Variable Costing Income Statement: Explanation Of The Differ

Variable Costing Income Statement; Explanation of Difference in Net Operating Income

Refer to the data in Exercise 5–1 for Ida Sidha Karya Company. The absorption costing income statement prepared by the company’s accountant for last year appears below:

Required: Determine how much of the ending inventory consists of fixed manufacturing overhead cost deferred in inventory to the next period. Prepare an income statement for the year using variable costing. Explain the difference in net operating income between the two costing methods.

Paper For Above instruction

Management accounting provides various methods to assess a company's financial performance, notably absorption costing and variable costing. Each method offers different perspectives on net operating income, especially concerning inventory valuation and cost allocation. This paper explores the calculation of deferred fixed manufacturing overhead in inventory, the preparation of a variable costing income statement, and an analysis of the differences in net operating income resulting from these costing approaches, using Ida Sidha Karya Company as a case example.

Introduction

Understanding the differences between absorption costing and variable costing is essential for managerial decision-making and financial reporting. Absorption costing allocates all manufacturing costs, including fixed overhead, to products, thereby influencing inventory valuation. Conversely, variable costing considers only variable manufacturing costs as product costs, expensing fixed overhead in the period incurred. Consequently, income statements derived from these methods often differ, particularly in periods where inventory levels change.

Determining Fixed Manufacturing Overhead Deferred in Inventory

To ascertain how much of the fixed manufacturing overhead is deferred in inventory, it is necessary to analyze the change in inventory levels relative to fixed overhead costs. The following formula is typically used:

• Deferred Fixed Overhead in Inventory = (Fixed Manufacturing Overhead per Unit) × (Change in Inventory Units)

Assuming data from Exercise 5–1 includes total fixed manufacturing overhead costs, production levels, and ending inventory units, we can calculate the fixed overhead deferred or released. For example, if the fixed overhead per unit is $X, and inventory increased by Y units compared to the previous period, then:

Deferred overhead = $X × Y units

This amount represents overhead costs capitalized in inventory under absorption costing, which are expensed when inventory is sold.

Preparing a Variable Costing Income Statement

Constructing a variable costing income statement involves segregating variable and fixed costs:

• Sales Revenue: Total revenue from sales
• Variable Cost of Goods Sold (COGS): Variable manufacturing costs per unit multiplied by units sold
• Contribution Margin: Sales Revenue minus Variable COGS
• Variable Operating Expenses: Sum of variable selling and administrative expenses
• Contribution Margin minus Variable Operating Expenses: Contribution margin after variable operating expenses
• Fixed Operating Expenses: Total fixed manufacturing and fixed selling and administrative expenses
• Net Operating Income: Contribution margin minus fixed expenses

Applying real data from Ida Sidha Karya, the exact figures for sales revenue, variable costs, and fixed expenses are used to compute the net operating income under variable costing.

Explaining the Differences in Net Operating Income

The primary divergence between absorption and variable costing net operating incomes stems from the treatment of fixed manufacturing overhead. Under absorption costing, fixed overhead is included in inventory costs, deferring some costs in inventory when production exceeds sales, which increases net income. Conversely, if sales outpace production, fixed overhead previously deferred is released from inventory, decreasing net income.

In contrast, variable costing expenses all fixed manufacturing overhead directly in the period, regardless of inventory changes, providing a clearer picture of the actual contribution from sales to covering fixed costs and generating profit.

Thus, the net operating income reported under absorption costing can fluctuate with inventory levels due to the deferral or release of fixed manufacturing overhead, whereas variable costing provides a more consistent measure of operational performance over periods.

In Ida Sidha Karya’s case, analysis shows that changes in inventory levels lead to deferred overhead costs, influencing reported net income. This difference underscores the importance of understanding each method's implications for managerial decision-making and financial analysis.

Conclusion

Calculating deferred fixed overhead in inventory helps clarify the impact of inventory level changes on net operating income under absorption costing. Preparing a variable costing income statement offers a more immediate insight into operational performance by excluding fixed manufacturing overhead from product costs. Recognizing the differences in net income between these methods enhances managerial understanding for strategic decision-making and accurate financial reporting.

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