Income Statements:
Variable Cost vs Absorption Cost
Medium Practice Test
Medium Practice Test
Click the “Check Your Answer” box below each question to reveal the correct answer and explanation.
1. A company incurred the same sales and costs in the prior year as it did in the current year. Production is higher in the current year. When preparing the current year income statement for its shareholder’s
a. income will be higher this year than last year
b. variable cost will give a higher income than absorption cost
c. absorption cost will give a lower income than variable cost
d. income will be lower this year than last year
Answer
A. Income statements presented to shareholders are done using the absorption cost method. Under absorption cost, when production is higher, income is higher. The level of production does not impact a variable cost statement.
2. A company that uses variable cost for management decisions does not rely on
a. the matching concept
b. cost volume relationships
c. fixed costs remaining constant with changes in volume
d. variable costs change as volume changes
Answer
A. The matching concept is not followed under a variable cost statement because the product cost fixed manufacturing overhead is expensed as incurred, not when the product is sold. The variable cost statement sorts by fixed and variable and all other things listed are true.
3. To determine income using variable cost, you do not need to know
a. units sales
b. units produced
c. variable costs per unit
d. total fixed costs
Answer
B. Units produced has no affect on a variable cost statement. The quantity of units produced is only used on an absorption cost statement to determine fixed manufacturing overhead cost per unit. Units sold is used to determine total costs when working with variable costs for both statements. Total fixed costs is reported on the variable cost income statement.
4. A company using absorption cost reported lower income in a year that production increased. The company most likely
a. increased the sales price of units
b. incurred increased period costs
c. decreased fixed manufacturing costs
d. decreased variable production costs
Answer
B. When using absorption cost, an increase in production will give increased income when all other factors are the same. Since it decreased income, other factors changed. The most likely change that would cause a lower income is increased period costs. Increasing the sales price would give higher income. Decreasing production costs would lead to a higher income.
5. Which of the following related to a variable cost income statement is not true
a. gross profit is not calculated
b. you cannot determine fixed production costs
c. variable period costs are not included when determining contribution margin
d. fixed and variable costs are separated
Answer
C. All variable costs, including variable period costs, are considered when determining contribution margin. Gross profit is not shown on a variable cost statement. Fixed and variable costs are separated and fixed production costs are reported separately.
6. For an absorption cost income statement, inventory costs are determined so
a. the matching principle is followed
b. product costs are only variable production costs
c. inventory costs are used for cost volume profit analysis
d. period costs are part of inventory
Answer
A. On an absorption cost income statement all product costs are expensed in the period the product is sold and sales revenue is matched with ALL the cost of making the products sold. Costs are sorted by product and period and it is not used for CVP analysis since it is not sorted by variable and fixed. Period costs are never considered to be part of the cost of inventory.
7. When you reconcile variable cost income to absorption cost income and production is higher than sales, you would
a. add the fixed manufacturing overhead in inventory to absorption cost income to get variable cost income
b. subtract fixed manufacturing overhead in inventory from absorption cost income to get variable cost income
c. do nothing, the statements will report the same amount
d. none of the answers are correct
Answer
B. Production is higher than sales means that absorption income is higher than variable cost income by the fixed manufacturing overhead in the additional units. Since absorption cost income is higher, you subtract this amount to get variable cost income
8. When managers earn a bonus based on income reported to shareholders, they will have an incentive to
a. produce as many units as possible
b. produce as few units as possible
c. report manufacturing overhead as a period cost
d. report variable period costs as fixed costs
Answer
A. Statements reported to shareholders are prepared using absorption cost. Under absorption cost, higher production will give a higher income. Manufacturing overhead can not be reported as a period cost under GAAP. Variable costs are never reported as fixed costs.
9. Which of the following statements is applicable to a variable cost income statement?
a. the reported cost per unit will vary directly with the number of units sold
b. profits change as some fixed manufacturing overhead costs are expensed
c. period costs are impacted by production
d. the number of units produced does not impact fixed manufacturing costs reported
Answer
D. Fixed manufacturing costs are all expensed in the period incurred under variable cost. The cost per unit for fixed manufacturing overhead is not used. A variable cost per unit is always the same regardless of volume. Period costs are not impacted by production.
10. The only real difference in absorption and variable cost income statements is
a. they always give a different reported income
b. the format is different
c. manufacturing overhead is treated differently
d. there is no difference, a company has to report all costs on the income statement no matter what
Answer
11. The manufacturing company sold 20,000 units at $27 each and produced 22,000 during the year. Variable costs of production were $225,000 and variable period expenses were 40% of total period expenses. Total fixed product costs were $121,000. The company prepared the following absorption cost income statement for external reporting.
Sales $540,000
- Cost of Goods sold $335,000
= Gross Profit $205,000
- Operating Expenses $180,000
= Operating Income $25,000
A. Determine income using variable cost without preparing an income statement.
B. Prepare an income statement using variable cost.
Answer
The fixed manufacturing overhead per unit is $5.50 per unit
Total fixed manufacturing overhead
Total units produced
$121,000
22,000
A. The difference in absorption and variable income can be determined as follows:
Units Made 22,000
- Units Sold (20,000)
= Change in Inventory 2,000
x Fixed M O/H rate per unit x $5.50
= Difference in the two statements $11,000
Inventory increased, absorption cost income is $11,000 higher
Absorption Cost Income is $25,000
Less the difference $11,000
= Variable Cost Income $14,000
B. Variable Cost Income Statement
Sales ($27 x 20,000 units sold) $540,000
- Variable Product Costs $225,000 given
- Variable Period * $ 72,000
= Total Contribution Margin $243,000
- All Fixed Expenses:
Selling, G& A ** $108,000
Fixed Manufacturing O/H $121,000 given
= Total Operating Income $14,000
* On an absorption cost income statement, operating expenses are all period costs.
It states that 40% of the $180,000 operating/period costs are variable.
** Fixed operating expenses is the total of $180,000 less the variable $72,000
12. A manufacturing company produced 30,000 units. The selling price per unit is $15. Beginning inventory was 33,000 units and ending inventory is 27,000 units. The following additional information is available:
Production costs: $280,000 75% variable Selling costs: $110,000 50% variable Administrative costs $89,000 100% fixed
A. Prepare an income statement using variable cost
B. Prepare an income statement using absorption cost
C. Reconcile the difference in income for the two statements.
Answer
First determine the units sold:
Beginning Inventory 33,000 + Made 30,000 - Ending Inventory (27,000) Sold 36,000
Then, before you do anything else, determine variable and fixed costs, variable costs per unit, and the fixed manufacturing overhead cost per unit
| Fixed | Variable | Per Unit | |
| Production costs: | $70,000 | $210,000 / 30,000 made | $7.00 |
| Selling costs: | $55,000 | $55,000 / 36,000 sold | $1.528 |
| Administrative costs | $89,000 | 0 | N/A |
| Fixed Manufacturing overhead costs | $70,000 = | $2.33 per unit |
| Units produced | 30,000 | for F M O/H |
You can not prepare the income statements without this information, so always do the calculations first. Then drop the numbers into the proper format.
A. Variable cost income statement
Sales ($15 x 36,000 units sold) $540,000 - Variable Product Costs ($7 x # sold) $252,000 - Variable Period ($1.528 x $ sold) $55,008 = Total Contribution Margin $232,992 - All Fixed Expenses: Selling, G& A $144,000 Fixed Manufacturing O/H $70,000 = Total Operating Income $ 18,992
B. Absorption cost income statement:
Sales ($15 x 36,000 units sold) $540,000 - Cost of Goods Sold: Variable product cost per unit ($7 x # sold) $252,000 Fixed product cost per unit ($2.33 x # sold)= $83,880 = Gross Profit $204,120 - All variable period expenses ($1.528 x # sold) $55,008 All fixed period expenses $144,000 = Income Before Taxes $5,112
C.
Units Made 30,000 - Units Sold (36,000) = Change in Inventory (6,000) x Fixed M O/H rate per unit $2.33 = Difference in the two statements $13,980
Inventory is lower, absorption income should be lower
Variable Cost Income $18,992
Absorption Cost Income $ 5,112
Absorption Cost Income is $13,880 lower
It does not equal exactly because of rounding on the cost per unit.
13. Information related to two companies follows:
| Company 1 | Company 2 | |
| Sales price per unit | $10 | $10 |
| Variable production costs | $5 | $5 |
| Variable period costs | $1 | $1.50 |
| Fixed production costs | $65,000 | $35,000 |
| Fixed period costs | $35,000 | $65,000 |
| Units produced | 15,000 | 25,000 |
| Units sold | 20,000 | 20,000 |
A. Which company will report the largest difference between absorption cost and
variable cost income? Show the calculations to support your answer.
B. Which company will report the largest income using variable cost? Show the
calculations to support your answer
C. Which company will report the largest income using absorption cost? Show the
calculations to support your answer
Answer
A. The difference in absorption cost and variable cost income is calculated
| Company 1 | Company 2 | |
| Units Made | 15,000 | 25,000 |
| – Units Sold | (20,000) | 20,000 |
| = Change in Inventory | (5,000) | 5,000 |
| x Fixed M O/H rate per unit | x $4.33 | x $1.40 |
| = Difference in the two statements | $(21,650) | $7,000 |
| Absorption will be | lower | higher |
| Total fixed O/H costs | $65,000 | $35,000 |
| Units produced | 15,000 | 25,000 |
| Fixed M O/H rate | $4.33 | $1.40 |
Company 1 will give the largest difference between the two statements.
It is much easier to prepare a variable cost income statement because the costs are already sorted according to fixed and variable. We will do variable cost first and then reconcile to determine absorption cost without actually doing an absorption cost statement. The questions do not ask you to do income statements and you most likely won’t have the time to do full income statements for both methods. Learn to quickly determine and use the difference between the two statements.
B.
| Variable Cost Income Statements: | Company 1 | Company 2 |
| Sales ($10 x 20,000 units sold) | $200,000 | $200.000 |
| – Variable Product Costs ($5 x # sold) | $100,000 | $100,000 |
| – Variable Period ($cost per x # sold) | $20,000 | $30,000 |
| = Total Contribution Margin | $80,000 | $70,000 |
| – Fixed Period | $35,000 | $65,000 |
| – Fixed Product | $65,000 | $35,000 |
| = Total Operating Income | $(20,000) | $(30,000) |
Company 1 reports the higher income (a lower loss is considered higher)
C.
| Company 1 | Company 2 | |
| Variable Cost Income | $(20,000) | $(30,000) |
| Difference in two statements (see A.) | (21,650) | 7,000 |
| Absorption Cost Income | $(41,650) | $(23,000) |
Company 2 reports the higher income under Absorption Cost.