Absorption vs. Variable

Operating income is one of the most important items reported by a company. Depending on the decision-making needs of management, operating income can be determined using absorption costing or variable costing.

Select whether the following characteristics are most often associated with absorption costing or variable costing.

Required under generally accepted accounting principles (GAAP)
Often used for internal use in decision making
Cost of goods manufactured includes only variable manufacturing costs
Used in reports prepared for external users
Fixed factory overhead costs are not part of cost of goods manufactured
Both fixed and variable factory costs are included in cost of goods sold and inventory

Absorption Statement

Absorption costing does not distinguish between variable and fixed costs. All manufacturing costs are included in the cost of goods sold.

Saxon, Inc. Absorption Costing Income Statement For the Year Ended December 31
Sales		$1,200,000
Cost of goods sold:
Cost of goods manufactured	$800,000
Ending inventory	(160,000)
Total cost of goods sold		(640,000)
Gross profit		$560,000
Selling and administrative expenses		(273,000)
Operating income		$287,000

Variable Statement

Under variable costing, the cost of goods manufactured includes only variable manufacturing costs. This type of income statement includes a computation of manufacturing margin.

Saxon, Inc. Variable Costing Income Statement For the Year Ended December 31
Sales		$1,200,000
Variable cost of goods sold:
Variable cost of goods manufactured	$560,000
Ending inventory	(112,000)
Total variable cost of goods sold		(448,000)
Manufacturing margin		$752,000
Variable selling and administrative expenses		(208,000)
Contribution margin		$544,000
Fixed costs:
Fixed manufacturing costs	$240,000
Fixed selling and administrative expenses	65,000
Total fixed costs		(305,000)
Operating income		$239,000

Method Comparison

Review the income statements on the Absorption Statement and Variable Statement, then complete the following table. The companys sales price per unit is $75, and the number of units in ending inventory is 4,000. There was no beginning inventory.

Item	Amount
Number of units sold
Variable sales and administrative cost per unit
Number of units manufactured
Variable cost of goods manufactured per unit
Fixed manufacturing cost per unit

Manufacturing Decisions

Whenever the units manufactured differ from the units sold, finished goods inventory is affected. In analyzing operating income, such increases and decreases could be misinterpreted as operating efficiencies or inefficiencies. Each decision-making situation should be carefully analyzed in deciding whether absorption or variable costing reporting would be more useful.

All costs are controllable in the long run by someone within a business. For a given level of management, costs may be controllable costs or noncontrollable costs.

The production manager for Saxon, Inc. is worried because the company is not showing a high enough profit. Looking at the income statements on the Absorption Statement and the Variable Statement, he notices that the operating income is higher on the absorption cost income statement. He is considering manufacturing another 10,000 units, up to the companys capacity for manufacturing, in the coming year. He reasons that this will boost operating income and satisfy the companys owner that the company is sufficiently profitable. Although the total units manufactured changes, assume that total fixed costs, unit variable costs, unit sales price, and the sales levels are the same. Complete questions (1)-(4) that follow. If the answer is zero, enter "0".

1. Use the income statements on the Absorption Statement and Variable Statement to complete the following table for the original production level. Then prepare similar income statements at a production level 10,000 units higher and add that information to the table. Assume that total fixed costs, unit variable costs, unit sales price, and the sales levels are the same at both production levels.

Operating Income
Original Production Level-Absorption	Original Production Level-Variable	Additional 10,000 Units-Absorption	Additional 10,000 Units-Variable
$fill in the blank 2936b0f3600af91_1	$fill in the blank 2936b0f3600af91_2	$fill in the blank 2936b0f3600af91_3	$fill in the blank 2936b0f3600af91_4

2. What is the change in operating income from producing 10,000 additional units under absorption costing?

$fill in the blank 2936b0f3600af91_5

3. What is the change in operating income from producing 10,000 additional units under variable costing?

$fill in the blank 2936b0f3600af91_6

4. What would be your recommendation to the production manager?

a. Do not produce the extra 10,000 units. The increase in operating income under absorption costing is due to fixed manufacturing costs being held in inventory, and the additional inventory will lead to higher handling, storage, financing, and obsolescence costs.

b. Produce the extra 10,000 units. Operating income will be increased, and the production manager will receive praise for creating higher profits.

c. Do not produce the extra 10,000 units. Operating income does not change under absorption costing when the additional units are produced.

d. Produce the extra 10,000 units. It's always a good idea to have extra units on hand and keep the factory operating at capacity, even if all the units are not sold.