Question

Dowell Company produces a single product. Its income statements under absorption costing for its first two years of operation follow.

2016 2017
Sales ($46 per unit) $920,000 $1,840,000
Cost of goods sold ($31 per unit) 620,000 1,240,000
Gross margin 300,000 600,000
Selling and administrative expenses 290,000 340,000
Net income $10,000 $260,000

Additional Information:

1. Sales and production data for these first two years follow.

2016 2017
Units produced 30,000 30,000
Units sold 20,000 40,000

Variable cost per unit and total fixed costs are unchanged during 2016 and 2017. The company's $31 per unit product cost consists of the following.

Direct materials $5
Direct labor 9
Variable overhead 7
Fixed overhead ($300,000/30,000 units) 10
Total product cost per unit $31
Selling and administrative expenses consist of the following.

2016 2017
Variable selling and administrative expenses ($2.50 per unit) $50,000 $100,000
Fixed selling and administrative expenses 240,000 240,000
Total selling and administrative expenses $287,000 $322,000

Required:
What are the differences between the absorption costing income and the variable costing income for these two years?

Answer 1

Answer:

the income statement using the variable costing method would be:

                                                                         2016               2017

Sales revenue                                            $920,000       $1,840,000

Variable costs:

• Direct materials                                 $100,000          $200,000
• Direct labor                                        $180,000          $360,000
• Overhead                                           $140,000          $280,000
• S&A                                                     $50,000           $100,000

Contribution margin                                 $450,000          $900,000

Fixed costs:

• Overhead                                         $300,000          $300,000
• S&A                                                   $240,000          $240,000

Operating income                                    ($90,000)          $360,000

the differences are:

Under absorption costing, the ending inventory carries $100,000 of fixed overhead, so the 2016 operating income = ($90,000) + $100,000 = $10,000. While the 2017 operating income = $360,000 - $100,000 = $260,000.

The problem with variable costing method is that it underestimates the value of ending inventory. In this case, ending inventory will be worth only $210,000 (direct materials + direct labor + variable overhead) instead of $310,000 (including allocation of fixed costs incurred during 2016).