Income statements of manufacturing firms prepared for external purposes use full costing (also called absorption costing).In full costing, inventory costs include direct material, direct labor, and all manufacturing overhead.In variable costing, only variable production costs are included in inventory costs. All fixed production costs are treated as period costs and expensed in the period incurred.Selling price per unit$2,000Variable production costs per unit: Direct material $600 Direct labor 225 Variable overhead 75 900Variable selling expense per unit 40Contribution margin per unit$1,060FULL (ABSORPTION) AND VARIABLE COSTING

Fixed manufacturing overhead per year $1,200,000Fixed selling expense $100,000Fixed administrative expense $500,000There is no beginning inventory of finished goods, 5,000 units are produced, and 5,000 units are sold.Full CostingSales ($2,000 X 5,000 units) $10,000,000Cost of goods sold ($1,140 X 5,000 units) 5,700,000Gross margin 4,300,000Less selling and administrative expense: Selling expense$ 300,000 Administrative expense 500,000 800,000Net income $ 3,500,000Notes: Units produced and both equal 5,000 selling expense = $100,000 + ($40 X 5,000 units)ClausenTubeIncome StatementFor the Year Ended December 31, 2006

Variable CostingSales ($2,000 X 5,000 units) $10,000,000Less variable costs: Variable cost of goods sold ($900 X 5,000 units)$4,500,000 Variable selling costs ($40 X 5,000) 200,000 4,700,000Contribution margin 5,300,000Less fixed costs: Fixed production costs 1,200,000 Fixed selling costs 100,000 Fixed administrative costs 500,000 1,800,000Net income $3,500,000Note: Units produced and sold both equal 5,000.Thus, the only difference between the two methods in this situation is that variable costing breaks out total costs into both fixed and variable costs and provides a contribution margin. That, however, is not a trivial difference since the contribution margin can be very helpful in planning and decision making.

In this case, income will be greater using full costing as opposed to variable costing. Lets see why this is the case.ClausenTube increased production to 6,000 units but only sold 4,800 due to a weakening economy.QUANTITY PRODUCED IS GREATER THAN QUANTITY SOLDFull CostingSales ($2,000 X 4,800 units) $9,600,000Cost of goods sold ($1,110 X 4,800 units) 5,280,000Gross margin 4,320,000Less selling and administrative expense: Selling expense$ 292,000 Administrative expense 500,000 792,000Net income $3,528,000Notes: 6,000 units produced and 4,800 units sold Selling expense = $100,000 + ($40 X 4,800 units).ClausenTubeIncome StatementsFor the Year Ended December 31, 2007

Variable CostingSales ($2,000 X 4,800 units) $9,600,000Less variable costs: Variable cost of goods sold ($900 X 4,800 units)$4,320,000 Variable selling costs ($40 X 4,800) 192,000 4,512,000Contribution margin 5,088,000Less fixed costs: Fixed production costs 1,200,000 Fixed selling costs 100,000 Fixed administrative costs 500,000 1,800,000Net income $3,288,000Note: 6,000 units produced and 4,800 units sold.

Full Costing Inventory valueCost Per UnitDirect material per unit $ 600Direct labor per unit 225Variable manufacturing overhead 75Fixed manufacturing overhead ($1,200,000 6,000 units) 200 Total $1,100Ending Inventory Value ($1,100 X 1,200 units)$1,320,000Variable Costing Inventory ValueCost Per UnitDirect material per unit $ 600Direct labor per unit225Variable manufacturing overhead 75 Total $ 900Ending Inventory Value ($900 X 1,200 units)$1,080,000Difference of $240,000 due to $200 per unit of fixed manufacturing overhead in ending inventory under full costing ($200 X 1,200 units = $240,000)

When the beginning inventory is charged to cost of goods sold, the charge will be higher under full costing. The result income is lower under full costing when the quantity produced is less than the quantity sold.QUANTITY PRODUCED IS LESS THAN QUANTITY SOLDManagers simply cant estimate accurately the impact of changes in volume on cost and profit unless they know which costs are fixed and which costs are variable.Another reason why variable costing may be preferred for internal purposes is that it does not allow managers to artificially inflate profit by producing more units than they can sell.BENEFITS OF VARIABLE COSTING FOR INTERNAL REPORTING

Explain the difference between full (absorption) and variable costing. In full costing, product cost includes direct material, direct labor, and variable and fixed manufacturing overhead. In variable costing, fixed manufacturing overhead is not included in product cost. Rather, it is treated as a period expense.Discuss the effect of production on full and variable costing income. If the quantity produced equals the quantity sold, there is no difference in income. If the quantity produced exceeds the quantity sold, full costing income is higher than variable costing income. If the quantity produced is less than the quantity sold, full costing income is less than variable costing income.