Over the past year, a company’s inventory has increased significantly.

Sample Solution

The internal financial statements using variable costing will show the highest operating income. This is because absorption costing and variable costing treat fixed manufacturing overhead differently, leading to discrepancies in reported operating income.

Here's why:

Absorption Costing:

• Includes all manufacturing costs (both variable and fixed) in the cost of goods sold (COGS).
• This means that even if production decreases, the fixed overhead cost remains the same and gets allocated to the fewer units produced, inflating the cost per unit and subsequently reducing the operating income.

Full Answer Section

Variable Costing:

• Only includes variable manufacturing costs in COGS.
• Fixed manufacturing overhead is treated as a period cost and expensed in the same period it is incurred, regardless of production volume.
• This results in a more accurate reflection of the relationship between costs and volume, leading to higher operating income when production decreases.

In the scenario you described, with increased inventory, under absorption costing, the inflated cost per unit due to fixed overhead allocation will be applied to the larger inventory amount, further depressing the operating income. Variable costing, on the other hand, will only consider the variable costs associated with the increased inventory, leading to a higher operating income compared to absorption costing.

Therefore, the internal financial statements based on variable costing will show a more realistic picture of the company's performance in this situation, reflecting the impact of reduced production on unit costs and operating income.

Additional Points:

• The difference between absorption and variable costing will only affect operating income. Net income will remain the same under both methods as long as all costs are ultimately recognized.
• The choice of costing method for external financial reporting is governed by Generally Accepted Accounting Principles (GAAP), which often require absorption costing. Therefore, the company might still need to prepare absorption costing statements for external reporting purposes, even though they use variable costing internally.

I hope this explanation clarifies the difference between absorption and variable costing in this scenario. Feel free to ask if you have any further questions!