Chapter 10

• Absorption Costing

  Full Traditional, conventional and normal, costing. Method of product costing all manufacturing cost, fixed and variable, as product inventoriable cost
• Variable Costing (Direct Costing)


  A method of Inventory costing which all variable manufacturing cost are included as inventoriable cost. Fixed manufacturing cost is excluded.
• Underlying concept of variable costing

  • Maintain fixed part of factory overhead more closely related to capacity to produce than to production of specific units
  • Permit construction of an income statement that highlights contribution margin of product and facilitates managerial decision making process
  • Companies want to use it must convert inventory and COGS to an absorption costing basis for external reporting
• Advantages of Variable Costing


  • Meet three objectives of management control system: show separate of these cost traced & controlled each strategic Business unit (SBU)
  • Net income not affected by changes in inventory level as Fixed cost deducted from income as they occurred
  • Cost volume profit data needed for profit planning readily obtained from regular accounting statements
  • Analysis of cost relevant to pricing likewise simplified and enhanced
• Disadvantages of Variable Costing

  • Encourage shortsighted approach
  • Give impression that variable cost are recovered first
  • Not acceptable for external reporting & tax purpose
• Absorption Costing


  Net income changes in production when absorption costing is used goes up in response to increase in production for particular year
• Relationship between production (P) & sales ($)

  Absorption costing: P > S, Variable costing: P = S
• Reconciliation of net income, Absorption costing to Variable costing

  1. Add: fixed overhead in beginning Inventory

  2. Less: Fixed overhead in ending Inventory
• Segmented Reporting


  Reporting profit contribution of activities or other units within an organization. Provides valuable information on cost controllable by segment manager.
• Fixed expense categories

  • Direct fixed expense - directly traceable to segment. Sometimes called avoidable fixed expense
  • Common Fixed expenses - jointly caused by two or more segments that even if one of segment common is eliminated it persists
• Segment margin


  The profit contribution to each segment make toward covering firm's common fixed cost. Should be able to cover both own variable cost & direct fixed cost.
• Variable Costing for Planning & Control

  • Financial planning require manager to estimate future sales, production levels. Distinguishing between fixed & variable cost essential for accurate cost assessment at different possibilities sales & production volume.
  • If actual performance differ to expected, corrective action may be necessary. Compare Actual to expected and take corrective action.