6.5: Analysis of variable and absorption costing
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.
|
15,000 units |
20,000 units |
10,000 units |
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|
Sales |
$750,000 |
$750,000 |
$750,000 |
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|
Variable cost of goods sold |
375,000 |
375,000 |
375,000 |
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Manufacturing margin |
$375,000 |
$375,000 |
$375,000 |
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|
Variable selling and administrative expenses |
75,000 |
75,000 |
75,000 |
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Contribution margin |
$300,000 |
$300,000 |
$300,000 |
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Fixed costs: |
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\(\ \quad \quad\)Fixed manufacturing costs |
$150,000 |
$150,000 |
$150,000 |
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\(\ \quad \quad\)Fixed selling and administrative expenses |
50,000 |
50,000 |
50,000 |
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\(\ \quad \quad\quad \quad\)Total fixed costs |
200,000 |
200,000 |
200,000 |
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|
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.
|
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.