AGA company manufactures and sells a product for $20/Kg. The data for the last year is given below:

Sales 75,000 Kg
Finished goods inventory at the beginning of the period 12,000 Kg
Finished goods inventory at the closing of the period 17,000 Kg
Manufacturing costs:
   Variable cost $8 per Kg
    Fixed manufacturing overhead cost $320,000 per year
Marketing and administrative expenses:
Variable expenses $2 per Kg of sale
 Fixed expenses $300,000 per year

Required:

  1. Income statement using absorption and variable costing methods.
  2. Explanation of the cause of difference in operating income under two concepts.

Solution

(1) Income statements:

(a) Absorption costing:

Sales 1,500,000
Less cost of goods sold:
Beginning inventory (12000Kg × $12) 144,000
Cost of goods manufactured (80,000* Kg × $12**) 960,000
———
Cost of goods available for sale 1,104,000
Closing inventory (17,000Kg × 12 ) 204,000 900,000
——— ———
Gross profit 600,000
Less marketing and administrative expenses:
Variable expenses (75,000Kg × $2) 150,000
Fixed expenses 300,000 450,000
——— ———
Net operating income 150,000
———
*Production for last year: **Manufacturing cost per unit
Sales 75,000Kg Variable $8
Closing inventory 17,000Kg Fixed (320,000 / 80,000) $4
———- ——
Total inventory available for sale 92,000Kg $12
Opening inventory 12,000Kg ——
———-
Production for the period 80,000Kg
———-

(b)Variable costing:

Sales 1,500,000
Less variable cost of goods sold:
Beginning inventory (12000Kg × $8) 96,000
Variable cost of goods manufactured (80,000 Kg × $8) 640,000
———
Variable cost of goods available for sale 736,000
Closing inventory (17,000Kg × 8 ) 136,000 600,000
——— ———
Gross contribution margin 900,000
Variable marketing and admin. expenses (75,000Kg × $2) 150,000
———
750,000
Less period costs:
Marketing and administrative 300,000
Manufacturing 320,000 620,000
 ———  ———
 Net operating income 130,000
———

(2) Explanation of the difference in net operating income:

The net operating income under absorption costing is $20,000 more than the net operating income under variable costing. When production is more than sales (as in this exercise), the fixed manufacturing overhead is deferred in inventory that causes a higher net operating income under absorption costing than under variable costing. The reconciliation of net operating income is as follows:

Operating income under absorption costing 150,000
Operating income under variable costing 130,000
———
Difference in net operating income 20,000
———
Change in inventory (17,000Kg – 12,000Kg) 5,000Kg
———
Fixed cost deferred in inventory (5,000Kg × $4.00) 20,000
———

or

Net operating income under variable costing 130,000
Add fixed manufacturing overhead cost deferred in inventory (5,000Kg × $4.00) 20,000
———
$150,000
———