Causes of difference in net operating income under variable and absorption costing

Variable costing and absorption costing usually produce different net operating income numbers. 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 numbers 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 at a price of $80 per unit. 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 the month of 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 reason of difference in net operating income (if any) under two approaches.

Solution

(1) Income statements

(a). Absorption Costing:

*Computation of units in ending inventory:

(b). Variable Costing:

Reconciliation of net operating income:

(2). 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 of net operating income is because of fixed manufacturing overhead that becomes the part of ending inventory under absorption costing but not under variable costing system.

The ending inventory absorbs a portion of fixed manufacturing overhead and reduces the cost burden of the current period. Consequently, a portion of fixed cost that relates to the current period is transferred to the next period. This is typically known as the deferring of fixed cost in the inventory. In our example, the portion of fixed overhead deferred in inventory is $7,500 (= 1,500 units x $5).

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 can be absorbed by the ending inventory.

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

Important points to remember:

Students always need to remember the following key points while solving their questions related to variable and absorption costing income statements:

1. The net operating income under absorption costing systems is always higher than variable costing system when inventory increases during the period.
2. The net operating income under variable costing systems is always higher than absorption costing system when inventory decreases during the period.
3. When inventory increases, the fixed manufacturing overhead cost is deferred to inventory which reduces the current period’s total cost burden.
4. When inventory decreases, the fixed manufacturing overhead cost is released from inventory which causes an increase in the current period’s total cost burden.