"A company prepares variable costing income statement for the use of internal management andabsorption costing income statement for the use of external parties like creditors, banks, tax authoritiesetc.The company manufactures a product that is sold for $80. The variable and fixed cost data is givenbelow:Direct materials: $30.00Direct labor:$19.00Factory over head:Variable cost: $6.00Fixed cost ($45,000 / 9000 units): $5.00Marketing, general and administrative:Variable cost (per unit sold): $4.00Fixed cost (per month): $28,000 During the month of June, 9,000 units were produced and 7,500 units were sold. The opening inventorywas 2,000 units.Required: (1) Prepare two income statements, one using variable costing method and one using absorptioncosting method.(2) Explain the difference in net operating income (if any) under two approachesSolution:(1)(A) Absorption costing: Units* rate per Amount AmountParticulars unit ($) ($)(a) Sales (7500*$80) 600,000(b) Cost of goods sold: Opening Inventory (2000*$60) 120,000Add : Production cost (9000*$60) 540,000Less : Closing inventory (**3500*$60) -210,000Net cost of goods sold 450,000( c) Gross Profit (a-b) 150,000 (d) Administrative and marketing expenses:Variable cost (7500*$4) 30,000Fixed Cost 28,000 total admin and marketing cost 58,000Net Operating Income (c-d) 92,000 (B) Variable costing: (Units*rate per Amount AmountParticulars unit) ($) ($)(a) Sales (7500*$80) 600,000(b) Variable cost: Opening Inventory (2000*$55) 110,000Add : Production cost (9000*$55) 495,000Less : Closing inventory (**3500*$55) -192,500Variable net production cost 412,500 Variable marketing and admin. Expenses 30,000 total variable cost (b) 442,500(c )Contribution (a-b) 157,500(d) Fixed Cost Manufacturing overhead 45,000 Marketing and admin. overhead 28,000 total fixed cost (d ) 73,000Net Operating Income (c-d) 84,500 AmountReconciliation: ($)Net operating income as per variable costing 84,500Deferred fixed manufacturing overhead cost in inventory (1500*$5) 7,500Net operating income as per absorption costing 92,000 Particulars UnitsOpening inventory 2000Produced during the period 9000Units sold during the period -7500Closing inventory 3500 (2)If we observe the net operating income under absorption costing is $7,500 ($92,000 – $84,500)higher than the net operating income under variable costing. This difference is because of fixedmanufacturing overhead that becomes the part of ending inventory under absorption costingsystem. The ending inventory absorbs a portion of fixed manufacturing overhead and reducesthe burden of the current period. In this way a portion of fixed cost that relates to the currentperiod is transferred to the next period.Under variable costing, the fixed manufacturing overhead cost is not included in the productcost but charged to the income statement of the relevant period in its entirety. Therefore, noportion of fixed cost is absorbed by the ending inventory.In our example, the net operating income is higher under absorption costing than variablecosting because closing inventory is higher than the opening inventory. "