Acc202 - Managerial Accounting Case 1

Explain the main differences between the absorption and contribution (behavioral, variable) income statements. Will net income always be the same under the two approaches? If not, explain the difference.

The differences between the absorption and variable income statements are as follows:

1. Under absorption income statement, the cost of per unit of inventory is inclusive of direct material, direct labor, variable manufacturing overhead and fixed manufacturing overhead. on the other hand, in case of variable costing income statement, cost per unit of inventory is inclusive of direct material, direct labor, variable manufacturing overhead.

2. In case of absorption costing income statement, the gross margin is computed by deducting the cost of goods sold from the sales. On the other hand, in case of variable costing income statement variable expenses are deducted from sales to arrive at contribution margin and the fixed expenses are deducted from the contribution margin to arrive at sales.

3. In case of absorption costing, the inventories are always valued at full costs. On the other hand, under variable costing, inventories are always valued at variable costs.

The net income under two approaches will be the same if the production equals sales. In case the production is more than the sales, then absorption costing will show more profit than the variable costing income statement because the closing stock is valued at high cost per unit compared to variable costing because of inclusion of fixed manufacturing cost in the cost per unit.

Comment specifically on why companies feel the need to create yet another income statement in a different format. What information can the company gleam from this approach which is helpful as a tool in the decision making process.

The income statement under absorption costing is statutorily required to be prepared. On the other hand, variable costing income statement is prepared for decision making purposes. Examples: make or buy decision, accepting the special offer, dropping the product line etc.,

Example:

If the company has the capacity to produce 10000 units of Product A and presently manufacturing 8000 units. The cost details are as follows for the product are as follows:

Direct materials $5 per unit

Direct labor $4 per unit

Variable overhead $3 per unit

Fixed costs $400000 per annum.

The present selling price of product A is $15 per unit. If the company has got special offer from external market to produce 1000 units for $13 per unit, the company can accept this offer as accepting the special offer will generate the ADDITIONAL contribution of ($13-$12)*1000=$1000. If the income statement is prepared under absorption costing, it will not be possible