1). Income statement using absorption costing method: - Revenues: $100 * 35,000 cost of goods sold: Direct Materials ($75 * 35,000) Direct Labor costs ($50 * 35,000) Variable manufacturing overheads ($20 *35,000) Fixed Manufacturing overhead ($7.5 *35,000) cost of goods sold Gross margin operating costs: Variable selling expenses ($15*35,000) Fixed selling and administrative expenses Total operating costs operating income $3,500,000 $2,625,000 $1,750,000 $700,000 262500 $5,337,500 -$1,837,500 $525,000 $200,000 $725,000 -$2,562,500 Calculation of Fixed Manufacturing overhead applied: Fixed Manufacturing overhead cost per unit = Total Fixed Manufacturing overhead cost / total units produced = $300,000 / 40,000 =$7.5 per unit Fixed Manufacturing overhead applied = unit sold × cost per unit = 35,000 × $7.5 = $262,500 Total unit product cost = Direct Materials + Direct Materials + Variable manufacturing overheads + Fixed Manufacturing overhead Total unit product cost = $75 +$50 +$20 +$7.5 = $152.5 2). Income statement using variable costing method: - Revenues: $100 * 35,000 variable costs: Direct Materials ($75 * 35,000) $3,500,000 $2,625,000 Direct Labor costs ($50 * 35,000) Variable manufacturing overheads ($20 *35,000) Variable selling expenses ($15*35,000) Total variable costs contribution margin Fixed costs: Fixed Manufacturing overhead Fixed selling and administrative expenses Total fixed costs operating income $1,750,000 $700,000 $525,000 $5,600,000 -$2,100,000 $300,000 $200,000 $500,000 -$2,600,000 Total unit product cost = Direct Materials + Direct Materials + Variable manufacturing overheads Total unit product cost = $75 +$50 +$20 = $145 3.) The ending inventory under variable costing = 5,000 × $145 = $725,000 The ending inventory under absorption costing = 5,000 × $152.5 = $762,500 Difference = $37,500 ($762,500 - $725,000) OR (5000 × $7.5) The reason behind the difference between the ending inventory balances using absorption costing and variable costing is that, in absorption costing fixed manufacturing overhead is treated as product cost and in variable costing it is treated as a non- product cost. Therefore, in absorption costing only the portion corresponding to the units sold is treated as cost and the balance goes to the ending inventory, but in the case of variable costing the whole fixed manufacturing overhead is treated as cost in the current period and no fixed manufacturing overhead goes to the ending inventory. This creates a difference in the ending inventories calculated under the two methods. The fixed manufacturing overhead cost is fully included in variable costing and partially in absorption costing. This makes the cost in current period higher in variable costing than absorption costing. Therefore, the operating income calculated using absorption will be higher than that of calculated using variable costing in the current period.