Concept explainers
Absorption and variable costing income statements for two months and analysis
During the first month of operations ended July 31, Head Gear Inc. manufactured 6,400 hats, of which 5,200 were sold. Operating data for the month are summarized as follows:
During August, Head Gear Inc. manufactured 4,000 hats and sold 5,200 hats. Operating data for August are summarized as follows:
Instructions
- 1. Using the absorption costing concept, prepare income statements for (a) July and (b) August.
- 2. Using the variable costing concept, prepare income statements for (a) July and (b) August.
- 3.
- A. Explain the reason for the differences in the amount of operating income in (1) and (2) for July.
- B. Explain the reason for the differences in the amount of operating income in (1) and (2) for August.
- 4. Based on your answers to (1) and (2), did Head Gear Inc. operate more profitably in July or in August? Explain.
1.(A)
Compute the income statement according to the absorption costing concept of the H Incorporation for the month of July.
Explanation of Solution
Absorption Costing
Absorption costing is compulsory under Generally Accepted Accounting Principles (GAAP) for financial statements which are circulated to the external users. The cost of goods manufactured includes direct materials, direct labor, and factory overhead costs under absorption costing. Fixed factory overhead and variable factory overhead included as a part of factory overhead.
Variable Costing
Variable costing is the method that is used by the management (managers) for decision making purposes. The cost of goods manufactured includes direct materials, direct labor, and variable factory overhead. Fixed factory overhead is treated as period (fixed) expense.
Calculate the income statement according to the absorption costing concept of the H Incorporation as shown below:
H Incorporation | ||
Absorption costing income statement for the month ended | ||
July 31 | ||
Particulars | $ | $ |
Sales | 104,000 | |
Less: Cost of goods sold | ||
Cost of goods manufactured | 97,280 | |
Inventory on July 31 | (18,240) | |
Total cost of goods sold | 79,040 | |
Gross profit | 24,960 | |
Less: Selling and administrative expenses | 16,120 | |
Income from operations | 8,840 |
Table (1)
Working note (1):
Calculate the value of ending inventory per unit.
Therefore, income from operations under absorption costing concept of H Incorporation for the month ended July 31 is $8,840.
1. (B)
Compute the income statement according to the absorption costing concept of the H Incorporation for the month ended August.
Explanation of Solution
Calculate the income statement according to the absorption costing concept of the H Incorporation as shown below:
H Incorporation | ||
Absorption costing income statement for the month ended | ||
August 31 | ||
Particulars | $ | $ |
Sales | 104,000 | |
Less: Cost of goods sold | ||
Cost of goods manufactured | 18,240 | |
Inventory on August, 1 | 66,560 | |
Total cost of goods sold | 84,800 | |
Gross profit | 19,200 | |
Less: Selling and administrative expenses | 16,120 | |
Income from operations | 3,080 |
Table (2)
Therefore, income from operations under absorption costing concept of H Incorporation for the month ended August, 31 is $3,080.
2. (A)
Compute the income statement according to the variable cost concept of the H Incorporation for the month ended July, 31.
Explanation of Solution
Calculate the income statement according to the variable costing concept of the H Incorporation as shown below:
H Incorporation | ||
Variable costing income statement for the month ended | ||
July 31 | ||
Particulars | $ | $ |
Sales | 104,000 | |
Less: Variable cost of goods sold | ||
Variable cost of goods manufactured | 81,920 | |
Inventory on July, 31 | (15,360) | |
Total variable cost of goods sold | 66,560 | |
Manufacturing margin | 37,440 | |
Less: Variable selling and administrative expenses | 10,920 | |
Contribution margin | 26,520 | |
Less: Fixed costs | ||
Fixed manufacturing costs | 15,360 | |
Fixed selling and administrative expenses | 5,200 | |
Total fixed cost | 20,560 | |
Income from operations | 5,960 |
Table (3)
Working note (2):
Calculate the value of ending inventory per unit.
Therefore, income from operations under variable costing concept of H Incorporation for the month ended July, 31 is $5,960.
2. (B)
Compute the income statement according to the variable cost concept of the H Incorporation for the month ended August, 31.
Explanation of Solution
Calculate the income statement according to the variable costing concept of the H Incorporation as shown below:
H Incorporation | ||
Variable costing income statement for the month ended | ||
August 31 | ||
Particulars | $ | $ |
Sales | 104,000 | |
Less: Variable cost of goods sold | ||
Variable cost of goods manufactured | 15,360 | |
Inventory on August, 1 | 51,200 | |
Total variable cost of goods sold | 66,560 | |
Manufacturing margin | 37,440 | |
Less: Variable selling and administrative expenses | 10,920 | |
Contribution margin | 26,520 | |
Less: Fixed costs | ||
Fixed manufacturing costs | 15,360 | |
Fixed selling and administrative expenses | 5,200 | |
Total fixed cost | 20,560 | |
Income from operations | 5,960 |
Table (4)
Therefore, income from operations under variable costing concept of H Incorporation for the month ended August, 31 is $5,960.
3.(A)
Identify the reason for the difference between the amount of income from operations reported in absorption costing income statement and variable costing income statement for the month ended July, 31.
Explanation of Solution
The difference between the absorption and variable costing income from operations of $2,880
Increase in inventory = 1,200 units
Fixed factory overhead per unit = $2.4
Under absorption costing method, the fixed factory overhead cost included in the cost of goods sold is coordinated with the incomes. As an effect, 1,200 units that were produced, but unsold includes fixed factory overhead cost, which is not involved in the cost of goods sold.
Under variable costing, all of the fixed factory overhead cost is subtracted in the period in which it is incurred, regardless of the amount of inventory change. Therefore, when inventory rises, the absorption costing income statement will have a higher income from operations than the variable costing income statement.
3. (B)
Identify the reason for the difference between in the amount of income from operations reported in absorption costing income statement and variable costing income statement for the month ended August, 31.
Explanation of Solution
The difference between the absorption and variable costing income from operations of $2,880
Increase in inventory = 1,200 units
Fixed factory overhead per unit = $2.4
Under absorption costing method, the fixed factory overhead cost included in the cost of goods sold is coordinated with the incomes. As an effect, 1,200 units that were produced, but unsold includes fixed factory overhead cost, which is not involved in the cost of goods sold.
Under variable costing, all of the fixed factory overhead cost is subtracted in the period in which it is incurred, regardless of the amount of inventory change. Therefore, when inventory rises, the absorption costing income statement will have a higher income from operations than the variable costing income statement.
4.
Describe whether H Incorporation operates more profitability in July or August.
Explanation of Solution
Based on variable costing concept, the H Incorporation was equally profitable in July and August. Sales and variable cost per unit were the same for both the month and under both concept. The combined income from operations reported based on absorption concept for July and August
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