Industries manufactures and sells a single product.

The controller has prepared the following income

statement for the most recent year:
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The company produced
9 comma 0009,000
units and sold
8 comma 0008,000
units during the year ending December 31. Fixed manufacturing overhead (MOH) for the year was
$ 162 comma 000$162,000,
while fixed operating expenses were
$ 57 comma 000$57,000.
The company had no beginning inventory.
Requirements
1. Will the company's operating income under variable costing
be higher, lower, or the same as its operating income under
absorption costing? Why?
2. Project the company's operating income under variable
costing without preparing a variable costing income
statement.
3. Prepare a variable costing income statement for the year.
Requirement 1. Will the company's operating income under variable costing be higher, lower, or the
same as its operating income under absorption costing? Why?
In this problem, the company manufactures
9 comma 0009,000
units and sells
8 comma 0008,000
of those units, resulting in a change of
1 comma 0001,000
units. Since the number of units produced is greater than the number of units sold, the inventory level has
increased. When inventory levels increase, operating income will be greater under absorption costing
than it is under variable costing. This scenario typically occurs at traditional manufacturers during times of
economic growth. In this situation, all fixed MOH incurred during the period is expensed as a period cost
under variable costing. However, under absorption costing, some of the fixed MOH remains "trapped" on
the balance sheet, as part of the cost of inventory. As a result, more cost is expensed under variable
costing than under absorption costing, leading to a higher operating income under absorption costing.
Requirement 2. Project the company's operating income under variable costing without preparing a
variable costing income statement.
For manufacturers, the absorption and variable costing systems will yield different results for operating
income when inventory levels increase or decline. The variable costing operating income for a given year
can be predicted without preparing a variable costing income statement by taking that year's absorption
costing operating income and adding or subtracting the difference in operating income as calculated
using the following formula:
Change in inventory level in
x Fixed MOH per unit = Difference in operating income
units
Let's begin by calculating the difference in operating income each year.
Recall that in the first year, the company manufactures
9 comma 0009,000
units and sells
8 comma 0008,000
of those units, resulting in a change of
1 comma 0001,000
units. Since the inventory level has grown, we can expect operating income under absorption costing to
be greater than it is under variable costing.
Calculate the
fixed MOH per unit
and then determine the difference in operating income now.
Change in inventory level in Difference in operating
x Fixed MOH per unit =
units income
1,000 x $18 = $18,000
Now predict
WatsonWatson's
projected operating income (loss) under variable costing by subtracting the difference in operating income
from the absorption costing operating income. Note that the income statement provided in the problem
statement shows an operating income of
$ 22 comma 000$22,000.
(Use a minus sign or parentheses for a loss.)
Projected operating
Operating income Difference in
income
(loss) under variable
under absorption costing +/- operating income =
costing
$22,000 - $18,000 = $4,000
Requirement 3. Prepare a variable costing income statement for the year.
To provide managers with cost behavior information, companies often prepare contribution margin
income statements for internal use. Contribution margin income statements use variable (or direct
costing)
in which only variable manufacturing costs are treated as product costs. Costs are organized by behavior,
rather than by function. Therefore, managers generally find contribution margin income statements more
helpful for planning and decision making than traditional income statements. Since GAAP and the IRS
require absorption costing for external reporting, variable costing may only be used for internal
management purposes.
The first step in preparing the contribution margin income statement is to deduct all variable expenses
from sales revenue, to arrive at the company's
contribution margin.
Next, all fixed expenses (including fixed MOH) are deducted from the contribution margin to arrive at
operating income. Let's begin by selecting the labels for the contribution margin income statement.

Watson Industries
Contribution Margin Income Statement (Variable Costing)
For the Year Ended December 31
Sales revenue
Less: Variable expenses
Variable cost of goods sold
Variable operating expenses
Contribution margin
Less: Fixed expenses
 Fixed manufacturing overhead
Fixed operating expenses
Operating income
The first line of the variable costing income statement, sales revenue, will be the same under variable
costing as for absorption costing. Next let's calculate the variable expenses, beginning with variable cost
of goods sold.
Since variable costing assigns only variable manufacturing costs to products (fixed manufacturing costs
are treated as period costs and expensed in the period in which they are incurred), we need to multiply
the total variable costs per unit by the number of units sold during the year to calculate the cost of goods
sold under variable costing. We can use the absorption costing income statement to determine what the
variable costs per unit are, since this information is not directly given to us in the problem statement.
Absorption costing includes variable costs and fixed manufacturing overhead in the calculation of the cost
of goods sold. Let's calculate the cost of goods sold per unit under absorption costing.
Absorption cost of goods
/ # of units sold = Absorption cost of goods sold per unit
sold
$360,000 / 8,000 = $45.00
Since we know the cost of goods sold per unit under absorption costing and we previously solved for the
fixed MOH per unit, we can solve for the variable cost of goods sold per unit. Calculate this amount now.
Absorption cost of goods sold Variable cost of goods sold per
- Fixed MOH per unit =
per unit unit
$45 - $18 = $27
Now we can multiply the variable cost of goods sold per unit by the number of units sold to determine the
variable cost of goods sold.
Variable cost of goods sold per Variable cost of goods
x # of units sold =
unit sold
$27 x 8,000 = $216,000
Next let's discuss the variable operating expenses. Of the
$ 66 comma 000$66,000
in operating expenses on the absorption costing income statement, this includes both variable and fixed
operating expenses. Remember that when preparing the contribution margin income statement we
deduct all variable expenses from sales revenue, to arrive at the company's contribution margin, and then
deduct all fixed expenses (including fixed MOH) from the contribution margin to arrive at operating
income. Since we know the amount of the fixed operating expenses, we can back this amount out from
the
$ 66 comma 000$66,000
in operating expenses on the absorption costing income statement to get to the variable operating
expenses.

Total operating expenses - Fixed operating expenses = Variable operating expenses

$66,000 - $57,000 = $9,000
Finally, finish the income statement under variable costing. The fixed (MOH) and the fixed operating
expenses for the year are provided to us in the data given. (Use a minus sign or parentheses for a loss.)

Watson Industries
Contribution Margin Income Statement (Variable Costing)
 For the Year Ended December 31
Sales revenue $448,000
Less: Variable expenses
Variable cost of goods sold 216,000
Variable operating expenses 9,000
Contribution margin 223,000
Less: Fixed expenses
Fixed manufacturing overhead 162,000
Fixed operating expenses 57,000
Operating income (loss) $4,000
Reviewing the contribution margin income statement, we can see that the actual operating income (loss)
using variable costing of
$ 4 comma 000$4,000,
is equal to the projected income (loss) that we made in requirement (2).
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The annual data that follows pertain to

ShadyShady,
a manufacturer of swimming goggles (the company had no beginning inventory):
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Requirements
1. Prepare both conventional (absorption costing) and contribution margin (variable costing) income statements for
ShadyShady
for the year.
2. Which statement shows the higher operating income? Why?
3. The company marketing vice president believes a new sales promotion that costs
$ 140 comma 000$140,000
would increase sales to
215 comma 000215,000
goggles. Should the company go ahead with the promotion? Give your reason.
In order to determine which method of costing is better for
ShadyShady,
we will need to prepare two different income statements. They are the conventional (absorption costing)
income statement and the contribution margin (variable costing) income statement. The absorption
costing income statement groups costs by function: manufacturing costs or nonmanufacturing costs. We
subtract manufacturing costs of goods sold before gross profit, whereas we subtract all nonmanufacturing
costs (operating expenses) after gross profit. In contrast, the contribution margin income statement
subtracts all variable costs (both manufacturing and nonmanufacturing) to obtain contribution margin.
Requirement 1. Prepare both conventional (absorption costing) and contribution margin (variable
costing) income statements for
ShadyShady
for the year. Begin with the conventional (absorption costing) income statement.
Start by selecting the labels.

Shady
Income Statement (Absorption Costing)
For the Year Ended December 31
Sales revenue
Less: Cost of goods sold
Gross profit
Less: Operating expenses
Operating income
Next let's calculate sales revenue. Recall that the number of units sold and the sales price per unit have
been given to us in the information.

Shady
Income Statement (Absorption Costing)
For the Year Ended December 31
Sales revenue $9,200,000
The next part of the statement involves the calculation of the total cost of goods sold. Absorption costing
includes fixed manufacturing overhead in the calculation of the cost of goods sold. We first need to
determine the fixed manufacturing costs per unit in order to calculate cost of goods sold. To determine
the
fixed manufacturing costs per unit,
simply divide the fixed manufacturing overhead (MOH) in total for the year by the number of goggles
produced. You are now ready to calculate the cost of goods sold.

Total variable Fixed manufacturing Number of

( cost per unit + costs per unit )x goggles sold = Cost of goods sold
( $19 + $9 )x 200,000 = $5,600,000
Now calculate the gross profit.

Shady
Income Statement (Absorption Costing)
For the Year Ended December 31
Sales revenue $9,200,000
Less: Cost of goods sold 5,600,000
Gross profit 3,600,000
Before we complete the statement, let's compute the total operating expenses (Total op. exp.). Use the
following formula.
Goggles sold Sales commission per Fixed operating
( x ) + = Total op. exp
(units) unit expenses
( 200,000 x $9 ) + $240,000 = $2,040,000
Complete the rest of the conventional income statement.

Shady
Income Statement (Absorption Costing)
For the Year Ended December 31
Sales revenue $9,200,000
Less: Cost of goods sold 5,600,000
Gross profit 3,600,000
Less: Operating expenses 2,040,000
Operating income $1,560,000
To provide managers with cost behavior information, companies prepare contribution margin income
statements. Contribution margin income statements organize costs by behavior, rather than by function.
Therefore, managers find contribution margin income statements more helpful for planning and decision
making than traditional income statements. The contribution margin income statement presents all
variable costsminus−whether
relating to the merchandise sold or selling and administrative
activitiesminus−above
the contribution margin line. The contribution margin income statement shows all
fixed costsminus−whether
relating to the merchandise sold or selling and administrative
activitiesminus−below
the
contribution margin
line. Thus, contribution margin income statements separate costs according to behavior, rather than
function. The contribution margin, rather than the gross profit, is the dividing line.
Now let's prepare the contribution margin (variable costing) income statement for
ShadyShady
for the year. Think carefully about which costs are variable (dependent on the amount of sales) and which
are fixed. Start with the labels.

Shady
Contribution Margin (Variable Costing) Income
Statement
For the Year Ended December 31
Sales revenue
Less: Variable expenses
Variable cost of goods sold
Variable operating expenses
Contribution margin
Less: Fixed expenses
Fixed manufacturing overhead
 Fixed operating expenses
Operating income
Next let's calculate the variable cost of goods sold and variable operating expenses.
Variable costing assigns only variable manufacturing costs to products. Variable costing treats fixed
manufacturing costs as period costs (so they are expensed in the period in which they are incurred). Use
the variable manufacturing costs per unit manufactured given in the problem to compute the variable cost
of goods sold.
Total variable costs per Variable cost of goods
x Number of goggles sold =
unit sold
$19 x 200,000 = $3,800,000
Now calculate the variable operating expense for the year. The sales commission expense is a variable
operating expense. Calculate this amount now.

Goggles sold (units) x Sales commission per unit = Variable op. exp
200,000 x $9 = $1,800,000
Next calculate the total variable expenses and the contribution margin.

Shady
Contribution Margin (Variable Costing) Income
Statement
For the Year Ended December 31
Sales revenue $9,200,000
Less: Variable expenses
Variable cost of goods sold $3,800,000
Variable operating expenses 1,800,000
Contribution margin 3,600,000
In order to figure out the fixed expenses, all we need to do is look at the popup table provided for this
information. Complete the rest of the contribution margin income statement.

Shady
Contribution Margin (Variable Costing) Income
Statement
For the Year Ended December 31
Sales revenue $9,200,000
Less: Variable expenses
Variable cost of goods sold $3,800,000
Variable operating expenses 1,800,000
Contribution margin 3,600,000
Less: Fixed expenses
 Fixed manufacturing overhead 1,935,000
Fixed operating expenses 240,000
Operating income $1,425,000
Requirement 2. Which statement shows the higher operating income? Why?
Review the income statements above to determine which income statement method produces the higher
operating income. Why is that? Review the statements and think carefully about which statement
expensed more during the period and why.
Managers can use contribution margin income statements to predict how changes in volume will affect
operating income. Changes in volume will affect total sales revenue and total variable costs (and,
therefore, the contribution margin). However, changes in volume will not affect fixed costs within the same
relevant range. Therefore, the contribution margin income statement distinguishes the financial figures
that will change from those that will not change in response to fluctuations in volume. Traditional income
statements do not make this distinction.
Requirement 3.
ShadyShady's
marketing vice president believes a new sales promotion that costs
$ 140 comma 000$140,000
would increase sales to
215 comma 000215,000
goggles. Should the company go ahead with the promotion? Give your reason.
Use the contribution margin income statement format to evaluate the sales promotion. To calculate the
increase in the contribution margin, multiply the contribution margin per unit sold (based on the total
contribution margin you calculated above and the total units sold) by the increase in number of units to be
sold
(215 comma 000215,000
goggles under the new promotion less
200 comma 000200,000
goggles as sold prior to the promotion).

Increase in contribution margin $270,000

Increase in fixed expenses 140,000
Increase in operating income $130,000
If a company expects a promotion to bring in additional operating income, then management would want
to go ahead with the sales promotion. If the promotion was expected to reduce operating income,
managers would not want to go ahead with the promotion.
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