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# Income Statements: Variable Cost vs Absorption Cost

## Practice As You Learn

### Introduction to Accounting

#### Medium Practice Test

The key to preparing each type of income statement is putting things in the right place in the right format:

You must memorize the following formats:

 Absorption Cost Variable Cost Sales Sales – CGS **(all product costs) – All variable costs =Gross Profit = Contribution Margin – All Period Expenses – All Fixed Costs =Income Before Tax = Income Before Tax

** CGS is calculated by taking all product costs per unit x units sold this period. CGS includes DM, DL, VOH, and FOH

Get a cost per unit for Fixed M O/H using:

Total Fixed MO/H\$
Total units produced

To prepare the income statement you should do these steps in this order

1) Identify the period and product costs for all except fixed manufacturing overhead costs

2) Determine if the statement you are preparing treats fixed manufacturing overhead as a period (variable) or product (absorption) cost.

3) Write the format of the income statement, leaving room to show each type of cost per unit.

4) Put the variable costs in the correct place and multiply the cost per unit times units sold to get the total cost for each type of variable cost

5) For an absorption cost statement, compute the fixed manufacturing overhead cost per unit. Multiplying this cost per unit times the units sold to get the amount included in cost of goods sold.

6) Put fixed costs period costs on the statement. Fixed manufacturing overhead is considered a fixed period cost on the variable cost income statement

#### Practice as You Learn – Problem

The following information is related to a manufacturing company for the month:

Sales price per unit                           \$20

Variable cost per unit
Direct Materials                          \$ 4
Direct Labor                               \$ 2

Fixed costs:
Fixed Selling & Administrative       \$ 33,000

Units Produced                                10,000
Units Sold                                         9,000
Units in Beginning Inventory            13,000

A. Prepare a variable cost income statement and determine:

1. Total product costs
2. Total contribution margin
3. Total operating Income

B. Prepare an absorption cost income statement and determine:

1. The manufacturing overhead cost per unit
2. Total cost of goods sold
3. Total operating income

C. Reconcile the difference between variable cost income and absorption
cost income

A. Variable Cost Income Statement: Follow the steps

1) Identify the period and product costs for all except fixed manufacturing overhead costs

Product

Direct Material              \$4
Direct Labor                 \$2
Variable M O/H            \$1
Total per unit                \$7
x units sold               9,000
Total Variable
Product Costs:         \$63,000        Answer to A.1.

Period
Fixed M O/H               \$50,000
Selling, G & A             \$33,000
Total Period                \$83,000

2) Determine if the statement treats fixed manufacturing overhead as a period or product cost.

Manufacturing overhead is a period cost for a variable cost income statement

3) Write the format of the income statement required, leaving room to show each type of cost per unit.

Sales
– Variable Product Costs
DM        \$ 4 x units sold
DL         \$ 2 x units sold
M O/H   \$ 1 x units sold
= Total Contribution Margin
– All Fixed Expenses:
Selling, G& A
Fixed Manufacturing O/H
= Income Before Taxes

There are no variable selling costs in this practice problem. If there were, they would be reported above the total contribution margin line. The total amount is calculated as variable cost per unit x units sold.

4) Put the variable costs in the correct place and multiple the cost per unit times units sold to get the total cost each type of cost

```		Sales (\$20 x 9,000 units sold)		    \$180,000
- Variable Product Costs
DM		\$ 4 x units sold		\$ 36,000
DL		\$ 2 x units sold		\$ 18,000
M O/H	        \$ 1 x units sold  		\$   9,000
= Total Contribution Margin			\$117,000   Answer to A.2.
- All Fixed Expenses:
Selling, G& A				    \$ 33,000
Fixed Manufacturing O/H		       \$ 50,000
= Total Operating Income			\$ 34,000   Answer to A.3.

```

6) Put fixed costs period costs on the statement. Fixed manufacturing overhead is considered a fixed period cost on the variable cost income statement.

Steps 1 and 2) Identify the period and product costs. For an absorption cost statement, fixed manufacturing overhead is a product cost. Go ahead and do step 5) here and compute the cost per unit for fixed manufacturing overhead so you can also include the fixed manufacturing costs in total product cost.

Product Costs

Direct Material          \$4
Direct Labor              \$2
Variable M O/H         \$1
Fixed M O/H             \$5
Total per unit             \$12
x units sold             9,000
Total Product Costs:    \$108,000

Period Costs
Selling, G & A           \$33,000

5) \$5 per Unit

Total Fixed M O/H \$ =   \$50,000
Total units produced    10,000 units

Be sure to divide by units produced, not units sold

Answer to B.1. Total manufacturing overhead cost per unit is variable plus
fixed: \$1 + \$5 = \$6 per unit

Answer to B. 2. Total cost of goods sold is total product cost per unit x units sold: \$12 x 9,000 = \$108,000.

See all product costs listed above.

3) Write the format of the income statement, leaving room to show each type of cost per unit.

Sales
– Cost of Goods Sold:
DM            \$ 4 x units sold
DL             \$ 2 x units sold
V M O/H    \$ 1 x units sold
F M O/H    \$ 5 x units sold
= Gross Profit
– All Period Fixed Expenses:
– Selling Expense
= Income Before Taxes

4) Put the variable costs in the correct place and multiply the cost per unit times units sold to get the total cost for each type of cost.

Go ahead and do step 6), put fixed period costs on the statement

```		Sales  (\$20 x 9,000 units sold)			\$180,000
- Cost of Goods Sold
DM	    \$  4 x units sold			\$ 36,000
DL	    \$  2 x units sold			\$ 18,000
V O/H  	\$  1 x units sold		    \$ 9,000
M O/H	\$  5 x units sold  		        \$ 45,000
= Gross Profit							\$ 72,000
- All Fixed Expenses:
Selling, G& A					        \$ 33,000
= Total Operating Income				\$ 39,000 	 Answer to B.3.

```
``` Units Made					   10,000
- Units Sold                                           ( 9,000)
= Inventory Change in Units                  1,000
x  Fixed M O/H rate per unit                   x  \$5
= Difference in absorption cost
and variable cost income                   \$5,000
```

Inventory increased so absorption income is higher because the fixed manufacturing overhead costs associated with those units in inventory is reported on the balance sheet and not yet on the income statement (until they are sold).

Income
Variable Cost            \$34,000
Absorption Cost        \$39,000
Difference                 \$ 5,000

Absorption is higher