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

Choose whether the characteristics below are most often associated with absorption costing or variable costing.

	Absorption Costing	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 sold
Both fixed and variable factory costs are included in cost of goods sold and inventory

Method Comparison

Review the income statements on the Absorption Statement and Variable Statement panels, then complete the table below. The companys sales price per unit is $75.00, and the number of units in ending inventory is 4,000.

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

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, 2016

1	Sales		$1,200,000.00
2	Cost of goods sold:
3	Beginning inventory	$0.00
4	Cost of goods manufactured	800,000.00
5	Less ending inventory	160,000.00	640,000.00
6	Gross profit		$560,000.00
7	Selling and administrative expenses		289,000.00
8	Income from operations		$271,000.00

Variable Statement

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

Saxon, Inc.

Variable Costing Income Statement

For the Year Ended December 31, 2016

1	Sales		$1,200,000.00
2	Variable cost of goods sold:
3	Beginning inventory	$0.00
4	Variable cost of goods manufactured	560,000.00
5	Less ending inventory	112,000.00	448,000.00
6	Manufacturing margin		$752,000.00
7	Variable selling and administrative expenses		224,000.00
8	Contribution margin		$528,000.00
9	Fixed costs:
10	Fixed manufacturing costs	$240,000.00
11	Fixed selling and administrative expenses	65,000.00	305,000.00
12	Income from operations		$223,000.00

Manufacturing Decisions

Whenever the units manufactured differ from the units sold, finished goods inventory is affected. In analyzing income from operations, 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 panel and the Variable Statement panel, he notices that the net 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 net 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) below.

1. Use the income statements on the Absorption Statement and Variable Statement panels 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.

Income From Operations
Original	Original	Additional	Additional
Production	Production	10,000	10,000
Level-Absorption	Level-Variable	Units-Absorption	Units-Variable

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

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

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

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

Do not produce the extra 10,000 units. The increase in net 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.

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.

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

Contribution Margin Data

For planning and control purposes, managers often compare planned and actual contribution margins. Variable costing is used as a basis for such analyses.

Examine the contribution margin data below, and then complete the Contribution Margin Analysis panel.

Saxon, Inc.
Contribution Margin Data Schedule
	Actual	Planned
Sales	$1,200,000	$1,190,000
Less variable cost of goods sold	$448,000	$462,000
Less variable selling and administrative expenses	224,000	154,000
Total	$672,000	$616,000
Contribution margin	$528,000	$574,000
Number of units sold	16,000	14,000
Per unit:
Sales price	$75.00	$85.00
Variable cost of goods sold	$28.00	$33.00
Variable selling and administrative expenses	$14.00	$11.00

Contribution Margin Analysis

Contribution margin analysis focuses on explaining the differences between planned and actual contribution margins, considering the quantity factor and the unit price factor.

After reviewing the data on the Contribution Margin Data panel, complete the contribution margin analysis below. For those boxes in which you must enter subtracted or negative numbers use a minus sign.

Saxon, Inc.

Contribution Margin Analysis

1	Planned contribution margin
2	Effect of changes in sales:
3	Sales quantity factor
4	Unit price factor
5	Total effect of changes in sales
6	Effect of changes in variable cost of goods sold:
7	Variable cost quantity factor
8	Unit cost factor
9	Total effect of changes in variable cost of goods sold
10	Effect of changes in selling and administrative expenses:
11	Variable cost quantity factor
12	Unit cost factor
13	Total effect of changes in selling and administrative expenses
14	Actual contribution margin

Final Questions

After reviewing your work on the Contribution Margin Analysis panel, answer the three questions below.

1. Explain the total effect of changes in sales on the contribution margin.

The reduction in sales price caused higher sales, but contribution margin was nevertheless negative overall.

Lowering the sales price caused sales to be lower, decreasing overall contribution margin.

Actual total units sold was lower than planned, causing a decrease in contribution margin.

The reduction in sales price lowered contribution margin, but the increased quantity of sales more than made up for it.

2. Explain the total effect of changes in variable cost of goods sold.

Variable cost of goods sold negatively affected contribution margin because of an increase in per-unit costs.

The reduction in per-unit variable cost of goods sold negatively affected contribution margin, but the increased sales overcame this effect.

Overall, the effect of changes in variable cost of goods sold increased contribution margin.

More units were sold and so the variable cost of goods sold was higher, even though the per-unit variable cost of goods sold was less than planned.

3. Explain the total effect of changes in selling and administrative expenses.

Due to increased sales there was a increased contribution margin due to increased selling and administrative expenses.

Because the per-unit variable selling and administrative expenses increased, contribution margin was greater.

Contribution margin went up because of a decrease in selling and administrative expenses.

The per-unit variable selling and administrative expense was higher than planned, and more units were sold, yielding a negative effect on contribution margin.