Source: Chapter 6, Exercises 6-1 through 6-9, 6-16, Problems 6-19, 6-21, 6-23, 6-24, 6-25, 6-26
Tags: variable costing, absorption costing, fixed manufacturing overhead, product costs, period costs, contribution format, segmented income statement, segment margin, traceable fixed costs, common fixed costs, reconciliation
Difficulty: Intermediate | Prerequisites: Chapter 2 cost classifications, Chapter 5 CVP and contribution margin concepts.
Chapter 6 tackles one of the most exam-tested distinctions in managerial accounting: the difference between variable costing and absorption costing. The two methods treat fixed manufacturing overhead differently, which means they produce different unit product costs, different inventory valuations, and different net operating income figures when production and sales volumes diverge. This chapter also introduces segmented income statements, which break a company's results down by division, product line, or territory so managers can see where value is created and where it leaks. You need the contribution format income statement from Chapter 5 to follow this material.
Under variable costing, only variable manufacturing costs go into the product cost; fixed manufacturing overhead is expensed in full each period. Under absorption costing, fixed manufacturing overhead is also included in the product cost and sits in inventory until units are sold. When production exceeds sales, absorption costing reports higher income (because some fixed overhead is deferred in inventory). Segmented income statements use the contribution format and distinguish between traceable and common fixed costs to measure segment performance.
Absorption costing (full costing)
A costing method that includes all manufacturing costs (direct materials, direct labour, variable manufacturing overhead, and fixed manufacturing overhead) in the unit product cost. This is required under GAAP for external reporting. Think of it as: every cost of making the product, variable or fixed, goes into inventory.
Variable costing (direct costing / marginal costing)
A costing method that includes only variable manufacturing costs (direct materials, direct labour, variable manufacturing overhead) in the unit product cost. Fixed manufacturing overhead is treated as a period expense. Think of it as: only costs that change with production volume go into the product.
Fixed manufacturing overhead (fixed MOH)
Manufacturing costs that do not change with the level of production (e.g. factory rent, depreciation on equipment, plant manager salary). The treatment of this cost is the sole difference between variable and absorption costing.
Period costs
Costs expensed in the period incurred rather than attached to units produced. Under variable costing, fixed manufacturing overhead is a period cost. Selling and administrative expenses are period costs under both methods.
Product costs
Costs attached to units of product and recognised as expense (cost of goods sold) only when those units are sold. Variable costing has a narrower definition of product costs than absorption costing.
Segmented income statement
A contribution format income statement that reports results for segments (divisions, product lines, territories, etc.) as well as the company as a whole.
Segment margin
Contribution margin minus traceable fixed expenses for a segment. This is the best measure of a segment's long-run profitability.
Traceable fixed costs
Fixed costs that exist because a particular segment exists and would disappear if the segment were eliminated. In simple terms, these are the fixed costs a segment "causes."
Common fixed costs
Fixed costs that support the operations of more than one segment and would not disappear if any single segment were eliminated. These should not be allocated to segments for performance evaluation.
Reconciliation of variable and absorption costing income
The difference in net operating income between the two methods equals the change in fixed manufacturing overhead in inventory: fixed MOH in ending inventory minus fixed MOH in beginning inventory.
Both methods include direct materials, direct labour, and variable manufacturing overhead in the product cost.
Absorption costing adds fixed manufacturing overhead per unit (total fixed MOH / units produced).
Variable costing excludes fixed manufacturing overhead from the product cost entirely.
Selling and administrative expenses (variable or fixed) are never product costs under either method.
Exercise 6-1 (Ida Company, gamelans): Direct materials $100, direct labour $320, variable MOH $40, fixed MOH $60,000 for 250 units produced.
Absorption costing unit cost: $100 + $320 + $40 + ($60,000 / 250) = $100 + $320 + $40 + $240 = $700.
Variable costing unit cost: $100 + $320 + $40 = $460.
The $240 per-unit difference is the fixed MOH allocated under absorption costing.
Exercise 6-9 (Walsh Company): Direct materials $25, direct labour $15, variable MOH $5, fixed MOH $250,000.
Year 1 (50,000 units produced): absorption cost = $25 + $15 + $5 + $5 = $50. Variable cost = $45.
Year 2 (40,000 units produced): absorption cost = $25 + $15 + $5 + $6.25 = $51.25. Variable cost = $45.
The variable costing unit cost stays the same regardless of production volume because it contains no fixed element. The absorption costing unit cost changes because the fixed MOH per unit depends on how many units are produced.
Problem 6-19 (Heaton Company): Direct materials $4, direct labour $7, variable MOH $1, fixed MOH $270,000 for 45,000 units.
Absorption cost: $4 + $7 + $1 + $6 = $18. Variable cost: $4 + $7 + $1 = $12.
Format: Sales – Variable expenses (variable COGS + variable selling and admin) = Contribution margin – Fixed expenses (fixed MOH + fixed selling and admin) = Net operating income.
All fixed manufacturing overhead is expensed in the period incurred, regardless of how many units are produced or remain in inventory.
Format: Sales – Cost of goods sold (at full absorption cost per unit) = Gross margin – Selling and admin expenses = Net operating income.
Fixed MOH is included in the unit cost and flows through COGS only when units are sold. Unsold units carry their share of fixed MOH in inventory on the balance sheet.
Production > Sales (inventory increases): Absorption costing income > Variable costing income. Some fixed MOH is deferred in ending inventory under absorption costing.
Production < Sales (inventory decreases): Absorption costing income < Variable costing income. Fixed MOH from earlier periods is released from inventory under absorption costing.
Production = Sales: Both methods report the same net operating income.
The income difference = Fixed MOH in ending inventory – Fixed MOH in beginning inventory.
Example (Exercise 6-2, Ida Company): 250 produced, 225 sold, 25 in ending inventory. Fixed MOH deferred = 25 × $240 = $6,000. Absorption NOI ($9,250) exceeds variable NOI ($3,250) by $6,000.
Example (Exercise 6-9, Walsh Company, Year 1): 50,000 produced, 40,000 sold, 10,000 in ending inventory. Fixed MOH deferred = 10,000 × $5 = $50,000. Variable NOI = $190,000, absorption NOI = $240,000.
Year 2: 40,000 produced, 50,000 sold, ending inventory = 0. Fixed MOH released from beginning inventory = 10,000 × $5 = $50,000. Variable NOI = $320,000, absorption NOI = $270,000.
Three-year example with fixed MOH of $560 per unit, inventories fluctuating.
Year 1: Inventory decreases by 30 units. Fixed MOH released = 30 × $560 = $16,800. Absorption income is $16,800 less than variable income.
Year 2: Inventory increases by 10 units. Fixed MOH deferred = 10 × $560 = $5,600. Absorption income is $5,600 more.
Year 3: Inventory increases by 40 units. Fixed MOH deferred = 40 × $560 = $22,400. Absorption income is $22,400 more.
Parker Products reported sales of $123 million (above its $115 million break-even based on CVP/variable costing) but showed an $18 million absorption costing loss. This apparent contradiction means inventories must have decreased during the year, releasing previously deferred fixed MOH into the absorption income statement.
Quarter 1: 30,000 produced, 28,000 sold. Absorption unit cost = $26.50 ($3.50 + $12 + $1 + $10 fixed MOH). Variable costing shows a $10,000 loss; absorption shows $10,000 profit. Difference = 2,000 unsold units × $10 = $20,000.
Quarter 2: 30,000 produced, 32,000 sold. Variable costing NOI = $60,000, absorption NOI = $40,000. The 2,000-unit inventory from Q1 is sold, releasing $20,000 of fixed MOH.
Three-year example where production fluctuates (50,000, 60,000, 40,000) while sales fluctuate too (50,000, 40,000, 50,000). Variable costing gives NOI of $30,000, ($100,000), and $30,000 for Years 1, 2, 3. Absorption costing gives $30,000, $60,000, ($10,000).
Year 2 absorption profit rises despite fewer sales because production exceeded sales by 20,000 units, deferring $160,000 of fixed MOH. Year 3 shows the reverse.
A segmented income statement uses the contribution format: Sales – Variable expenses = Contribution margin – Traceable fixed expenses = Segment margin – Common fixed expenses = Net operating income.
Segment margin is the key line. It captures what each segment contributes after covering its own fixed costs.
Common fixed expenses are shown only at the company level and are never allocated to segments.
A fixed cost is traceable to a segment if it would disappear over time if the segment were eliminated.
A fixed cost is common if it would continue even after eliminating the segment.
A cost traceable to one level of segmentation may become common at a lower level. For example, a factory manager's salary is traceable to the factory but common to the product lines within it.
Weedban: 15,000 units at $6.00, variable expenses $2.40, CM $3.60/unit. Total CM = $54,000, traceable fixed $45,000, segment margin = $9,000.
Greengrow: 28,000 units at $7.50, variable expenses $5.25, CM $2.25/unit. Total CM = $63,000, traceable fixed $21,000, segment margin = $42,000.
Company total: CM $117,000, traceable fixed $66,000, total segment margin $51,000, common fixed $33,000, NOI = $18,000.
Company-wide: sales $450,000, CM ratio 50%, traceable fixed $126,000, common fixed $63,000. Break-even = ($126,000 + $63,000) / 0.50 = $378,000.
Chicago office: CM ratio 70%, traceable fixed $78,000. Segment break-even = $78,000 / 0.70 = $111,429.
Minneapolis office: CM ratio 40%, traceable fixed $48,000. Segment break-even = $48,000 / 0.40 = $120,000.
The sum of segment break-even points ($231,429) is less than the company-wide break-even ($378,000) because the company-wide figure includes common fixed expenses.
If Minneapolis sales increase $75,000: additional CM = $75,000 × 0.40 = $30,000 increase in company NOI. Do not use the 24% segment margin ratio, because traceable fixed costs do not change with sales.
Two-tier segmentation: the company first by territory (Northern and Southern), then the Northern territory by product line (Paks and Tibs).
Northern territory: sales $300,000, variable expenses $156,000 (52%), CM $144,000 (48%), traceable fixed $120,000, segment margin = $24,000 (8%).
Southern territory: sales $450,000, variable expenses $180,000 (40%), CM $270,000 (60%), traceable fixed $108,000, segment margin = $162,000 (36%).
Within the Northern territory, Tibs ($250,000 sales, 42% CM ratio, $65,000 segment margin) outperforms Paks ($50,000 sales, 78% CM ratio, $9,000 segment margin) in absolute terms despite a lower CM ratio.
An intern used absorption format and allocated common costs to segments, obscuring true segment performance.
Corrected contribution format: company sales $750,000, variable expenses $575,000 (COGS $500,000 + commissions $75,000), CM $175,000, traceable fixed $93,000, segment margin $82,000, common fixed $72,000, NOI $10,000.
Company-wide break-even = $165,000 / 0.233 overall CM ratio = $708,155.
Commercial division break-even = $55,000 / 0.34 = $161,765. Residential = $38,000 / 0.18 = $211,111.
The original statement allocated corporate expenses to regions, which is misleading.
Corrected contribution format separates variable costs (COGS + shipping) from traceable fixed costs (salaries, utilities, advertising, depreciation). Common fixed costs (corporate advertising + general admin) remain unallocated.
Reveals that the East region has a negative segment margin of ($45,000), suggesting management should investigate whether to restructure or close it.
\text{Variable Costing Unit Cost} = \text{DM} + \text{DL} + \text{Variable MOH}\text{Absorption Costing Unit Cost} = \text{DM} + \text{DL} + \text{Variable MOH} + \frac{\text{Fixed MOH}}{\text{Units Produced}}\text{Income Difference} = \text{Fixed MOH in Ending Inventory} - \text{Fixed MOH in Beginning Inventory}\text{Segment Margin} = \text{Contribution Margin} - \text{Traceable Fixed Expenses}\text{Segment Break-Even (dollars)} = \frac{\text{Traceable Fixed Expenses}}{\text{Segment CM Ratio}}\text{Company Break-Even (dollars)} = \frac{\text{Traceable Fixed} + \text{Common Fixed}}{\text{Overall CM Ratio}}Absorption costing is required for external financial reporting (GAAP and IFRS), so every manufacturer prepares absorption-based statements for shareholders and tax authorities. Variable costing, however, is what managers often prefer internally because it aligns with CVP logic and avoids the distortions that come from production-volume swings. The tension between the two methods explains why a company can report rising profits to shareholders while internal managers see declining performance, or vice versa.
Segmented reporting is central to decentralised organisations. A retail chain uses it to evaluate store performance; a consultancy uses it to compare practice areas. The distinction between traceable and common fixed costs matters for closure or expansion decisions: dropping a segment saves its traceable fixed costs but not the common ones.
Students often think that absorption costing always shows higher income. It only shows higher income when production exceeds sales (inventory builds). When sales exceed production, variable costing reports higher income.
Students sometimes treat selling and administrative expenses as product costs. They are always period costs under both methods.
Students confuse segment margin with contribution margin. Contribution margin covers only variable costs; segment margin also deducts traceable fixed costs. Segment margin is the more useful figure for evaluating whether a segment should continue.
Students allocate common fixed costs to segments and then judge segment profitability by the resulting "net income." This is misleading because common costs do not change if a segment is dropped.
⚠️ Computing unit product costs under both methods is a near-certain exam question. The only difference is fixed MOH.
⚠️ Reconciling variable and absorption costing income is heavily tested. The reconciliation amount always equals the change in fixed MOH in inventory.
⚠️ Know which direction the income difference goes: production > sales means absorption income is higher; production < sales means variable income is higher.
⚠️ Segmented income statements will test whether you can distinguish traceable from common fixed costs. Never allocate common costs to segments.
⚠️ Problem 6-23 (Tami's Creations) is a classic exam scenario: a CPA argues absorption costing shows profit while variable costing shows a loss. Understand why both are "correct" and what drives the difference.
True or false: Under variable costing, fixed manufacturing overhead is included in the unit product cost. (False. It is treated as a period expense.)
Fill in the blank: The difference in net operating income between absorption and variable costing equals the change in ______ in inventory. (Fixed manufacturing overhead)
True or false: When units produced equal units sold, absorption costing and variable costing produce the same net operating income. (True.)
True or false: Common fixed costs should be allocated to segments when computing segment margins. (False. They should remain unallocated.)
Fill in the blank: Segment margin equals contribution margin minus ______. (Traceable fixed expenses)
Q: A company produces 10,000 units and sells 8,000. Fixed manufacturing overhead is $200,000. What is the fixed MOH per unit, and how much is deferred in ending inventory under absorption costing?
A: Fixed MOH per unit = $200,000 / 10,000 = $20. Units in ending inventory = 2,000. Fixed MOH deferred = 2,000 × $20 = $40,000.
Q: Variable costing net operating income is $150,000. During the period, 5,000 units were added to inventory, and fixed MOH is $10 per unit. What is absorption costing net operating income?
A: Fixed MOH deferred = 5,000 × $10 = $50,000. Absorption NOI = $150,000 + $50,000 = $200,000.
Q: A segment has sales of $400,000, a CM ratio of 45%, traceable fixed expenses of $90,000, and is allocated $60,000 of common fixed expenses. What is the segment margin?
A: CM = $400,000 × 0.45 = $180,000. Segment margin = $180,000 – $90,000 = $90,000. (The $60,000 common costs are ignored for segment margin.)
Q: A company reports absorption costing income of $500,000 and variable costing income of $530,000. Did inventories increase or decrease during the period? By how much in fixed MOH terms?
A: Variable costing income is higher, so inventories decreased (fixed MOH was released from inventory). The decrease in fixed MOH in inventory = $530,000 – $500,000 = $30,000.
Q: Why might a company show a profit under absorption costing and a loss under variable costing for the same period?
A: If production substantially exceeds sales, a large amount of fixed MOH is deferred in inventory under absorption costing. This reduces absorption COGS enough to show a profit. Under variable costing, all fixed MOH is expensed immediately, resulting in higher total expenses and a loss.
This connects directly to Chapter 5 (CVP analysis), which uses the contribution format (a variable-costing framework). If you try to apply CVP formulas to absorption costing numbers, you will get incorrect results because absorption costing mixes fixed and variable costs in the unit product cost.
Segment reporting connects to later chapters on decentralisation and performance evaluation, where managers are held accountable for segment margins rather than allocated-overhead figures.
The inventory-level effects covered here also connect to budgeting chapters: when a company budgets production above expected sales, it should anticipate the absorption costing income boost and not mistake it for genuine improvement.
Variable costing, direct costing, marginal costing, absorption costing, full costing, fixed manufacturing overhead, product cost, period cost, contribution format income statement, segmented income statement, segment margin, traceable fixed costs, common fixed costs, cost allocation, inventory changes, deferred fixed overhead, released fixed overhead, reconciliation of variable and absorption costing, GAAP, external reporting, internal reporting, lean production, FIFO inventory