To get a more comprehensive view of the effects of variable costing and absorption costing, Stassen’s management accountants prepare income statements for 2 years of operations, starting with 2020. The operating data, in units, are given in the following table:
The details of the spreadsheet are as follows:
Year 2020
Budgeted production: 8,000
Beginning inventory: 0
Actual production: 8,000
Sales: 6,000
Ending inventory: 2,000
Year 2021
Budgeted production: 8,000
Beginning inventory: 2,000
Actual production: 5,000
Sales: 6,500
Ending inventory: 500.
All other 2020 data given earlier for Stassen also apply for 2021.
In 2021, Stassen has a production-volume variance because actual telescope production differs from the budgeted level of production of 8,000 units per year used to calculate the budgeted fixed manufacturing cost per unit. The actual quantity sold for 2021 is 6,500 units, which is the same as the sales quantity budgeted for that year.
Exhibit 9-2 presents the income statements for 2020 and 2021, under variable costing in Panel A, and under absorption costing in Panel B. As you study Exhibit 9-2, note that the 2020 columns in both Panels A and B show the same figures as Exhibit 9-1. The 2021 column is similar to 2020 except for the production-volume variance line item under absorption costing in Panel B. Keep in mind the following points about absorption costing as you study Panel B of Exhibit 9-2:
Details of the spreadsheet classified as panel A and B are as follows:
Panel A: Variable costing
(a) Year 2020
1. Revenues ($1,000 times 6,000 units): $6,000,000
2. Variable cost of goods sold
• Beginning inventory ($200 times 0 units): $0
• Variable manufacturing costs ($200 times 8,000 units): 1,600,000
• Cost of goods available for sale: 1,600,000
• Deduct ending inventory ($200 times 2,000 units): (400,000) in parenthesis
• Variable cost of goods sold: 1,200,000
3. Variable marketing costs ($185 times 6,000 units): 1,110,000
4. Contribution margin: 3,690,000
5. Fixed manufacturing costs: 1,080,000
6. Fixed marketing costs: 1,380,000
7. Operating income: $1,230,000
(b) Year 2021
1. Revenues ($1,000 times 6,500 units): $6,500,000
2. Variable cost of goods sold
• Beginning inventory ($200 times 2000 units): $400,000
• Variable manufacturing costs ($200 times 5,000 units): 1,000,000
• Cost of goods available for sale: 1,400,000
• Deduct ending inventory ($200 times 500 units): (100,000) in parenthesis
• Variable cost of goods sold: 1,300,000
3. Variable marketing costs ($185 times 6,500 units): 1,202,500
4. Contribution margin: 3,997,500
5. Fixed manufacturing costs: 1,080,000
6. Fixed marketing costs: 1,380,000
7. Operating income: $1,537,500
Panel B: Absorption costing
(a) Year 2020
1. Revenues ($1,000 times 6,000 units): $6,000,000
2. Cost of goods sold
• Beginning inventory ($335 times 0 units): 0
• Variable manufacturing costs ($200 times 8,000 units): 1,600,000
• Allocated fixed manufacturing costs ($135 times 8,000 units): 1,080,000
• Cost of goods available for sale: 2,680,000
• Deduct ending inventory ($335 times 2,000 units): (670,000) in parenthesis
• Adjustment for production-volume variance: $0
• Cost of goods sold: 2,010,000
3. Gross Margin: 3,990,000
4. Variable marketing costs ($185 times 6,000 units): 1,110,000
5. Fixed marketing costs: 1,380,000
6. Operating Income: $1,500,000
(b) Year 2021
1. Revenues ($1,000 times 6,500 units): $6,500,000
2. Cost of goods sold
• Beginning inventory ($335 times 2,000 units): 670,000
• Variable manufacturing costs ($200 times 5,000 units): 1,000,000
• Allocated fixed manufacturing costs ($135 times 5,000 units): 675,000
• Cost of goods available for sale: 2,345,000
• Deduct ending inventory ($335 times 500 units): (167,500) in parenthesis
• Adjustment for production-volume variance: $405,000 U
• Cost of goods sold: 2,582,500
3. Gross Margin: 3,917,500
4. Variable marketing costs ($185 times 6,500 units): 1,202,500
5. Fixed marketing costs: 1,380,000
6. Operating Income: $1,335,000.
Note:
1. Production-volume variance equals Budgeted fixed manufacturing costs minus Fixed manufacturing overhead allocated using budgeted cost per output unit allowed for actual output produced. (Panel B, line 22)
• 2020: $1,080,000 minus ($135 times 8,000) equals $1,080,000 minus $1,080,000 which equals $0
• 2021: $1,080,000 minus ($135 times 5,000) equals $1,080,000 minus $675,000 which equals $405,000 U
2. Production-volume variance can also be calculated as follows:
Fixed manufacturing cost per unit times (Denominator level minus Actual output units produced)
2020: $135 times (difference of 8,000 and 8,000) units equals $135 times 0 which equals $0.
2021: $135 times (difference of 8,000 and 5,000) units equals $135 times 3,000 which equals $405,000 U.
Here’s a summary (using information from Exhibit 9-2) of the operating-income differences for Stassen Company for 2020 and 2021:
The table depicts absorption-costing operating income, variable-costing operating income, and the difference between the two for 2020 and for 2021. The details of the table are as follows:
Absorption-costing operating income
Variable-costing operating income
Difference: Absorption-costing operating income minus variable-costing operating income
The sizeable differences in the preceding table illustrate why managers whose performance is measured by reported income are concerned about the choice between variable costing and absorption costing.
Why do variable costing and absorption costing report different operating income numbers? In general, if inventory increases during an accounting period, less operating income will be reported under variable costing than under absorption costing. Conversely, if inventory decreases, more operating income will be reported under variable costing than under absorption costing. The difference in reported operating income is due solely to the fact that, under absorption costing, (1) fixed manufacturing costs are moved into inventories as inventories increase and (2) fixed manufacturing costs are moved out of inventories as inventories decrease.
The difference between operating income under absorption costing and variable costing can be computed by formula 1, which focuses on fixed manufacturing costs in beginning inventory and ending inventory:
The spreadsheet shows the formula and the equations, as follows:
Formula 1:
Absorption-costing operating income minus variable-costing operating income equals the difference of fixed manufacturing costs in ending inventory under absorption costing and fixed manufacturing costs in beginning inventory under absorption costing.
Year 2020:
$1,500,000 minus $1,230,000 equals the product of $135 and 2,000 units minus the product of $135 and 0 units, which equals $270,000 on both sides of the equation.
Year 2021:
$1,335,000 minus $1,537,500 equals the product of $135 and 500 units minus the product of $135 and 2,000 units, which equals $202,500 on both sides of the equation.
Fixed manufacturing costs in ending inventory are deferred to a future period under absorption costing. For example, $270,000 of fixed manufacturing overhead is deferred to 2021 on December 31, 2020. In contrast, under variable costing, all $1,080,000 of fixed manufacturing costs are treated as an expense of 2020.
Recall that
Therefore, instead of focusing on fixed manufacturing costs in ending and beginning inventory (as in formula 1), we could alternatively look at fixed manufacturing costs in units produced and units sold. The latter approach (see formula 2) highlights how fixed manufacturing costs move between units produced and units sold during the fiscal year.
The spreadsheet shows the formula and the equations, as follows:
Formula 2:
Absorption-costing operating income minus variable-costing operating income equals the difference of fixed manufacturing costs inventoried in units produced under absorption costing and fixed manufacturing costs in cost of goods sold under absorption costing.
Year 2020:
$1,500,000 minus $1,230,000 equals the product of $135 and 8,000 units minus the product of $135 and 6,000 units, which equals $270,000 on both sides of the equation.
Year 2021:
$1,335,000 minus $1,537,500 equals the product of $135 and 5,000 units minus the product of $135 and 6,500 units, which equals $202,500 on both sides of the equation.
Managers face increasing pressure to reduce inventory levels. Some companies are achieving steep reductions in inventory levels using management approaches such as just-in-time production—a production system under which products are manufactured only when needed. Formula 1 illustrates that, as Stassen reduces its inventory levels, operating income differences between absorption costing and variable costing become smaller, and even immaterial. Consider, for example, the formula for 2020. If instead of 2,000 units in ending inventory, Stassen had only two units in ending inventory, the difference between absorption-costing operating income and variable-costing operating income would drop from $270,000 to just $270.