Hanks Company Produces a Single Product

Hanks Company produces a single product. Operating data for the company and its absorption costing income statement for the last year is presented below:

Units in beginning inventory...... 0 Units produced...... 9,000 Units sold...... 8,000

Sales...... 80,000

Less cost of goods sold:

Beginning inventory 0

Add cost of goods manufactured. 54,000

Goods available for sale.... 54,000

Less ending inventory... 6,000

Cost of goods sold...... 48,000

Gross margin...... 32,000

Less selling & admin. expenses...... 28,000

Net operating income...... 4,000

Variable manufacturing costs are $4 per unit. Fixed factory overhead totals $18,000 for the year. This overhead was applied at a rate of $2 per unit. Variable selling and administrative expenses were $1 per unit sold. Required: Prepare a new income statement for the year using variable costing. Comment on the differences between the absorption costing and the variable costing income statements

SUGGESTED ANSWER

workings / ($) / ($)
Sales / 80,000
Less : Variable Cost of Goods Sold
Opening Inventory / 0
Cost of Goods Manufactured / 9,000 X $4 / 36,000
Goods Available For Sale / 36,000
Less : Closing Inventory / 1,000 X $4 / (4,000) / (32,000)
Contribution / 48,000
Less : Variable Selling & Admin Cost / 8,000 X 1 / (8,000)
40,000
Less Fixed Expenses
Fixed Factory OHD / (18,000)
Fixed Selling & Admin Cost / 28,000 – 8,000 / (20,000)
Net Operating Income / 2,000

The difference in the operating profit in both variable costing and absorption costing is due to the difference in Closing Inventory Valuation. In variable costing method, closing inventory is values at variable cost only while in absorption costing the inventory is valued at a higher price because it includes portion of Fixed Cost. When Closing Inventory is higher, the profit is higher. As such, the profit shown in Absorption costing is higher that that calculated using variable costing method. Following is the Profit Reconciliation Statement

Absorbtion Costing Profit 4,000

Less : Fixed Cost Element in Closing Inventory

($2 X 1,000) (2,000)

Variable Costing Profit 2,000