Why variable costing and absorption costing produce different net operating income? How to reconcile net operating income figures produced by these two costing approaches?

Variable costing and absorption costing usually produce different net operating income figures. The reason is that the fixed manufacturing overhead cost is not treated the same way under two costing methods. To understand how the difference in treatment of fixed manufacturing overhead cost changes the net operating income figures of two costing systems, we need to prepare two income statements, one under variable costing and one under absorption costing. For this purpose, consider the following example:

Example

A company prepares variable costing income statement for the use of internal management and absorption costing income statement for the use of external parties like creditors, banks, tax authorities etc.  The company manufactures a product that is sold for $80. The variable and fixed cost data is given below:

Direct materials $30.00
Direct labor $19.00
Factory over head:
Variable cost $6.00
Fixed cost ($45,000 / 9000 units) $5.00
Marketing, general and administrative:
Variable cost (per unit sold) $4.00
Fixed cost (per month) $28,000

During June 9,000 units were produced and 7,500 units were sold. The opening inventory was 2,000 units.

Required:

  1. Prepare two income statements, one using variable costing method and one using absorption costing method.
  2. Explain the difference in net operating income (if any) under two approaches.

Solution

(1)

Income Statement – Absorption Costing

Sales (7,500 units × $80) $600,000
Cost of goods sold:
Beginning inventory (2000 units × $60) $120,000
Units manufactured this month (9,000 × $60) $540,00
 ———-
Available for sale $660,000
Ending inventory (3,500* × $60)  $210,000
 ———-
Cost of goods sold $450,000
———-
 Gross profit  $150,000
Marketing, general and administration expenses:
Variable (7,500 units × $4) $30,000
Fixed  $28,000 $58,000
———-  ———-
Net operating income $92,000
 ———-

*Computation of units in ending inventory:

Beginning inventory 2,000 units
Produced during the month 9,000 units
————
Units available for sale 11,000 units
Sold during the month 7,500 units
————
Ending inventory 3,500 units
————-

Income Statement – Variable Costing

Sales (7,500 × $80) $600,000
Variable cost of goods sold:
Beginning inventory (2000 units × $55) $110,000
Units manufactured this month (9,000 units × $55) $495,00
 ———-
Available for sale $605,000
Ending inventory (3,500 units × $55)  $192,500
 ———-
Variable cost of goods sold $412,500
———-
 Gross contribution margin  $187,500
 Variable marketing, general and administration expenses: $30,000
———-
Contribution margin $157,500
 Less fixed costs:
 Manufacturing overhead  $45,000
 Marketing, general and administration expenses  $28,000 $73,000
 ———-  ———-
Net operating income $84,500
———-

(2) Reconciliation of net operating income:

Net operating income under variable costing $84,500
Fixed manufacturing overhead cost deferred (1500 units × $5) $7,500
——–
Net operating income under absorption costing $92,000
——–

Explanation of the difference in net operating income:

Notice that the net operating income under absorption costing is $7,500 ($92,000 – $84,500) higher than the net operating income under variable costing. This difference is because of fixed manufacturing overhead that becomes the part of ending inventory under absorption costing system. The ending inventory absorbs a portion of fixed manufacturing overhead and reduces the burden of the current period. In this way a portion of fixed cost that relates to the current period is transferred to the next period.

Under variable costing, the fixed manufacturing overhead cost is not included in the product cost but charged to the income statement of the relevant period in its entirety. Therefore no portion of fixed cost is absorbed by the ending inventory.

In our example, the net operating income is higher under absorption costing than variable costing because closing inventory is higher than the opening inventory.

Important points to remember:

  1. The net operating income under absorption costing systems is always higher than variable costing system when inventory increases.
  2. The net operating income under variable costing systems is always higher than absorption costing system when inventory decreases.
  3. When inventory increases, the fixed manufacturing overhead cost is deferred to inventory.
  4. When inventory decreases, the fixed manufacturing overhead cost is released from inventory.
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