Absorption costing fixed manufacturing costs	$10 fixed cost per unit x 15,000 units sold = $150,000

When more units are manufactured (20,000) than sold (15,000), operating income is higher under absorption costing ($137,500). Under variable costing, fixed factory overhead is the flat amount of $150,000 that follows the contribution margin line. Under absorption costing, $112,500 of fixed factory overhead cost is included in cost of goods sold. The fixed cost per unit is $7.50, determined by dividing the $150,000 total fixed factory overhead cost by the number of units produced, 20,000. The $7.50 per unit is then multiplied by 15,000, the number of units sold to get $112,500.

Variable costing fixed manufacturing costs	$150,000 fixed factory overhead
Absorption costing fixed manufacturing costs	$7.50 fixed cost per unit x 15,000 units sold = $112,500

Since there is $37,500 less in cost of goods sold under absorption costing, there is $37,500 more operating income as a result for the same level of sales.

Conversely, when fewer units are manufactured (10,000) than sold (15,000), operating income is lower under absorption costing ($50,000). Under variable costing, fixed factory overhead is the flat amount of $150,000 that follows the contribution margin line. Under absorption costing, $225,000 of fixed factory overhead cost is included in cost of goods sold. The fixed cost per unit is $15, determined by dividing the $150,000 total fixed factory overhead cost by the number of units produced, 10,000. The $15 per unit is then multiplied by 15,000, the number of units sold to get $225,000.

Variable costing fixed manufacturing costs	$150,000 fixed factory overhead
Absorption costing fixed manufacturing costs	$15 fixed cost per unit x 15,000 units sold = $225,000

Since there is $75,000 more in cost of goods sold under absorption costing, there is $75,000 less operating income as a result for the same level of sales.

The point of this analysis is to illustrate that under absorption costing, operating income changes based on increases or decreases in inventory due to producing more or fewer units than were sold in a period. Such changes are unrelated to a company’s operating performance, and managers need to be aware of this type of distortion under absorption costing. On a variable costing income statement, changes in inventory have no effect on operating income, making this method more reliable and desirable for analyzing profitability for an accounting period.