# Income Statements: Variable Cost vs Absorption Cost

## Easy Practice Test

1. The difference in absorption cost income and variable cost income can be explained as

a. all production costs in the change in inventory for the period
b. all manufacturing overhead in the change in inventory for the period
c. fixed manufacturing overhead in the change in inventory for the period
d. it is affected by a variety of factors and can not be easily explained

C. The only difference in the two statements is how fixed manufacturing overhead is treated. It is treated as a period cost for variable cost and as a product cost for absorption cost.

2. Total manufacturing overhead is reported as a product cost when using

a. a variable cost statement
b. an absorption cost statement
c. both a. and b.
d. neither a. or b.

B. Total manufacturing overhead includes both fixed and variable. Absorption cost treats both fixed and variable manufacturing overhead as product costs. Variable cost treats fixed manufacturing overhead as a period cost.

3. Which income statement format follows the matching principle

a. a variable cost statement
b. an absorption cost statement
c. both a. and b.
d. neither a. or b.

B. Cost of goods sold matches the sales during the period because it includes all product costs and is based on the same quantity of units. Cost of goods sold is reported on the absorption cost income statement only. Variable cost does not match all expenses with revenues because fixed manufacturing overhead is not matched to the period the products are sold.

4. On a variable cost income statement,

a. product costs consist of only variable costs
b. product costs consist of all manufacturing costs
c. period expenses are considered a product cost
d. none of the above

A. Product costs on a variable cost statement are direct materials, direct labor, and variable manufacturing overhead. All of these costs are variable costs. Fixed manufacturing overhead is not considered a product cost for variable cost. Period expenses are never considered to be product costs on either statement.

5. When finished goods inventory increases

a. absorption cost will give a higher income than variable cost
b. variable cost will give a higher income than absorption cost
c. absorption cost and variable cost will show the same income
d. period costs will differ between the two statements

A. For absorption cost, fixed manufacturing overhead costs are inventory costs until sold. When inventory increases, these costs are not yet sold and stay on the balance sheet. Costs on the income statement are lower, because some costs are still on the balance sheet, therefore, income is higher under absorption cost. Inventory levels do not impact a variable cost income statement.

6. Absorption cost income statements

a. treat some period costs as product costs
b. treat some product costs as period costs
c. assign only direct costs to inventory
d. assign all manufacturing costs as inventory costs

D. The absorption cost income statement treats all product costs as inventory costs. All product costs are direct material, direct labor, variable and fixed overhead. Period costs are never treated as product costs for either statement.

7. To determine a product cost under absorption cost, include

a. direct material and direct labor only
b. direct material, direct labor, and variable manufacturing overhead
c. direct material, direct labor, and all manufacturing overhead
d. direct material, direct labor, and fixed manufacturing overhead

C. The absorption cost income statement treats all product costs as product costs. All product costs are direct material, direct labor, variable and fixed overhead.

8. When a company produces fewer units than it sells

a. absorption cost will give a lower income than variable cost
b. variable cost will give a lower income than absorption cost
c. absorption cost and variable cost will show the same income
d. period costs will differ between the two statements

A. Inventory in this situation decreases. This causes fixed manufacturing overhead that was on the balance sheet as inventory to be moved to the income statement as cost of goods sold under absorption cost. Absorption cost will expense more product costs and will show less income. Period costs are reported the same for both statements.

9. You can reconcile the difference in absorption cost income and variable cost income by

a. multiplying the total manufacturing cost per unit by the change in inventory
b. multiplying the fixed manufacturing cost per unit by the change in inventory
c. multiplying the variable manufacturing cost per unit by the change in inventory
d. determining the change in inventory on the balance sheet for the period

B. The difference in the two statements is the fixed manufacturing overhead that is in inventory. This is considered on a per unit basis. Inventory on the balance sheet consists of all product costs, not just fixed manufacturing overhead costs. (d.)

10. Total cost of goods sold is determined by

a. multiplying total product cost per unit by units produced
b. multiplying total product cost per unit by units sold
c. multiplying variable product costs per unit by units sold
d. multiplying all company costs per unit by units sold

B. Cost of goods sold represents the cost of making the products that were sold. Under absorption cost, which reports cost of goods sold, all manufacturing costs are included. Period costs are never included in cost of goods sold.

11. A company sells its products for \$25 each. The following information is related to
the company’s first year of operations.

```Sales					\$750,000
Production costs
Variable costs			\$5 per unit
Fixed costs                    \$288,000
Variable				\$2 per unit
Fixed					\$74,000
Units produced			32,000
```

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.

A. First determine the quantity of units sold: \$750,000 / \$25 per unit = 30,000
For all variable costs, multiply the cost per unit times units sold.

Units produced is not used on a variable cost income statement.

```Sales  (\$25 x 30,000 units sold)			    \$750,000
- Variable Product Costs (\$5 x units sold)            \$150,000
- Variable Selling and Admin (\$2 x units sold)        \$  60,000
= Total Contribution Margin			        \$540,000
- All Fixed Expenses:
Selling, G& A                           \$  74,000
Fixed Manufacturing O/                                   \$288,000
= Total Operating Income				    \$178,000
```

B. Use the same units sold as you used for variable cost
Compute the fixed overhead cost per unit: \$288,000 / 32,000 = \$9.00

To calculate all variable expense, multiply cost per unit by units sold

```Sales								    \$750,000
- Cost of Goods Sold:
Variable product cost per unit (\$5 x # sold)		\$150,000
Fixed product cost per unit  (\$9 x # sold)		\$270,000
= Gross Profit						        \$330,000
-  All variable period expenses (\$2 x # sold)		\$  60,000
-  All fixed period expenses                                     \$  74,000
= Income Before Taxes					    \$196,000
```

C.

```Units Made					    32,000
Units Sold                                               (30,000)
Change in Inventory				  2,000
x. Fixed M O/H rate per unit                        x \$9
Difference in the two statements	          \$18,000
```

Inventory increased, absorption should be higher

```Variable Cost Income	  \$178,000
Absorption Cost Income      \$196,000
Absorption Cost Income is  \$18,000 higher
```

12. The following information is available for the manufacturing company:

```Variable cost per unit:
Direct Material					    \$1.50
Direct Labor						\$2.25

Fixed costs:

Units Sold						10,000
Units Produced					8,500
Sales price per unit					\$50
```

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.

A.

```Sales  (\$50 x 10,000 units sold)		   \$500,000
- Variable Product Costs
DM	(\$ 1.50 x units sold)            \$15,000
DL	(\$  2.25 x units sold)           \$22,500
M O/H	(\$    .40 x units sold)  	   \$4,000
Variable Selling (\$.75 x units sold)        \$7,500
= Total Contribution Margin		       \$451,000
- All Fixed Expenses:
Selling, G& A                      \$239,000
Fixed Manufacturing O/H                       \$127,500
= Total Operating Income                              \$  84,500
```

B. You should first determine fixed manufacturing overhead per unit:
\$127,500 / 8,500 = \$15 Make sure you divide by units produced

```Sales  (\$50 x 10,000 units sold)		\$500,000
- Cost of Goods Sold
DM	(\$ 1.50 x units sold)			    \$15,000
DL	(\$  2.25 x units sold)		    \$22,500
V M O/H	(\$    .40 x units sold)	    \$4,000
F M O/H	(\$ 15  x units sold)                  \$150,000
= Gross Profit				        \$308,500
-  All variable period expenses		\$    7,500
-  All fixed period expenses                     \$239,000
= Total Operating Income			\$  62,000
```

Variable period expenses = (\$.75 x # sold)

C.

```Units Made					      8,500
Units Sold                                               (10,000)
Change in Inventory				(1,500)
x. Fixed M O/H rate per unit                      x \$15
Difference in the two statements	          \$22,500
```

Inventory decreased, absorption should be lower

Variable Cost Income           \$84,500
Absorption Cost Income       \$62,000

Absorption Cost Income is    \$22,500 lower

13. A manufacturing company produced 20,000 units and sold 18,000 units for \$17 per unit. During the period, the company incurred the following costs:

```Direct materials				       \$85,000
Direct labor					       \$65,000
```

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.

The first thing you must do is determine the variable cost per unit for all variable costs.

Direct materials
\$85,000 / 20,000 = \$4.25 per unit

Direct labor
\$65,000 / 20,000 = \$3.25 per unit

\$15,000 / 20,000 = \$0.75 per unit

\$18,000 / 18,000 = \$1.00 per unit

Use units made for production costs.
Use units sold for selling costs.

Then determine the fixed overhead cost per unit to be used on the absorption cost statement:

\$96,000 / 20,000 = \$4.80

Use units produced

Then write the formats correctly and fill in the numbers.

A. Variable cost income statement

```Sales  (\$17 x 18,000 units sold)       \$306,000
- Variable Product Costs
DM	(\$ 4.25 x units sold)	        \$76,500
DL	(\$ 3.25 x units sold)	        \$58,500
V M O/H	(\$ 0.75 x units sold)	    \$13,500
Variable Selling (\$1 x units sold)   \$18,000
= Total Contribution Margin           \$139,500
- All Fixed Expenses:
Selling, G& A                  \$32,000
Fixed Manufacturing O/H               \$96,000
= Total Operating Income                      \$11,500
```

B. Absorption cost income statement

```Sales  (\$17 x 18,000 units sold)			 \$306,000
- Cost of Goods Sold
DM	(\$4.25 x units sold)			     \$76,500
DL	(\$3.25 x units sold)			     \$58,500
V M O/H	(\$  .75 x units sold) 			 \$13,500
F M O/H	(\$4.80 x units sold)  		 \$86,400
= Gross Profit					          \$71,100
-  All variable period expenses: (\$1 x # sold)	 \$18,000
-  All fixed period expenses			     \$32,000
= Total Operating Income				 \$21,100
```

C.

```  Units Made				              20,000
-  Units Sold                                             (18,000)
= Change in Inventory			      2,000
x  Fixed M O/H rate per unit                     x \$4.80
=  Difference in the two statements	     \$9,600
```

Inventory increased, absorption should be higher

Variable Cost Income        \$11,500
Absorption Cost Income    \$21,100

Absorption Cost Income is \$9,600 higher