Income Statements under Absorption Costing and Variable Costing

Gallatin County Motors Inc. assembles and sells snowmobile engines. The company began operations on July $1$ and operated at $100\%$ of capacity during the first month. The following data summarize the results for July:

Sales $(19,000$ units$)$ $$2,660,000$

Production costs $(25,000$ units$)$:

Direct materials $$1,295,000$

Direct labor $622,500$

Variable factory overhead $310,000$

Fixed factory overhead $207,5002,435,000$

Selling and administrative expenses:

Variable selling and administrative expenses $$377,400$

Fixed selling and administrative expenses $146,100523,500$

If required, round interim per$-$unit calculations to the nearest cent.

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a$.$ Prepare an income statement according to the absorption costing concept.

Gallatin County Motors Inc.

Absorption Costing Income Statement

For the Month Ended July $31$

Sales

$Sales

$2,660,000$

Cost of goods sold

Cost of goods sold

$1,843,000$

Gross profit

$Gross profit

Selling and administrative expenses

Selling and administrative expenses

Operating income

$Operating income

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a$.$ Under absorption costing, the cost of goods manufactured includes direct materials, direct labor, and factory overhead costs. Both fixed and variable factory costs are included as part of factory overhead.

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b$.$ Prepare an income statement according to the variable costing concept.

Gallatin County Motors Inc.

Variable Costing Income Statement

For the Month Ended July $31$

$$-$ Select $-$

$-$ Select $-$

$$-$ Select $-$

$-$ Select $-$

$$-$ Select $-$

Fixed costs:

$$-$ Select $-$

$-$ Select $-$

$-$ Select $-$

$$-$ Select $-$

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b$.$ Under variable costing, the cost of goods manufactured includes only variable manufacturing costs.

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c$.$ What is the reason for the difference in the amount of operating income reported in $($a$)$ and $($b$)?$

Under the

absorption costing

method, the fixed manufacturing cost included in the cost of goods sold is matched with the revenues. Under

variable costing

$,$ all of the fixed manufacturing cost is deducted in the period in which it is incurred, regardless of the amount of inventory change. Thus, when inventory increases, the

absorption costing

income statement will have a higher operating income.

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c$.$ Consider what causing the difference in operating income reported under the two methods. There is a need for management to exercise care in interpreting operating income reported under absorption costing when significant changes in inventory levels occur.

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