CHAPTER 6

Variable Costing and Segment Reporting:

Tools for Management
Misguided Incentives in the Auto Industry

LEARNING OBJECTIVES
BUSIN ESS FO CUS

After studying Chapter 6, you should be

able to:

LO6–1 Explain how variable costing differs

from absorption costing and
compute unit product costs under
each method.

LO6–2 Prepare income statements using

both variable and absorption
costing.

LO6–3 Reconcile variable costing and

When the economy tanks, automakers, such as General Motors and absorption costing net operating
Chrysler, often “flood the market” with a supply of vehicles that far exceeds incomes and explain why the two
customer demand. They pursue this course of action even though it tarnishes amounts differ.
their brand image and increases their auto storage costs, tire replacement
costs, customer rebate costs, and advertising costs. This begs the question LO6–4 Prepare a segmented income
why would managers knowingly produce more vehicles than are demanded statement that differentiates
by customers? traceable fixed costs from
In the auto industry, a manager’s bonus is often influenced by her com- common fixed costs and use it to
pany’s reported profits; thus, there is a strong incentive to boost profits by make decisions.
producing more units. How can this be done you ask? It would seem logi-
cal that producing more units would have no impact on profits unless the LO6–5 Compute companywide and
units were sold, right? Wrong! As we will discover in this chapter, absorption segment break-even points for
costing—the most widely used method of determining product costs—can a company with traceable fixed
artificially increase profits when managers choose to increase the quantity of costs.
units produced. ■
LO6–6 (Appendix 6A) Prepare an income
Source: Marielle Segarra, “Lots of Trouble,” CFO, March 2012, pp. 29–30.
statement using super-variable
costing and reconcile this
approach with variable costing.

233
234 Chapter 6

his chapter describes two applications  of the contribution for-

T mat income statements that were introduced in earlier chapters. First, it explains
how manufacturing companies can prepare variable costing income statements,
which rely on the contribution format, for internal decision making purposes.
The variable costing approach will be contrasted with absorption costing income state-
ments, which were discussed in Chapter 3 and are generally used for external reports.
Ordinarily, variable costing and absorption costing produce different net operating
income figures, and the difference can be quite large. In addition to showing how these
two methods differ, we will describe the advantages of variable costing for internal
reporting purposes and we will show how management decisions can be affected by the
costing method chosen.
Second, the chapter explains how the contribution format can be used to prepare seg-
mented income statements. In addition to companywide income statements, managers
need to measure the profitability of individual segments of their organizations. A segment
is a part or activity of an organization about which managers would like cost, revenue, or
profit data. This chapter explains how to create contribution format income statements
that report profit data for business segments, such as divisions, individual stores, geo-
graphic regions, customers, and product lines.

Overview of Variable and Absorption Costing

As you begin to read about variable and absorption costing income statements in the
LO6–1 coming pages, focus your attention on three key concepts. First, both income state-
Explain how variable costing ment formats include product costs and period costs, although they define these cost
differs from absorption costing classifications differently. Second, variable costing income statements are grounded in
and compute unit product costs the contribution format. They categorize expenses based on cost behavior—variable
under each method. expenses are reported separately from fixed expenses. Absorption costing income state-
ments ignore variable and fixed cost distinctions. Third, as mentioned in the paragraph
above, variable and absorption costing net operating income figures often differ from
one another. The reason for these differences always relates to the fact the variable cost-
ing and absorption costing income statements account for fixed manufacturing overhead
differently. Pay very close attention to the two different ways that variable costing and
absorption costing account for fixed manufacturing overhead.

Variable Costing
Under variable costing, only those manufacturing costs that vary with output are
treated as product costs. This would usually include direct materials, direct labor, and
the variable portion of manufacturing overhead. Fixed manufacturing overhead is not
treated as a product cost under this method. Rather, fixed manufacturing overhead is
treated as a period cost and, like selling and administrative expenses, it is expensed in
its entirety each period. Consequently, the cost of a unit of product in inventory or in
cost of goods sold under the variable costing method does not contain any fixed manu-
facturing overhead cost. Variable costing is sometimes referred to as direct costing or
marginal costing.

Absorption Costing
As discussed in Chapter 3, absorption costing treats all manufacturing costs as product
costs, regardless of whether they are variable or fixed. The cost of a unit of product under
the absorption costing method consists of direct materials, direct labor, and both variable
and fixed manufacturing overhead. Thus, absorption costing allocates a portion of fixed
 Variable Costing and Segment Reporting: Tools for Management 235

manufacturing overhead cost to each unit of product, along with the variable manufactur-
ing costs. Because absorption costing includes all manufacturing costs in product costs, it
is frequently referred to as the full cost method.

Selling and Administrative Expenses

Selling and administrative expenses are never treated as product costs, regardless of the
costing method. Thus, under absorption and variable costing, variable and fixed sell-
ing and administrative expenses are always treated as period costs and are expensed as
incurred.

Summary of Differences The essential difference between variable costing and

absorption costing, as illustrated in Exhibit 6–1, is how each method accounts for fixed
manufacturing overhead costs—all other costs are treated the same under the two meth-
ods. In absorption costing, fixed manufacturing overhead costs are included as part of
the costs of work in process inventories. When units are completed, these costs are trans-
ferred to finished goods and only when the units are sold do these costs flow through to
the income statement as part of cost of goods sold. In variable costing, fixed manufactur-
ing 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.

EXHIBIT 6–1
Variable Costing versus
Absorption Costing

Costs

Manufacturing costs Balance Sheet

Raw materials Raw Materials inventory
purchases
Direct materials
used in production
Direct labor
Work in Process inventory
ng n

Variable Goods completed

co rptio

manufacturing (cost of goods

Income Statement
so
sti

manufactured)
Ab

overhead
Finished Goods inventory Cost of Goods Sold
Goods
Fixed
sold
manufacturing
overhead
Variab
le costin
g
Nonmanufacturing costs

Selling and
Period Expenses
administrative
236 Chapter 6

Variable and Absorption Costing—An Example

To illustrate the difference between variable costing and absorption costing, consider
Weber Light Aircraft, a company that produces light recreational aircraft. Data concern-
ing the company’s operations appear below:

Per Aircraft Per Month

Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000
Variable manufacturing overhead . . . . . . . . . . . . . . . . . $1,000
Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . . $70,000
Variable selling and administrative expenses . . . . . . . . $10,000
Fixed selling and administrative expenses . . . . . . . . . $20,000
January February March
Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 1
Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2 4
Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 5
Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 1 0

As you review the data above, it is important to realize that for the months of January,
February, and March, the selling price per aircraft, variable cost per aircraft, and total
monthly fixed expenses never change. The only variables that change in this example
are the number of units produced (January  5 1 unit produced; February  5 2 units pro-
duced; March 5 4 units produced) and the number of units sold (January 5 1 unit sold;
February 5 1 unit sold; March 5 5 units sold).
We will first construct the company’s variable costing income statements for January,
February, and March. Then we will show how the company’s net operating income would
be determined for the same months using absorption costing.

Variable Costing Contribution Format Income Statement

LO6–2 To prepare the company’s variable costing income statements for January, February, and
Prepare income statements March we begin by computing the unit product cost. Under variable costing, product
using both variable and costs consist solely of variable production costs. At Weber Light Aircraft, the variable
absorption costing. production cost per unit is $25,000, determined as follows:

Variable Costing Unit Product Cost

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . 1,000
Variable costing unit product cost . . . . . . . . . . . . . . . . . . . $25,000

Since each month’s variable production cost is $25,000 per aircraft, the variable costing
cost of goods sold for all three months can be easily computed as follows:

Variable Costing Cost of Goods Sold

January February March
Variable production cost (a) . . . . . . . . . . . . . . . . . $25,000 $25,000 $25,000
Units sold (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 5
Variable cost of goods sold (a) 3 (b) . . . . . . . . . . $25,000 $25,000 $125,000
 Variable Costing and Segment Reporting: Tools for Management 237

And the company’s total selling and administrative expense would be derived as follows:

Selling and Administrative Expenses

January February March
Variable selling and administrative expense
(@ $10,000 per unit sold) . . . . . . . . . . . . . . . . . . $10,000 $10,000 $50,000
Fixed selling and administrative expense . . . . . . . 20,000 20,000 20,000
Total selling and administrative expense . . . . . . . . $30,000 $30,000 $70,000

Putting it all together, the variable costing income statements would appear as shown in
Exhibit 6–2. Notice, the contribution format has been used in these income statements.
Also, the monthly fixed manufacturing overhead costs ($70,000) have been recorded as a
period expense in the month incurred.

EXHIBIT 6–2
Variable Costing Contribution Format Income Statements
Variable Costing Income
January February March
Statements
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $100,000 $500,000
Variable expenses:
Variable cost of goods sold . . . . . . . . . . . . 25,000 25,000 125,000
Variable selling and administrative
expense . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,000 50,000
Total variable expenses . . . . . . . . . . . . . . . . . 35,000 35,000 175,000
Contribution margin . . . . . . . . . . . . . . . . . . . . 65,000 65,000 325,000
Fixed expenses:
Fixed manufacturing overhead . . . . . . . . . . 70,000 70,000 70,000
Fixed selling and administrative expense . . . 20,000 20,000 20,000
Total fixed expenses . . . . . . . . . . . . . . . . . . . 90,000 90,000 90,000
Net operating income (loss) . . . . . . . . . . . . . . $ (25,000) $ (25,000) $235,000

A simple method for understanding how Weber Light Aircraft computed its variable
costing net operating income figures is to focus on the contribution margin per aircraft
sold, which is computed as follows:

Contribution Margin per Aircraft Sold

Selling price per aircraft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
Variable production cost per aircraft . . . . . . . . . . . . . . . . . . . . $25,000
Variable selling and administrative expense per aircraft . . . . . 10,000 35,000
Contribution margin per aircraft . . . . . . . . . . . . . . . . . . . . . . . $ 65,000

The variable costing net operating income for each period can always be computed by
multiplying the number of units sold by the contribution margin per unit and then subtract-
ing total fixed costs. For Weber Light Aircraft these computations would appear as follows:

January February March

Number of aircraft sold . . . . . . . . . . . . . . . 1 1 5

Contribution margin per aircraft . . . . . . . . . 3 $65,000 3 $65,000 3 $65,000
Total contribution margin . . . . . . . . . . . . . . $65,000 $65,000 $325,000
Total fixed expenses . . . . . . . . . . . . . . . . . . 90,000 90,000 90,000
Net operating income (loss) . . . . . . . . . . . . $(25,000) $(25,000) $235,000

Notice, January and February have the same net operating loss. This occurs because one
aircraft was sold in each month and, as previously mentioned, the selling price per air-
craft, variable cost per aircraft, and total monthly fixed expenses remain constant.
238 Chapter 6

Absorption Costing Income Statement

As we begin the absorption costing portion of the example, remember that the only rea-
son absorption costing income differs from variable costing is that the methods account
for fixed manufacturing overhead differently. Under absorption costing, fixed manufac-
turing overhead is included in product costs. In variable costing, fixed manufacturing
overhead is not included in product costs and instead is treated as a period expense just
like selling and administrative expenses.
The first step in preparing Weber’s absorption costing income statements for January,
February, and March is to determine the company’s unit product costs for each month as
follows1:

Absorption Costing Unit Product Cost

January February March
Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,000 $19,000 $19,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 5,000 5,000
Variable manufacturing overhead . . . . . . . . . . . . . . . 1,000 1,000 1,000
Fixed manufacturing overhead ($70,000 4 1 unit
produced in January; $70,000 4 2 units produced in
February; $70,000 4 4 units produced in March) . . . 70,000 35,000 17,500
Absorption costing unit product cost . . . . . . . . . . . . $95,000 $60,000 $42,500

Notice that in each month, Weber’s fixed manufacturing overhead cost of $70,000 is
divided by the number of units produced to determine the fixed manufacturing overhead
cost per unit.
Given these unit product costs, the company’s absorption costing net operating
income in each month would be determined as shown in Exhibit 6–3.
The sales for all three months in Exhibit 6–3 are the same as the sales shown in the
variable costing income statements. The January cost of goods sold consists of one unit
produced during January at a cost of $95,000 according to the absorption costing sys-
tem. The February cost of goods sold consists of one unit produced during February at
a cost of $60,000 according to the absorption costing system. The March cost of goods
sold ($230,000) consists of one unit produced during February at an absorption cost
of $60,000 plus four units produced in March with a total absorption cost of $170,000
(5 4 units produced 3 $42,500 per unit). The selling and administrative expenses equal
the amounts reported in the variable costing income statements; however they are reported
as one amount rather than being separated into variable and fixed components.

EXHIBIT 6–3
Absorption Costing Income Statements
Absorption Costing Income
January February March
Statements
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $100,000 $500,000
Cost of goods sold ($95,000 3 1
unit; $60,000 3 1 unit;
$60,000 3 1 unit 1 $42,500 3 4 units) . . . 95,000 60,000 230,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 40,000 270,000
Selling and administrative expenses . . . . . . . 30,000 30,000 70,000
Net operating income (loss) . . . . . . . . . . . . . . $ (25,000) $ 10,000 $200,000

1
For simplicity, we assume in this section that an actual costing system is used in which actual costs
are spread over the units produced during the period. If a predetermined overhead rate were used, the
analysis would be similar, but more complex.
 Variable Costing and Segment Reporting: Tools for Management 239

Note that even though sales were exactly the same in January and February and the
cost structure did not change, net operating income was $35,000 higher in February than
in January under absorption costing. This occurs because one aircraft produced in Febru-
ary is not sold until March. This aircraft has $35,000 of fixed manufacturing overhead
attached to it that was incurred in February, but will not be recorded as part of cost of
goods sold until March.
Contrasting the variable costing and absorption costing income statements in Exhibits
6–2 and 6–3, note that net operating income is the same in January under variable costing
and absorption costing, but differs in the other two months. We will discuss this in some
depth shortly. Also note that the format of the variable costing income statement differs
from the absorption costing income statement. An absorption costing income statement
categorizes costs by function—manufacturing versus selling and administrative. All of
the manufacturing costs flow through the absorption costing cost of goods sold and all of
the selling and administrative expenses are listed separately as period expenses. In con-
trast, in the contribution approach, costs are categorized according to how they behave.
All of the variable expenses are listed together and all of the fixed expenses are listed
together. The variable expenses category includes manufacturing costs (i.e., variable cost
of goods sold) as well as selling and administrative expenses. The fixed expenses cat-
egory also includes both manufacturing costs and selling and administrative expenses.

IN BUSINESS
THE BEHAVIORAL SIDE OF CALCULATING UNIT PRODUCT COSTS
Andreas STIHL, a manufacturer of chain saws and other landscaping products, asked its U.S. sub-
sidiary, STIHL Inc., to replace its absorption costing income statements with the variable costing
approach. From a computer systems standpoint, the change was not disruptive because STIHL
used an enterprise system called SAP that accommodates both absorption and variable costing.
However, from a behavioral standpoint, STIHL felt the change could be very disruptive. For exam-
ple, STIHL’s senior managers were keenly aware that the variable costing approach reported lower
unit product costs than the absorption costing approach. Given this reality, the sales force might be
inclined to erroneously conclude that each product had magically become more profitable, thereby
justifying ill-advised price reductions. Because of behavioral concerns such as this, STIHL worked
hard to teach its employees how to interpret a variable costing income statement.

Source: Carl S. Smith, “Going for GPK: STIHL Moves Toward This Costing System in the United States,” Strate-
gic Finance, April 2005, pp. 36–39.

Reconciliation of Variable Costing with Absorption Costing Income

As noted earlier, variable costing and absorption costing net operating incomes may not
be the same. In the case of Weber Light Aircraft, the net operating incomes are the same LO6–3
Reconcile variable costing
in January, but differ in the other two months. These differences occur because under
and absorption costing net
absorption costing some fixed manufacturing overhead is capitalized in inventories (i.e.,
operating incomes and explain
included in product costs) rather than being immediately expensed on the income state-
why the two amounts differ.
ment. If inventories increase during a period, under absorption costing some of the fixed
manufacturing overhead of the current period will be deferred in ending inventories.
For example, in February two aircraft were produced and each carried with it $35,000
(5 $70,000 4 2 aircraft produced) in fixed manufacturing overhead. Since only one air-
craft was sold, $35,000 of this fixed manufacturing overhead was on February’s absorp-
tion costing income statement as part of cost of goods sold, but $35,000 would have been
on the balance sheet as part of finished goods inventories. In contrast, under variable cost-
ing all of the $70,000 of fixed manufacturing overhead appeared on the February income
240 Chapter 6

statement as a period expense. Consequently, net operating income was higher under
absorption costing than under variable costing by $35,000 in February. This was reversed
in March when four units were produced, but five were sold. In March, under absorption
costing $105,000 of fixed manufacturing overhead was included in cost of goods sold
($35,000 for the unit produced in February and sold in March plus $17,500 for each of
the four units produced and sold in March), but only $70,000 was recognized as a period
expense under variable costing. Hence, the net operating income in March was $35,000
lower under absorption costing than under variable costing.
In general, when the units produced exceed unit sales and hence inventories increase,
net operating income is higher under absorption costing than under variable costing. This
occurs because some of the fixed manufacturing overhead of the period is deferred in
inventories under absorption costing. In contrast, when unit sales exceed the units pro-
duced and hence inventories decrease, net operating income is lower under absorption
costing than under variable costing. This occurs because some of the fixed manufactur-
ing overhead of previous periods is released from inventories under absorption costing.
When the units produced and unit sales are equal, no change in inventories occurs and
absorption costing and variable costing net operating incomes are the same.2
Variable costing and absorption costing net operating incomes can be reconciled by
determining how much fixed manufacturing overhead was deferred in, or released from,
inventories during the period:

Fixed Manufacturing Overhead Deferred in, or Released from,

Inventories under Absorption Costing
January February March
Fixed manufacturing overhead in
ending inventories . . . . . . . . . . . . . . . . . . . . . . . $0 $35,000 $ 0
Fixed manufacturing overhead in beginning
inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 35,000
Fixed manufacturing overhead deferred in
(released from) inventories . . . . . . . . . . . . . . . . $0 $35,000 $(35,000)

In equation form, the fixed manufacturing overhead that is deferred in or released

from inventories can be determined as follows:

Manufacturing overhead Fixed manufacturing Fixed manufacturing

deferred in 5 overhead in 2 overhead in
(released from) inventory ending inventories beginning inventories

The reconciliation would then be reported as shown in Exhibit 6–4:

EXHIBIT 6–4
Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes
Reconciliation of Variable
January February March
Costing and Absorption Costing
Net Operating Incomes Variable costing net operating income (loss) . . . . . $(25,000) $(25,000) $235,000
Add (deduct) fixed manufacturing overhead
deferred in (released from) inventory under
absorption costing . . . . . . . . . . . . . . . . . . . . . . . . 0 35,000 (35,000)
Absorption costing net operating income (loss) . . . $(25,000) $ 10,000 $200,000

2
These general statements about the relation between variable costing and absorption costing net oper-
ating income assume LIFO is used to value inventories. Even when LIFO is not used, the general state-
ments tend to be correct. Although U.S. GAAP allows LIFO and FIFO inventory flow assumptions,
International Financial Reporting Standards do not allow a LIFO inventory flow assumption.
 Variable Costing and Segment Reporting: Tools for Management 241

EXHIBIT 6–5
Effect on Relation between
Relation between Inventories Absorption and Variable Comparative Income Effects—
Production and Sales Costing Net Absorption and Variable Costing
for the Period Operating Incomes
Units produced 5 No change in inventories Absorption costing net
Units sold operating income 5
Variable costing net
operating income
Units produced . Inventories increase Absorption costing net
Units sold operating income .
Variable costing net
operating income*
Units produced , Inventories decrease Absorption costing net
Units sold operating income ,
Variable costing net
operating income†

*Net operating income is higher under absorption costing because fixed manufacturing
overhead cost is deferred in inventory under absorption costing as inventories increase.
†
Net operating income is lower under absorption costing because fixed manufacturing
overhead cost is released from inventory under absorption costing as inventories
decrease.

Again note that the difference between variable costing net operating income and absorp-
tion costing net operating income is entirely due to the amount of fixed manufacturing
overhead that is deferred in, or released from, inventories during the period under absorp-
tion costing. Changes in inventories affect absorption costing net operating income—they
do not affect variable costing net operating income, providing that variable manufactur-
ing costs per unit are stable.
The reasons for differences between variable and absorption costing net operating
incomes are summarized in Exhibit 6–5. When the units produced equal the units sold, as
in January for Weber Light Aircraft, absorption costing net operating income will equal
variable costing net operating income. This occurs because when production equals sales,
all of the fixed manufacturing overhead incurred in the current period flows through to
the income statement under both methods. For companies that use Lean Production, the
number of units produced tends to equal the number of units sold. This occurs because
goods are produced in response to customer orders, thereby eliminating finished goods
inventories and reducing work in process inventory to almost nothing. So, when a com-
pany uses Lean Production differences in variable costing and absorption costing net
operating income will largely disappear.
When the units produced exceed the units sold, absorption costing net operating
income will exceed variable costing net operating income. This occurs because invento-
ries have increased; therefore, under absorption costing some of the fixed manufacturing
overhead incurred in the current period is deferred in ending inventories on the balance
sheet, whereas under variable costing all of the fixed manufacturing overhead incurred
in the current period flows through to the income statement. In contrast, when the units
produced are less than the units sold, absorption costing net operating income will be
less than variable costing net operating income. This occurs because inventories have
decreased; therefore, under absorption costing fixed manufacturing overhead that had
been deferred in inventories during a prior period flows through to the current period’s
income statement together with all of the fixed manufacturing overhead incurred during
the current period. Under variable costing, just the fixed manufacturing overhead of the
current period flows through to the income statement.
242 Chapter 6

IN BUSINESS
LEAN MANUFACTURING SHRINKS INVENTORIES
Conmed, a surgical device maker in Utica, New York, switched to lean manufacturing by replac-
ing its assembly lines with U-shaped production cells. It also started producing only enough units
to satisfy customer demand rather than producing as many units as possible and storing them in
warehouses. The company calculated that its customers use one of its disposable surgical devices
every 90 seconds, so that is precisely how often it produces a new unit. Its assembly area for
fluid-injection devices used to occupy 3,300 square feet of space and contained $93,000 worth
of parts. Now the company produces its fluid-injection devices in 660 square feet of space while
maintaining only $6,000 of parts inventory.
When Conmed adopted lean manufacturing, it substantially reduced its finished goods inven-
tories. What impact do you think this initial reduction in inventories may have had on net operating
income? Why?

Source: Pete Engardio, “Lean and Mean Gets Extreme,” BusinessWeek, March 23 and 30, 2009, pp. 60–62.

Advantages of Variable Costing and the Contribution Approach

Variable costing, together with the contribution approach, offers appealing advantages
for internal reports. This section discusses three of those advantages.

Enabling CVP Analysis

CVP analysis requires that we break costs down into their fixed and variable components.
Because variable costing income statements categorize costs as fixed and variable, it is
much easier to use this income statement format to perform CVP analysis than attempt-
ing to use the absorption costing format, which mixes together fixed and variable costs.
Moreover, absorption costing net operating income may or may not agree with the
results of CVP analysis. For example, let’s suppose that you are interested in computing
the sales that would be necessary to generate a target profit of $235,000 at Weber Light
Aircraft. A CVP analysis based on the January variable costing income statement from
Exhibit 6–2 would proceed as follows:

Sales (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Contribution margin (b) . . . . . . . . . . . . . . . $65,000
Contribution margin ratio (b) 4 (a) . . . . . . . 65%
Total fixed expenses . . . . . . . . . . . . . . . . . $90,000

Target profit 1 Fixed expenses

Dollar sales to attain target profit 5 _________________________
CM ratio
$235,000 1 $90,000
5 _________________ 5 $500,000
0.65
Thus, a CVP analysis based on the January variable costing income statement predicts
that the net operating income would be $235,000 when sales are $500,000. And indeed,
the net operating income under variable costing is $235,000 when the sales are $500,000
 Variable Costing and Segment Reporting: Tools for Management 243

in March. However, the net operating income under absorption costing is not $235,000
in March, even though the sales are $500,000. Why is this? The reason is that under
absorption costing, net operating income can be distorted by changes in inventories. In
March, inventories decreased, so some of the fixed manufacturing overhead that had been
deferred in February’s ending inventories was released to the March income statement,
resulting in a net operating income that is $35,000 lower than the $235,000 predicted by
CVP analysis. If inventories had increased in March, the opposite would have occurred—
the absorption costing net operating income would have been higher than the $235,000
predicted by CVP analysis.

Explaining Changes in Net Operating Income

The variable costing income statements in Exhibit 6–2 are clear and easy to understand.
All other things the same, when sales go up, net operating income goes up. When sales go
down, net operating income goes down. When sales are constant, net operating income is
constant. The number of units produced does not affect net operating income.
Absorption costing income statements can be confusing and are easily misinter-
preted. Look again at the absorption costing income statements in Exhibit 6–3; a man-
ager might wonder why net operating income went up from January to February even
though sales were exactly the same. Was it a result of lower selling costs, more efficient
operations, or was it some other factor? In fact, it was simply 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 in that month. These costs
have not gone away—they will eventually flow through to the income statement in a later
period when inventories go down. There is no way to tell this from the absorption costing
income statements.
To avoid mistakes when absorption costing is used, readers of financial statements
should be alert to changes in inventory levels. Under absorption costing, if inventories
increase, fixed manufacturing overhead costs are deferred in inventories, which in turn
increases net operating income. If inventories decrease, fixed manufacturing overhead
costs are released from inventories, which in turn decreases net operating income. Thus,
when absorption costing is used, fluctuations in net operating income can be caused by
changes in inventories as well as changes in sales.

Supporting Decision Making

The variable costing method correctly identifies the additional variable costs that will be
incurred to make one more unit. It also emphasizes the impact of fixed costs on profits.
The total amount of fixed manufacturing costs appears explicitly on the income state-
ment, highlighting that the whole amount of fixed manufacturing costs must be covered
for the company to be truly profitable. In the Weber Light Aircraft example, the vari-
able costing income statements correctly report that the cost of producing another unit is
$25,000 and they explicitly recognize that $70,000 of fixed manufactured overhead must
be covered to earn a profit.
Under absorption costing, fixed manufacturing overhead costs appear to be variable
with respect to the number of units sold, but they are not. For example, in January, the
absorption unit product cost at Weber Light Aircraft is $95,000, but the variable portion
of this cost is only $25,000. The fixed overhead costs of $70,000 are commingled with
variable production costs, thereby obscuring the impact of fixed overhead costs on prof-
its. Because absorption unit product costs are stated on a per unit basis, managers may
mistakenly believe that if another unit is produced, it will cost the company $95,000.
But of course it would not. The cost of producing another unit would be only $25,000.
Misinterpreting absorption unit product costs as variable can lead to many problems,
including inappropriate pricing decisions and decisions to drop products that are in
fact profitable.