Chapter 19: Income Reporting

Here’s a step-by-step guide to preparing and analyzing income statements using absorption costing and variable costing based on IceAge Company’s data. The primary difference between these two costing methods is how fixed manufacturing overhead costs are treated, which impacts income differently depending on the relationship between units produced and units sold. 1. Income Statement Preparation Let's go through each scenario described: 1. When Units Produced Equal Units Sold (Year 1) 2. When Units Produced Exceed Units Sold (Year 2) 3. When Units Produced Are Less Than Units Sold (Year 3) Scenario 1: Units Produced Equal Units Sold (Year 1) Income Statement under Absorption Costing When units produced equal units sold, all costs (variable and fixed) allocated to production are expensed as cost of goods sold (COGS) under absorption costing. • • • • • Sales = (Sales Price per Unit) × (Units Sold) COGS = Total product cost per unit (under absorption costing) × Units Sold Gross Profit = Sales - COGS Operating Expenses = Selling and Administrative Costs Net Income = Gross Profit - Operating Expenses Income Statement under Variable Costing Under variable costing, only variable costs are included in the COGS. Fixed overhead is treated as a period cost and expensed immediately, regardless of the units sold. • • • • • Sales = (Sales Price per Unit) × (Units Sold) Variable COGS = Variable cost per unit × Units Sold Contribution Margin = Sales - Variable COGS Fixed Expenses = Fixed Manufacturing Overhead + Selling and Administrative Costs Net Income = Contribution Margin - Fixed Expenses Scenario 2: Units Produced Exceed Units Sold (Year 2) In Year 2, units produced exceed units sold, resulting in ending inventory and thus, some fixed manufacturing overhead is deferred to future periods under absorption costing. Income Statement under Absorption Costing • • • • • Sales = (Sales Price per Unit) × (Units Sold) COGS = Absorption Cost per Unit × Units Sold Gross Profit = Sales - COGS Operating Expenses = Selling and Administrative Costs Net Income = Gross Profit - Operating Expenses Income Statement under Variable Costing Since variable costing treats fixed manufacturing overhead as a period cost, all fixed overhead costs are expensed within the period. • • • • • Sales = (Sales Price per Unit) × (Units Sold) Variable COGS = Variable Cost per Unit × Units Sold Contribution Margin = Sales - Variable COGS Fixed Expenses = Fixed Manufacturing Overhead + Selling and Administrative Costs Net Income = Contribution Margin - Fixed Expenses Scenario 3: Units Produced Are Less Than Units Sold (Year 3) In Year 3, units produced are less than units sold, meaning IceAge sold all produced units and additional units from beginning inventory, which affects fixed overhead allocation under absorption costing. Income Statement under Absorption Costing Absorption costing will include fixed overhead from both current and prior periods as part of the COGS. Income Statement under Variable Costing Under variable costing, fixed manufacturing overhead costs are expensed in the current period only, resulting in potentially higher income since all fixed costs from the prior period were already accounted for. 2. Analysis of Income Differences Between Methods Absorption Costing vs. Variable Costing • • • Units Produced = Units Sold: Both costing methods yield the same income because all fixed overhead costs are expensed in the current period. Units Produced > Units Sold: Absorption costing shows higher income because some fixed overhead costs are deferred to inventory. Units Produced < Units Sold: Variable costing shows higher income because all fixed overhead costs were already expensed, avoiding additional current-period expenses. By tracking and analyzing these income differences, managers can better understand the effects of production volume on profitability under each costing method. The decision between absorption and variable costing depends on whether the goal is accurate financial reporting for external purposes (absorption costing) or internal decision-making support (variable costing).