AGA company manufactures and sells a product for $20 per Kg.

The data for the year 2016 is given below:

 Sales in kgs: 75,000 kgs

 Finished goods inventory at the beginning of the period: 12,000 kgs
 Finished goods inventory at the closing of the period: 17,000 kgs

Manufacturing costs:

 Variable cost: $8 per Kg

 Fixed manufacturing overhead cost: $320,000 per year

Marketing and administrative expenses:

 Variable expenses: $2 per Kg of sale

 Fixed expenses: $300,000 per year

Required:

1. Income statement using absorption and variable costing methods.

2. Explanation of the cause of difference in net operating income under two concepts.

Solution
(1) Income statements:
(a) Absorption costing income statement:
*Production for the year 2016:

Units manufactured during 2016 = Units sold + Units in closing inventory – Units in opening inventory

= 75,000 kgs + 17,000 kgs – 12,000 kgs

= 80,000 kgs

**Manufacturing expenses per unit:

Variable expenses + Fixed expenses

= $8 + ($320,000/80,000 kgs)

= $8 + $4

= $12

(b) Variable costing income statement:

(2) Explanation of the difference in net operating income:
The net operating income under absorption costing is $20,000 more than the net operating income under variable
costing. When production is more than sales (as in this exercise), the fixed manufacturing overhead is deferred in
inventory that causes a higher net operating income under absorption costing than under variable costing. The
reconciliation of net operating income is given below:
 Or

Explain the difference between variable and absorption costing. How unit product cost is computed under two
methods?

Variable and absorption are two different costing methods. Almost all successful companies in the world use both the
methods. Variable costing and absorption costing cannot be substituted for one another because both the systems
have their own benefits and limitations.

These costing approaches are known by various names. For example, variable costing is also known as direct
costing or marginal costing and absorption costing is also known as full costing or traditional costing.

The information provided by variable costing method is mostly used by internal management for decision making
purposes. Absorption costing provides information that is used by internal management as well as by external parties
like creditors, government agencies and auditors etc.

Computation of unit product cost under two

methods:
Under absorption costing system, the product cost consists of all variable as well as all fixed manufacturing costs i.e.,
direct materials, direct labor and factory overhead (FOH). But when variable costing system is used, the fixed cost
(both manufacturing and non-manufacturing) is treated as a period or capacity cost and is, therefore, not included in
the product cost.

Following exhibition summarizes the difference between variable costing and absorption costing:

Variable versus absorption costing

For further clarification of the concept, consider the following examples:

Example 1
A company manufactures and sells 5000 units of product X per year . Suppose one unit of product X requires the
following costs:

Direct materials: $5 per unit

Direct labor: $4 per unit
Variable manufacturing overhead: $1 per unit
Fixed manufacturing overhead: $20,000 per year

The unit product cost of the company is computed as follows:

Absorption Costing: $5 + $4 + $1 + $4* = $14

Variable Costing: $5 + $4 + $1 = $10

* $20,000 / 5,000

Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable costing
system but it has been included in the unit cost under absorption costing system. This is the primary difference
between variable and absorption costing.

Example 2
Sunshine company produces and sells only washing machines. The company uses variable costing for internal
reporting and absorption costing for external reporting. The data for the year 2016 is given below:

Direct materials: $150/unit

Direct labor: $45/unit
Variable manufacturing overhead: $25/unit
Fixed manufacturing overhead: $160,000 per year
Fixed marketing and administrative expenses: $110,000 per year
Variable marketing and administrative expenses: $15/unit sold

Company produced and sold 8,000 machines during the year 2016.

Required: Compute the unite product cost under variable costing and absorption costing.
Solution:

*$160,000 / 8,000 Units = $20

Note: Marketing and administrative expenses are period costs and are not relevant in the computation of unit product
cost.