Overview of Chapter A. Overview of variable and absorption costing. In manufacturing companies, at least two methods can be used to value product units for accounting purposes: absorption costing and variable costing. These methods differ only in how they deal with fixed manufacturing overhead. Variable cost. Variable costs include only variable manufacturing costs in product costs. Direct materials, direct labor, and variable manufacturing overhead would normally be included in product costs under variable costs. Fixed manufacturing overhead is not treated as product cost under this method. Rather, fixed manufacturing overhead is treated as period costs and charged to each period's revenue. Absorption cost. Absorption costing treats all production costs as product costs, regardless of whether they are variable or fixed. With absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product. B. Comparison of absorption and variable costs. When comparing absorption costing and variable costing income statements, a number of points should be noted: Deferral of fixed production costs by absorption costing. With absorption costing, if inventories increase, a portion of the current period's fixed manufacturing overhead costs are carried forward to future periods in the inventory account. When the units are subsequently removed from inventory and sold, the deferred fixed costs flow to the income statement as part of the cost of goods sold. Differences in inventories between the two methods. Closing inventory data under the variable costing and absorption costing methods are different. With variable costing, only variable manufacturing costs are included in inventory. With absorption costing, both variable and fixed production costs are included in inventory. 3. Suitability for CVP analysis. An absorption costing-based income statement is not suitable for providing data for CVP calculations because it does not distinguish between fixed and variable costs. In contrast, the variable cost method classifies costs based on behavior and is very useful in setting up CVP calculations. C. Extended comparison of income data. Exhibit 7-3 of the text presents a comparison between absorption costing and variable costing income statements over three years in which production is constant but sales vary. Exhibit 7-6 of the text also presents comparative income statements over three years, but keeps annual sales constant and varies annual production.