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Variable costing income statements: Rely on the contribution format for internal decision making purposes.Absorption costing income statement: used for external reports. Segment: part of activity of an organization about which managers would like cost, revenue, or profit data. I. Overview of Variable and Absorption Costinga. Both income statement formats include product costs and period costs, although they define these cost classifications differently.b. Variable costing income statements are grounded in the contribution format. i. Categorize expenses based on cost behavior- variable costs are reported separately from fixed costs.c. Absorption costing income statements ignore variable and fixed cost distinctions.d. Variable and absorption costing net operating income figures often differ from one another.i. Variable costing and absorption costing account for fixed manufacturing overhead differently.II. Variable Costing/ Direct Costing/ Marginal Costinga. Only the manufacturing costs that vary with output are treated as product costs.i. Direct materials, Direct Labor, and Variable ManufacturingOverhead.ii. Accounts for the cost of a unit of product in inventory or in costof goods sold.b. Period Costs are expensed in its entirety each period.i. Fixed Manufacturing Overhead, Selling and AdministrativeExpenses.ii. Cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost.c. Variable Costing Contribution Format Income Statementi.ii. Variable Costing Net Operating Income for each period can be computed by multiplying the number of units sold by the contribution margin per unit and then subtracting total fixed costs.III. Absorption Costing/ Full Cost Methoda. Treats all manufacturing costs, regardless of whether they are variable or fixed. i. Cost of a unit of product under the absorption costing method consists of direct materials, direct labor, variable manufacturing overhead and fixed manufacturing overhead.ii. Period costs are only selling and administrative expenses.iii.IV. Selling and Administrative Expensesa. Never treated as product costs, regardless of the costing method.b. Under absorption and variable costing, variable and fixed selling administrative expenses are ALWAYS treated as period costs and are expensed as incurred.c. In absorption costing, fixed manufacturing overhead costs are included as part of the costs of work in process inventories. i. When units are completed, these costs are transferred to finished goods and only when the units are sold do these costs flow through to the income statement as part cost of goods sold.d. In variable costing, fixed manufacturing overhead costs are considered to be period costs- just like selling and administrative costs- and are taken immediately to the income statement as period expenses.V. Reconciliation of Variable Costing with Absorption Costing Incomea. If inventories increase during a period, under absorption costing some of the fixed manufacturing overhead of the current period willbe deferred in ending inventories.b. UNITS PRODUCED > UNIT SALES = NOI ABSORPTION > NOI VARIABLE= UNITS DEFERREDi. In general, when the units produced exceed unit sales and inventories increase, net operating income is higher under absorption costing than under variable costing.ii. Some of the fixed manufacturing overhead of the period is deferred in inventories under absorption costing.c. UNITS PRODUCED < UNIT SALES = NOI ABSORPTION < NOI VARIABLE = UNITS RELEASEDi. When unit sales exceed the units produces and inventories decrease, net operating income is lower under absorption costing than under variable costing. ii. Occurs because some of the fixed manufacturing overhead of the previous periods is released from inventories under absorption costing.d. When units produced and unit sales are equal, no change in inventories occurs and absorption costing and variable costing net operating incomes are the same. VI. Advantages of Variable Costing and the Contribution Approacha. Enabling CVP Analysisi. Requires that costs are broken down into fixed and variable components making it easier to use variable costing.ii. Absorption costing net operating income may not agree withthe results of CVP analysis. 1. Dollar Sales to Attain Target Profit= ((Target Profit)+(Fixed Expenses))/(CM Ratio)b. Explaining Changes in Net Operating Income1. Sometimes can be because the number of units produced exceeded the number of units sold in February and so some of the fixed manufacturing overhead costs were deferred in inventories that month. (Based on example)ii. Readers should be alert to changes in inventory levels. 1. Absorption costing, if inventories increase, fixed manufacturing overhead costs are deferred in inventories, which in turn increases net operating income.2. If inventories decrease, fixed manufacturing overhead costs are released from inventories, which in turn decreases net operating income. iii. When absorption costing is used, fluctuations in net operating income can be due to changes in inventories rather than changes in sales. c. Support Decision Makingi. Variable costing method correctly identifies the additional variable costs that will be incurred to make one more unit. ii. Emphasizes the impact of fixed costs on profits. 1. The total amount of fixed manufacturing costs appears explicitly on the income statement, highlighting that thewhole amount of fixed manufacturing costs must be covered for the company to be truly profitable.2. Because absorption unit product costs are stated on a per unit basis, managers may mistakenly believe that if another unit is produced, it will costs the entire variableportion but of course it would not.d. Adapting to the Theory of Constraints (TOC)i. TOC suggests that the key to improving a company’s profits is managing its constraints.ii. Variable costing income statements require one adjustment to support the TOC approach. 1. Direct labor costs need to be removed from the variable production costs and reported as part of the fixed manufacturing costs that are entirely expensed in the period incurred.2. TOC treats direct labor costs as a fixed cost because:a. Even though direct labor workers may be paid on an hourly basis, many companies have a commitment-sometimes enforced by labor contracts or by law-to guarantee workers a minimum number of paid hours.b. Direct labor is not usually the constraint; therefore,


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