Absorption and Variable Costing Income Statements for Two Months and Analysis

During the first month of operations ended July 31, Head Gear Inc. manufactured 26,400 hats, of which 25,100 were sold. Operating data for the month are summarized as follows:

Sales			$165,660
Manufacturing costs:
Direct materials	$100,320
Direct labor	26,400
Variable manufacturing cost	13,200
Fixed manufacturing cost	10,560		150,480
Selling and administrative expenses:
Variable	$7,530
Fixed	5,500		13,030

During August, Head Gear Inc. manufactured 23,800 hats and sold 25,100 hats. Operating data for August are summarized as follows:

Sales			$165,660
Manufacturing costs:
Direct materials	$90,440
Direct labor	23,800
Variable manufacturing cost	11,900
Fixed manufacturing cost	10,560		136,700
Selling and administrative expenses:
Variable	$7,530
Fixed	5,500		13,030

Required:

1a. Prepare income statement for July using the absorption costing concept.

Head Gear Inc.
Absorption Costing Income Statement
For the Month Ended July 31
Sales		$
Cost of goods sold:
Cost of goods manufactured	$
Inventory, July 31
Total cost of goods sold
Gross profit		$
Selling and administrative expenses
Operating income		$

1b. Prepare income statement for August using the absorption costing concept.

Head Gear Inc.
Absorption Costing Income Statement
For the Month Ended August 31
Sales		$
Cost of goods sold:
Inventory, August 1	$
Cost of goods manufactured
Total cost of goods sold
Gross profit		$
Selling and administrative expenses
Operating income		$

2a. Prepare income statement for July using the variable costing concept.

Head Gear Inc.
Variable Costing Income Statement
For the Month Ended July 31
Sales		$
Variable cost of goods sold:
Variable cost of goods manufactured	$
Inventory, July 31
Total variable cost of goods sold
Manufacturing margin		$
Variable selling and administrative expenses
Contribution margin		$
Fixed costs:
Fixed manufacturing costs	$
Fixed selling and administrative expenses
Total fixed costs
Operating income		$

2b. Prepare income statement for August using the variable costing concept.

Head Gear Inc.
Variable Costing Income Statement
For the Month Ended August 31
Sales		$
Variable cost of goods sold:
Inventory, August 1	$
Variable cost of goods manufactured
Total variable cost of goods sold
Manufacturing margin		$
Variable selling and administrative expenses
Contribution margin		$
Fixed costs:
Fixed manufacturing costs	$
Fixed selling and administrative expenses
Total fixed costs
Operating income		$

3a. For July, operating income reported under variable costing is less than absorption costing due to part of fixed manufacturing costs that are expensed.

3b. When large changes in inventory levels occur from one period to the next, it is possible for management to misinterpret such increases (or decreases) in operating income as due to changes in:

1. costs.
2. prices.
3. sales volume.
4. "sales volume", "prices" and "costs" are correct.
5. None of these choices is correct.

The correct answer is: d

4. Based on your answers to (1) and (2), did Head Gear Inc. operate more profitably in July or in August? Explain.

Head Gear Inc. was equally profitable in July and in August under the variable costing concept. The difference in operating income reported under the absorption costing concept is due to allocating fixed manufacturing cost to the July 31 ending inventory .