Chapter 6- variable costing
6-1. Basic difference between absorption costing and variable costing
Absorption costing includes both fixed and variable manufacturing costs in the product
cost (direct materials, direct labour, variable and fixed overhead).
Variable costing includes only variable manufacturing costs in product cost, and fixed
overhead is treated as a period cost.
So, the main difference is in the treatment of fixed manufacturing overhead.
6-2. Treatment of selling and administrative expenses under variable costing
Under variable costing, selling and administrative expenses are treated as period costs.
They are not included in product cost because these expenses are not directly related to
production.
They are expensed in the period they are incurred.
6-3. Shifting of fixed manufacturing overhead under absorption costing
In absorption costing, fixed manufacturing overhead is part of product cost.
When production is more than sales, some units (with fixed overhead) remain in inventory.
These costs are carried to the next period, causing a shift of expense between periods.
So, fixed overhead costs move with inventory.
6-4. Arguments in favor of treating fixed manufacturing overhead as product cost
Fixed overhead is necessary to make the product — without it, production cannot happen.
It matches cost with the revenue earned when goods are sold.
Helps in accurate product pricing and inventory valuation.
Hence, it should be treated as a product cost.
6-5. Arguments in favor of treating fixed manufacturing overhead as period cost
Fixed costs do not change with production volume — they occur every period.
It is more logical to expense them in the period they are incurred.
This helps in clearer performance measurement for each period.
So, they should be treated as period costs.
6-6. When production equals sales — which method shows higher net income?
When units produced = units sold, no inventory remains.
So, both absorption and variable costing report the same net operating income,
because no fixed overhead is deferred or released from inventory.
Income will be equal under both methods.
6-7. When production exceeds sales — which shows higher net income?
If production > sales, inventory increases.
Under absorption costing, some fixed overhead remains in closing inventory,
so less fixed cost is expensed this period → higher income.
Absorption costing shows higher net income.
6-8. When fixed overhead is released from inventory under absorption costing
If fixed overhead is released from inventory, it means inventory has decreased.
That happens when sales are greater than production.
So, production is lower than sales.
6-9. How net income can increase without increasing sales (under absorption costing)
When a company produces more units, more fixed overhead is included in inventory.
This defers some expenses to the next period, reducing current expenses.
As a result, net operating income increases even if sales remain the same.
This is called profit increase due to inventory buildup.
6-10. How Lean Production reduces income difference between absorption and
variable costing
Lean production focuses on producing only what is needed and minimizing inventory.
When production ≈ sales, little or no fixed overhead is carried in inventory. Therefore, no
difference in income between absorption and variable costing.
Lean systems eliminate income distortion caused by inventory changes.
6-11. What is a segment of an organization? Give examples.
A segment is a part or division of an organization whose performance is measured
separately.
Examples: a product line, a sales region, a department, or a branch office.
Each segment has its own revenues and costs.
6-12. What costs are assigned to a segment under the contribution approach?
Under the contribution approach, only traceable costs are assigned to a segment.
Common costs are not included because they cannot be directly linked to one segment.
This shows the true contribution of each segment.
6-13. Difference between a traceable cost and a common cost (with examples)
Traceable cost: A cost that can be directly linked to a particular segment.
Example: Salary of the segment manager, depreciation of segment equipment.
Common cost: A cost that supports more than one segment and cannot be traced to any
single one.
Example: CEO’s salary, rent of the entire building.
Traceable costs are controllable by segment; common costs are not.
6-14. Explain how the segment margin differs from the contribution margin.
Contribution margin is the difference between a segment’s sales revenue and variable
costs.
It shows how much money is available to cover fixed costs and profit.
Segment margin is the segment’s contribution margin minus its traceable fixed costs.
It shows the true profit that a segment contributes to the company after covering its own
fixed expenses.
In short:
Contribution Margin = Sales – Variable Costs
Segment Margin = Contribution Margin – Traceable Fixed Costs
Example:
If a product has sales of $100, variable cost $60, and traceable fixed cost $20 —
then:
Contribution Margin = $40
Segment Margin = $20