Variable Versus Absorption Costing: Operating Income and Income Statements

Learning Objective 2 Compute operating income under absorption costing and variable costing, and explain the difference in operating income

• using the gross-margin format
• using the contribution-margin format
• income is affected by the unit level of production and the unit level of sales under absorption costing, but only by the unit level of sales under variable costing

When comparing variable and absorption costing, we must take the length of the time horizon over which we are comparing the two systems into account. How do the data produced by variable and absorption costing differ over a 1-year period? How do they differ over a 2-year period?

Comparing Income Statements for One Year

What will Stassen’s operating income be if it uses variable costing or absorption costing? The differences between these methods are illustrated in Exhibit 9-1. Panel A shows the variable costing income statement and Panel B the absorption-costing income statement for Stassen’s telescope product line for 2020. The variable-costing income statement uses the contribution-margin format introduced in Chapter 3; the absorption-costing income statement uses the gross-margin format introduced in Chapter 2. Why these different formats? The distinction between variable costs and fixed costs is central to variable costing, and it is highlighted by the contribution-margin format. In contrast, the distinction between manufacturing and nonmanufacturing costs is central to absorption costing, and it is highlighted by the gross-margin format.

Absorption-costing income statements do not need to differentiate between variable and fixed costs. However, we will make this distinction between variable and fixed costs in the Stassen example in order to illustrate how individual line items are classified differently under variable costing and absorption costing. In Exhibit 9-1, Panel B, note that inventoriable cost is $335 per unit under absorption costing: allocated fixed manufacturing costs of $135 per unit plus variable manufacturing costs of $200 per unit.

Notice how the fixed manufacturing costs of $1,080,000 are accounted for under variable costing and absorption costing in Exhibit 9-1. The income statement under variable costing deducts the $1,080,000 lump sum as an expense for 2020. In contrast, under absorption costing, the $\$\text{1,080,000},$ $(\mathrm{\$}135\hspace{0.17em}\text{per unit}\times \text{8,000}\hspace{0.17em}\text{units})$ is initially treated as an inventoriable cost in 2020. Of this $\$\text{1,080,000},\hspace{0.17em}\$\text{810,000}$ $(\$135\hspace{0.17em}\text{per unit}\times \text{6,000}\hspace{0.17em}\text{units})$ subsequently becomes a part of cost of goods sold in 2020, and $\$\text{270,000}$ $(\mathrm{\$}135\hspace{0.17em}\text{per unit}\times \text{2,000}\hspace{0.17em}\text{units})$ remains an asset—part of ending finished goods inventory on December 31, 2020.

Operating income is $270,000 higher under absorption costing compared with variable costing because only $810,000 of fixed manufacturing costs are expensed under absorption costing, whereas all $1,080,000 of fixed manufacturing costs are expensed under variable costing. Note that the variable manufacturing cost of $200 per unit is accounted for the same way in both income statements in Exhibit 9-1.

These points can be summarized as follows:

The basis of the difference between variable costing and absorption costing is how fixed manufacturing costs are accounted for. If inventory levels change, operating income will differ between the two methods because of the difference in accounting for fixed manufacturing costs. To see this difference, let’s compare telescope sales of 6,000, 7,000, and 8,000 units by Stassen in 2020, when 8,000 units were produced. Of the $1,080,000 total fixed manufacturing costs, the amount expensed in the 2020 income statement under each of these scenarios would be as follows:

In the last scenario, where 8,000 units are produced and sold, both variable and absorption costing report the same net income because inventory levels are unchanged. This chapter’s appendix describes how the choice of variable costing or absorption costing affects the breakeven quantity of sales when inventory levels are allowed to vary.