On July 31, 2005, the end of the first month of operations,...

On July 31, 2005, the end of the first month of operations, Franklin Pen Company prepared the following income statement, based on the absorption costing concept: Sales (12,000 units) . . . . . . . . . . . . . . . . . . . $564,000 Cost of goods sold: Cost of goods manufactured . . . . . . . . . . $503,100 Less ending inventory (900 units) . . . . . . . 35,100 Cost of goods sold . . . . . . . . . . . . . . . . 468,000 Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . $ 96,000 Selling and administrative expenses . . . . . . . 53,400 Income from operations . . . . . . . . . . . . . . . $ 42,600 Prepare a variable costing income statement, assuming that the fixed manufacturing costs were $32,250 and the variable selling and administrative expenses were $30,000.

On July 31, 2005, the end of the first month of operations, Franklin Pen Company
prepared the following income statement, based on the absorption costing concept:
Sales (12,000 units) . . . . . . . . . . . . . . . . . . . $564,000
Cost of goods sold:
Cost of goods manufactured . . . . . . . . . . $503,100
Less ending inventory (900 units) . . . . . . . 35,100
Cost of goods sold . . . . . . . . . . . . . . . . 468,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . $ 96,000
Selling and administrative expenses . . . . . . . 53,400
Income from operations . . . . . . . . . . . . . . . $ 42,600
Prepare a variable costing income statement, assuming that the fixed manufacturing
costs were $32,250 and the variable selling and administrative expenses were $30,000.

Key Concepts

Absorption Costing

Absorption costing is a method of product costing that allocates both variable and fixed manufacturing overhead costs to the cost of a product. This approach means that the cost of inventory includes a share of fixed costs, and these costs are only expensed on the income statement when the inventory is sold. It is widely used for external financial reporting purposes as it complies with generally accepted accounting principles (GAAP).

Variable Costing

Variable costing is a costing method where only variable manufacturing costs, such as direct materials, direct labor, and variable manufacturing overhead, are assigned to the product cost. Fixed manufacturing overhead costs are treated as period expenses and are expensed in the period incurred. This method is useful for internal decision making because it highlights the impact of fixed costs on profitability and helps in analyzing the cost behavior.

Inventory Valuation Differences

Inventory valuation differs between absorption costing and variable costing due to the treatment of fixed manufacturing overhead. Under absorption costing, fixed overhead is included in the cost of inventory, meaning that unsold inventory carries a portion of these costs into subsequent periods. In variable costing, inventory is valued only at variable production costs, and fixed overhead is expensed immediately, which can lead to differences in reported income between the two methods.

Income Statement Preparation

Preparing an income statement under different costing methods involves allocating manufacturing costs differently. Under absorption costing, the cost of goods sold includes both variable and fixed manufacturing overhead, whereas under variable costing the income statement treats fixed manufacturing overhead as a period cost. This fundamental difference leads to variations in reported operating income and is essential when comparing profitability between methods.

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