Chapter 10 :

SEGMENTED
REPORTING
Variable Costing
vs
Absorption Costing

LO 2

What are 2 ways to calculate income &

how do they differ?

Profit centers are evaluated based on

income statements. However, the overall
income statement for the company would
be of little use for this purpose. Instead, it is
important to develop a segmented income
statement for each profit center.

2 ways to calculate income are by absorption costing

& variable costing.

They differ in the treatment of fixed factory overhead.

Variable costing ( direct

costing)

Variable costing stresses the difference between

fixed and variable manufacturing costs.
Variable
costing
assigns
only
variable
manufacturing costs to the product; these costs
include direct materials, direct labor, and variable
overhead.
Fixed overhead is treated as a period expense and is
excluded from the product cost.
Variable costing is also known as direct costing.
However, not all variable manufacturing costs are
direct product costs. For example, variable
overhead, by definition, is indirect.

Absorption costing
Absorption costing assigns all
manufacturing costs to the product. Direct
materials, direct labor, variable overhead, and
fixed overhead define the cost of a product.
Thus, under absorption costing, fixed overhead is
viewed as a product cost, not a period cost.
Under this method, fixed overhead is assigned to
the product through the use of a predetermined
fixed overhead rate and is not expensed until the
product is sold. In other words, fixed overhead is
an inventoriable cost.

Generally
accepted
accounting
principles
(GAAP) require absorption costing for external
reporting. The Financial Accounting Standards
Board (FASB), the Internal Revenue Service
(IRS), and other regulatory bodies do not accept
variable costing as a product-costing method for
external reporting. Yet, variable costing can
supply vital cost information for decision making
and control, information not supplied by
absorption costing. For internal application,
variable costing is an invaluable managerial tool

LO 2

INVENTORY
INVENTORY VALUATION:
VALUATION:
Background
Background

Units in beginning inventory

Units produced
Units sold ($300 per unit)
Variable costs per unit

10,000
8,000

Direct materials

$ 50

Direct labor
Variable overhead

100
50

Fixed costs
Fixed overhead per unit produced

25

Fixed selling & administrative

100,000

Income Statements Using

Variable and Absorption Costing
Because unit product costs are the basis for
cost of goods sold, the variable- and
absorption-costing methods can lead to
different operating income figures. The
difference arises because of the amount of
fixed overhead recognized as an expense
under the two methods.
Next slide is showing the calculation, and
income statement of Fairchild Company,
using variable costing and absorption
costing

LO 2

ABSORPTION COSTING
Direct materials
Direct labor
Variable overhead
Fixed overhead per unit produced
Unit product cost

50
100
50
25
$ 225

Value of ending inventory =

2,000 x $ 225 = $ 450,000

LO 2

VARIABLE COSTING
Direct materials
Direct labor
Variable overhead
Unit product cost

50
100
50
$ 200

Value of ending inventory =

2,000 x $ 200 = $ 400,000

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LO 2

ABSORPTION INCOME
STATEMENT
Sales ($300 x 8,000)
Less Cost of goods sold
Gross margin
Less S&A expenses
Operating income

$ 2,400000
1,800,000
$ 600,000
100,000
$ 500,000

CGS =
8,000 x $ 225 = $ 1,800,000

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LO 2

VARIABLE INCOME STATEMENT

Sales
Less variable expenses
Contribution margin
Less fixed costs
Operating income

2,400,000
1,600,000
800,000
350,000
$

450,000

Variable costs: 8,000 x $200

Fixes costs: $250,000 + 100,000

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LO 2

ABSORPTION VS. VARIABLE

If more is sold than produced,
variable costing income >
absorption-costing income, opposite
of Fairchild situation. Equal
production & sales means equal
income.

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LO 2

EXPLANATION
The difference between variable
costing & absorption costing year to
year is equal to the change in fixed
overhead. Under absorption costing,
fixed overhead is assigned to
inventory produced. Under variable
costing, fixed overhead is a period
expense .

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LO 2

How do variable & absorption costing

affect performance evaluation?

Variable costing ensures that direct relationship

between sales & income holds whereas absorption
costing does not.

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