# Use the following data (in millions) for 2011 for Sprouse Company to prepare a variable costing...

## Question:

Use the following data (in millions) for 2011 for Sprouse Company to prepare a variable costing income statement, and an absorption costing income statement under the given conditions:

 Sales $150 Variable FOH$5 Var. S&A 27 DL 20 Fixed S & A 25 DM 50 Fixed FOH 10

a) Inventory levels remained constant.

b) No beginning inventory; 68 units were made; 52 units were sold.

## Variable costing:

Variable costing is a type of income statement widely used for management reporting purposes only. Variable costing is different from absorption costing in the way it recognizes the fixed overhead. Under variable costing, fixed overhead is treated as period cost while under absorption costing, fixed overhead is treated as product cost.

Scenario a

Variable Costing Income Statement

 Sales $150,000,000 Less: Variable costs Direct materials 50,000,000 Direct labor 20,000,000 Variable factory overhead 5,000,000 Variable selling and admin 27,000,000 102,000,000 Contribution margin 48,000,000 Less: Fixed costs Fixed factory overhead 10,000,000 Fixed selling and admin 25,000,000 35,000,000 Operating income$13,000,000

Absorption Costing Income Statement

 Sales $150,000,000 Less: Cost of goods sold Direct materials 50,000,000 Direct labor 20,000,000 Fixed factory overhead 10,000,000 Variable factory overhead 5,000,000 85,000,000 Gross profit 65,000,000 Less: Selling and admin expenses Variable selling and admin 27,000,000 Fixed selling and admin 25,000,000 52,000,000 Operating income$13,000,000

Since the inventory level remained constant (beginning inventory = ending inventory) therefore the total units produced is also equivalent to the total units sold . In this case the absorption costing operating income will be exactly the same with the variable costing operating income. The presentation of the income statement is different but the bottom line is the same.

Scenario 2

In this case the total units produced is 68 units while total units sold is 52. We can easily conclude that the absorption costing net income is higher in this scenario than the variable costing net income. Why is this so? This is because the fixed overhead to be recognized in absorption costing is lesser than the fixed overhead to be recognized in variable costing . Fixed overhead under variable costing is recognized outright while fixed overhead under fixed overhead is recognized as product cost therefore part of it will remain in the ending inventory while the other will be recognized in the income statement.

To illustrate:

Variable costing income statement

 Sales $150,000,000 Less: Variable costs Direct materials ($50m x 52 / 68 ) 38,235,294.12 Direct labor($20m x 52/68) 15,294,117.65 Variable factory overhead ($5m x 52 /68) 3,823,529.41 Variable selling and admin 27,000,000 84,352,941.18 Contribution margin 65,647,058.82 Less: Fixed costs Fixed factory overhead 10,000,000 Fixed selling and admin 25,000,000 35,000,000 Operating income $30,647,058.82 Absorption Costing Income Statement  Sales$150,000,000 Less: Cost of goods sold Direct materials ($50m x 52 / 68 ) 38,235,294.12 Direct labor($20m x 52/68) 15,294,117.65 Variable factory overhead ($5m x 52 /68) 3,823,529.41 Fixed factory overhead ($10m x 52/68) 7,647,058.82 65,000,000 Gross profit 85,000,000 Less: Selling and admin expenses Variable selling and admin 27,000,000 Fixed selling and admin 25,000,000 52,000,000 Operating income \$33,000,000