Absorption costing shows lower income due to fixed overhead allocation in inventory, while variable costing highlights profitability per unit and gives higher income by expensing all fixed costs. Both serve different purposes.
Company:
Years: 1 & 2
Units:
Year Sales Production
1 1500 2100
2 1800 1500
Costs:
Cost Type Year 1 (Rs.) Year 2 (Rs.)
Variable Manufacturing 1050 750
Fixed Manufacturing (allocated) 500 (1050 / 2100 * 2100) 700 (1050 / 1500 * 1500)
Total Manufacturing Cost 1550 1450
Variable Marketing & Admin 1500 1800
Fixed Marketing & Admin 600 600
Total Marketing & Admin 2100 2400
Income Statement:
a. Absorption Costing:
Year Sales (Rs.) Cost of Goods Sold (Rs.) Gross Profit (Rs.) Operating Expenses (Rs.) Net Income (Rs.)
1 4500 (1550 * 1500) = 2325 2175 2100 75
2 5400 (1450 * 1800) = 2595 2805 2400 405
b. Variable Costing:
Year Sales (Rs.) Variable Cost of Goods Sold (Rs.) Contribution Margin (Rs.) Fixed Costs (Rs.) Net Income (Rs.)
1 4500 (1050 * 1500) = 1575 2925 3100 (175)
2 5400 (750 * 1800) = 1350 4050 3000 1050
Analysis:
Absorption costing: Shows higher cost of goods sold and lower gross profit compared to variable costing in both years. This results in lower net income.
Variable costing: Provides insight into the variable cost behavior and contribution margin, highlighting the profitability per unit sold. It also shows a higher net income in both years.
The choice between absorption and variable costing depends on the purpose of the income statement. Absorption costing is mandatory for external reporting, while variable costing is useful for internal decision-making and performance analysis.