About this exercise:
Income statement under variable costing and absorption costing; explanation of the cause of difference in net operating income figures under two costing approaches.

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
  ———