Chapter 06 – Lecture Notes
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Chapter 6
Lecture Notes
Chapter theme: Two general approaches are used for valuing
inventories and cost of goods sold. One approach, called
absorption costing, is generally used for external reporting
purposes. The other approach, called variable costing, is
preferred by some managers for internal decision making and
must be used when an income statement is prepared in the
contribution format. This chapter shows how these two
methods differ from each other. It also explains how to create
segmented contribution format income statements.
I. Overview of variable and absorption costing
Learning Objective 1: Explain how variable costing differs
from absorption costing and compute unit product costs
under each method.
A. Variable costing treats only those costs of production that
vary with output as product costs. This approach dovetails
with the contribution approach income statement and
supports CVP analysis because of its emphasis on
separating variable and fixed costs.
i. The cost of a unit of product consists of direct
materials, direct labor, and variable overhead.
Helpful Hint: For simplicity, nearly all examples, exhibits,
problems, and exercises in this chapter treat direct labor as a
variable cost. However, students should be reminded that
labor is essentially a fixed cost in some companies. This is a
growing phenomenon as pointed out in earlier chapters.
Under variable costing, direct labor would not be included in
product costs when it is a fixed cost. This point is reinforced
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in the discussion on theory of constraints at the end of the
chapter.
ii. Fixed manufacturing overhead, and both variable and
fixed selling and administrative expenses are treated as
period costs and deducted from revenue as incurred.
Helpful Hint: Emphasize that the only difference between
variable and absorption costing is in how the two methods
treat fixed manufacturing overhead costs. Also, emphasize
that under both methods, selling and administrative costs are
period costs and are not product costs.
B. Absorption costing treats all costs of production as product
costs, regardless of whether they are variable or fixed. Since
no distinction is made between variable and fixed costs,
absorption costing is not well suited for CVP computations.
i. The cost of a unit of product consists of direct
materials, direct labor, and both variable and fixed
overhead.
ii. Variable and fixed selling and administrative expenses
are treated as period costs and are deducted from
revenue as incurred.
Quick Check – absorption vs. variable costing
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II. Harvey Company—an example
A. Unit cost computations
i. Assume Harvey Company produces a single product
with available information as shown.
ii. The unit product costs under absorption and variable
costing would be $16 and $10, respectively.
1. Under absorption costing, all production costs,
variable and fixed, are included when determining
unit product cost.
2. Under variable costing, only the variable
production costs are included in product costs.
Helpful Hint: Before beginning the forthcoming income
comparisons, remind students of the relationship between
ending inventory and net operating income. Higher ending
inventory results in higher net operating income since costs
of goods available for sale less ending inventory equals cost
of goods sold. Therefore, a higher ending inventory results in
a lower expense (cost of goods sold) deducted to arrive at net
operating income.
Learning Objective 2: Prepare income statements using both
variable and absorption costing.
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B. Income comparison of variable and absorption costing
i. Harvey Company—additional assumptions.
1. 20,000 units were sold during the year.
2. The selling price per unit is $30.
3. There is no beginning inventory.
ii. Variable costing
1. The unit product cost is $10.
2. All $150,000 of fixed manufacturing cost is
expensed in the current period.
3. The net operating income is $90,000.
iii. Absorption costing
1. The unit product cost is $16.
2. The fixed manufacturing overhead cost
deferred in inventory is $30,000 (5,000 units ×
$6 per unit).
3. The net operating income is $120,000.
Helpful Hint: Explain that under absorption costing, the
recognition of fixed costs as an expense is really a timing
issue. When the items are sold, the fixed costs will be
reflected on the income statement as part of cost of goods
sold.
Learning objective 3: Reconcile variable costing and
absorption costing net operating incomes and explain why
the two amounts differ.
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iv. Comparing the two methods
1. Under absorption costing, $120,000 of fixed
manufacturing overhead is included in cost of
goods sold and $30,000 is deferred in ending
inventory as an asset on the balance sheet.
2. Under variable costing, the entire $150,000 of
fixed manufacturing overhead is treated as a
period expense.
a. The variable costing ending inventory is
$30,000 less than absorption costing,
thus explaining the difference in net
operating income between the two
methods.
3. The difference in net operating income between
the two methods ($30,000) can also be reconciled
by multiplying the number of units in ending
inventory (5,000 units) by the fixed
manufacturing overhead per unit ($6) that is
deferred in ending inventory under absorption
costing.
C. Extended comparisons of income data
i. Harvey Company—additional assumptions/facts
1. 30,000 units were sold in year 2.
2. The selling price per unit, variable costs per unit,
total fixed costs, and number of units produced
remain unchanged.
3. 5,000 units are in beginning inventory.
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ii. Unit cost computations
1. Since the variable costs per unit, total fixed costs,
and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
iii. Variable costing
1. The unit product cost is $10.
2. All $150,000 of fixed manufacturing overhead
cost is expensed in the current period.
3. The net operating income is $260,000.
iv. Absorption costing
1. The unit product cost is $16.
2. The fixed manufacturing overhead cost
released from inventory is $30,000.
3. The net operating income is $230,000.
v. Comparing the two methods
1. The difference in net operating income between
the two methods ($30,000) can be reconciled by
multiplying the number of units in beginning
inventory (5,000 units) by the fixed
manufacturing overhead per unit ($6) that is
released from beginning inventory under
absorption costing.
2. Across the two-year time frame, both methods
reported the same total net operating income
($350,000). This is because over an extended
period of time sales cannot exceed production, nor
can production much exceed sales. The shorter the
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time period, the more the net operating income
figures will tend to differ.
D. Summary of key insights
i. When units produced equals units sold, the two
methods report the same net operating income.
ii. When units produced are greater than units sold, as
in year 1 for Harvey, absorption income is greater
than variable costing income.
iii. When units produced are less than units sold, as in
year 2 for Harvey, absorption costing income is less
than variable costing income.
III. Advantages of variable costing and the contribution approach
A. Enabling CVP analysis
i. Variable costing categorizes costs as fixed and variable
so it is much easier to use this income statement format
for CVP analysis.
ii. Absorption costing assigns per unit fixed manufacturing
overhead costs to production. This can potentially
produce positive net operating income even when
the number of units sold is less than the breakeven
point.
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B. Explaining changes in net operating income
i. Variable costing income is only affected by changes in
unit sales. It is not affected by the number of units
produced. As a general rule, when sales go up net
operating income goes up and vice versa.
ii. Absorption costing income is influenced by changes in
unit sales and units of production. Net operating
income can be increased simply by producing more
units even if those units are not sold.
C. Supporting decision making
i. Variable costing correctly identifies the additional
variable costs incurred to make one more unit. It
also emphasizes the impact of fixed costs on profits.
ii. Absorption costing gives the impression that fixed
manufacturing overhead is variable with respect to
the number of units produced, but it is not. This can
lead to inappropriate pricing decisions and product
discontinuation decisions.
IV. Segmented income statements and the contribution approach
Learning Objective 4: Prepare a segmented income
statement that differentiates traceable fixed costs from
common fixed costs and use it to make decisions.
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A. Key concepts/definitions
i. A segment is a part or activity of an organization
about which managers would like cost, revenue, or
profit data.
ii. Examples of segments include divisions of a
company, sales territories, individual stores, service
centers, manufacturing plants, marketing
departments, individual customers, and product
lines.
iii. There are two keys to building segmented income
statements.
1. First, a contribution format should be used
because it separates fixed from variable costs
and it enables the calculation of a contribution
margin.
a. The contribution margin is especially useful
in decisions involving temporary uses of
capacity such as special orders.
2. Second, traceable fixed costs should be separated
from common fixed costs to enable the
calculation of a segment margin. Further
clarification of these terms is as follows:
a. A traceable fixed cost of a segment is a
fixed cost that is incurred because of the
existence of the segment. If the segment
were eliminated, the fixed cost would
disappear. Examples of traceable fixed costs
include:
(1). The salary of the Fritos product
manager at PepsiCo is a traceable
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