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
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.
i. The cost of a unit of product consists of direct
materials, direct labor, and variable overhead.
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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.
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
Quick Check – absorption vs. variable costing
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II. Harvey Company—an example
A. Unit cost computations
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.
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.
ii. Variable costing
1. The unit product cost is $10.
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.
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iv. Comparing the two methods
2. Under variable costing, the entire $150,000 of
fixed manufacturing overhead is treated as a
period expense.
3. The difference in net operating income between
the two methods ($30,000) can also be reconciled
C. Extended comparisons of income data
i. Harvey Company—additional assumptions/facts
1. 30,000 units were sold in year 2.
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ii. Unit cost computations
1. Since the variable costs per unit, total fixed costs,
1. The unit product cost is $10.
3. The net operating income is $260,000.
iv. Absorption costing
1. The unit product cost is $16.
v. Comparing the two methods
1. The difference in net operating income between
the two methods ($30,000) can be reconciled by
2. Across the two-year time frame, both methods
reported the same total net operating income
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time period, the more the net operating income
figures will tend to differ.
D. Summary of key insights
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
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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.
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.
D. Adapting to the Theory of Constraints
i. Companies involved in TOC use a form of variable
costing. However, one difference of the TOC
approach is that it treats direct labor as a fixed cost
for three reasons:
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2. Direct labor is not usually the constraint;
therefore, there is no reason to increase the
number of direct laborers.
IV. Segmented income statements and the contribution approach
A. Learning Objective 4: Prepare a segmented income
statement that differentiates traceable fixed costs from
common fixed costs and use it to make decisions.
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.
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ii. 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.
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:
(1). The salary of the Fritos product
manager at PepsiCo is a traceable
fixed cost of the Fritos business
segment of PepsiCo.
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(1). The salary of the CEO of General
Motors is a common fixed cost of the
c. It is important to realize that the traceable
fixed costs of one segment may be a
common fixed cost of another segment.
For example:
(1). The landing fee paid to land an
d. A segment margin is computed by
subtracting the traceable fixed costs of a
segment from its contribution margin.
(1). The segment margin is a valuable tool
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margin as a guide to long-run
segment profitability.
Helpful Hint: Explain that a segment should not
B. Segmented income statements – an example
i. Assume that Webber, Inc. has two divisions – the
Computer Division and the Television Division.
1. The contribution format income statement for
the Television Division is as shown. Notice:
separate sections.
c. Contribution margin is computed by
taking sales minus variable costs.
overall company profits.
2. The Television Division’s results can be rolled
into Webber, Inc.’s overall results as shown.
Notice:
a. The results of the Television and Computer
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3. The Television Division’s results can also be
broken down into smaller segments. This enables
us to see how traceable fixed costs of the
Television Division can become common costs
of smaller segments.
c. Of the $90,000 of fixed costs that were
previously traceable to the Television
Division, $80,000 ($45,000 + $35,000) is
traceable to the two product lines and
$10,000 is a common cost.
4. The Television Division’s results can also be used
for decision making. For example, assume
Webber believes that if the Television Division
spends $5,000 additional dollars on advertising it
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IV. Segmented income statements—common mistakes
A. Omission of costs
i. The costs assigned to a segment should include all
the costs attributable to that segment from the
company’s entire value chain as discussed in Chapter
1.
1. Since only manufacturing costs are included in
product costs under absorption costing, those
a. “Upstream” costs include research and
development and product design costs.
b. “Downstream” costs include marketing,
distribution, and customer service costs.
Helpful Hint: An example of a company with a very high
amount of upstream and downstream costs is a
pharmaceutical company such as Merck. A great deal of its
costs are comprised of research and development and
marketing.
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B. Inappropriate methods for assigning traceable costs to
segments
i. Failure to trace costs directly
1. Costs that can be traced directly to specific
segments of a company should not be allocated
to other segments. Rather, such costs should be
charged directly to the responsible segment. For
example:
ii. Inappropriate allocation base
1. Some companies allocate costs to segments using
arbitrary bases. Costs should be allocated to
segments for internal decision making purposes
C. Arbitrarily dividing common costs among segments
i. Common costs should not be arbitrarily allocated
to segments based on the rationale that “someone
has to cover the common costs” for two reasons:
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Quick Check – common costs
V. Income statements—an external reporting perspective
A. Companywide income statements
i. Practically speaking, absorption costing is
ii. Probably because of the cost of maintaining two
separate costing systems, most companies use
absorption costing for their external and internal
reports.
iii. With all of the advantages of the contribution
1. Advocates of absorption costing argue that it
better matches costs with revenues. They
contend that fixed manufacturing costs are just as
essential to manufacturing products as are the
variable costs.
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B. Segmented financial information
i. U.S. GAAP and IFRS require publicly-traded
companies to include segmented financial data in
their annual reports. These rulings have implications
for internal segment reporting because:
1. They mandate that companies must prepare