Variable Costing Income Statement Format and example with Advantages

The other main difference is that only the absorption method is in accordance with GAAP. So the selling price should be $ 655 per unit to earn the standard profit of 25 percent on cost. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . Production is estimated wave software to hold steady at 5,000 units per year, while sales estimates are projected to be 5,000 units in year 1; 4,000 units in year 2; and 6,000 in year 3. Take your learning and productivity to the next level with our Premium Templates. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.

1. Variable costing suggests a profit of $0.50, and the information appears to support a decision to make the sale.
2. The $10 per unit is then multiplied by 15,000, the number of units sold.
3. Raw materials are the direct goods purchased that are eventually turned into a final product.
4. It is commonly used in managerial accounting and for internal decision-making purposes.

Under absorption costing, the 2,000 units in ending inventory include the $1.20 per unit share, or $2,400 of fixed cost. That cost will be expensed when the inventory is sold and accounts for the difference in net income under absorption and variable costing, as shown in Figure 6.14. Variable costing provides managers with the information necessary to prepare a contribution margin income statement, which leads to more effective cost-volume-profit (CVP) analysis.

Arguments for Variable Costing in Managerial Decision Making

Sales were 15,000 units in each of the three variable costing and three absorption costing income statements just presented. It was the number of units produced that varied among the three pairs of statements. Variable costing18 requires that all variable production costs be included in inventory, and all fixed production costs (fixed manufacturing overhead) be reported as period costs. In the latter, companies allocate specific fixed costs to a product based on an activity level. However, variable costing ignores fixed costs when calculating those product costs. Nonetheless, they are crucial in determining profitability for a period.

Using these techniques falls under the managerial accounting process within a company. Usually, companies can utilize several https://www.wave-accounting.net/ costing methods for the best results. However, they can only use specific techniques during financial accounting.

Variable Versus Absorption Costing

Another way to view the impact of the inventory build-up is to examine the following “cups.” The top set of cups initially contains the costs incurred in the manufacturing process. With absorption costing, those cups must be emptied into either cost of goods sold or ending inventory. After deducting the fixed costs from the contribution margin, the variable costing income statement reaches the net income. This income is similar to that reported under a traditional income statement. However, the method to arrive at this income is different under both approaches. However, the net income is not the focus of the variable costing income statement.

The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead. Using absorption costing, fixed manufacturing overhead is reported as a product cost. Using variable costing, fixed manufacturing overhead is reported as a period cost. Figure 6.8 summarizes the similarities and differences between absorption costing and variable costing. Variable costing data are quite useful in avoiding incorrect decisions about product discontinuation. Some will usually be more successful than others, and a logical business decision may be to focus on the best-performing units, while discontinuing others.

What is the difference between the Traditional and Variable Costing Income Statement?

Both costing methods can be used by management to make manufacturing decisions. For internal accounting purposes, both can also be used to value work in progress and finished inventory. The overall difference between absorption costing and variable costing concerns how each accounts for fixed manufacturing overhead costs. The traditional income statement also considers fixed costs under absorption costing. However, the variable costing income statement considers fixed costs a period cost. These features are also why the variable costing income statement is not allowed under financial reporting.

1: Introduction to Variable Costing Analysis

The key point here is that variable costing information is useful, but it should not be the sole basis for decision making. Assume each unit is sold for $33 each, so sales are $330,000 for the year. If the entire finished goods inventory is sold, the income is the same for both the absorption and variable cost methods.

In any case, the variable direct costs and fixed direct costs are subtracted from revenue to arrive at the gross profit. Absorption vs. variable costing will only be a factor for companies that expense costs of goods sold (COGS) on their income statement. Although any company can use both methods for different reasons, public companies are required to use absorption costing due to their GAAP accounting obligations. Marginal cost refers to how much it costs to produce one additional unit. The marginal cost will take into account the total cost of production, including both fixed and variable costs.

A company may see an increase in gross profit after paying off a mortgage or finishing the depreciation schedule on a piece of manufacturing equipment. These are considerations cost accountants must closely manage when using absorption costing. Public companies are required to use the absorption costing method in cost accounting management for their COGS. Many private companies also use this method because it is GAAP-compliant whereas variable costing isn’t. Variable costing allows companies to understand how their activity levels impact their costs.

Use a different format for each (see above), however, all amounts will be the same on both statements with the exception of fixed manufacturing overhead. The difference between the methods is attributable to the fixed overhead. Therefore, the methods can be reconciled with each other, as shown in Figure 6.17. It can be, especially for management decision-making concerning break-even analysis to derive the number of product units needed to be sold to reach profitability.

But, remember that “gross profit” is not the same thing as “contribution margin,” and decision logic is often driven by consideration of contribution effects. Further, when inventory levels fluctuate, the periodic income will differ between the two methods. With absorption costing, gross profit is derived by subtracting cost of goods sold from sales.

Figure 6.13 shows the cost to produce the 8,000 units of inventory that became cost of goods sold and the 2,000 units that remain in ending inventory. The three variable costing income statements at the different levels of production were exactly the same, each yielding operating income of $100,000, as shown in the following comparative statements. Using the absorption costing method will increase COGS and thus decrease gross profit per unit produced. This means companies will have a higher breakeven price on production per unit. Furthermore, it means that companies will likely show a lower gross profit margin.