6-1

Chapter 6: Variable Cos1ng and Segment Repor1ng: Tools for Management Two general approaches are used for valuing inventories and cost of goods sold. One approach, called absorp1on cos1ng, is generally used for external repor1ng purposes. The other approach, called variable cos1ng, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribu1on format. This chapter shows how these two methods dier from each other. It also explains how to create segmented contribu1on format income statements.

6-2

Learning objec1ve number 1 is to explain how variable cos1ng diers from absorp1on cos1ng and compute unit product costs under each method.

6-3

Variable cos1ng (also called direct cos1ng or marginal cos1ng) treats only those costs of produc1on that vary with output as product costs. This approach dovetails with the contribu1on approach income statement and supports CVP analysis because of its emphasis on separa1ng variable and xed costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and xed selling and administra1ve expenses are treated as period costs and deducted from revenue as incurred. Absorp1on cos1ng (also called the full cost method) treats all costs of produc1on as product costs, regardless of whether they are variable or xed. Since no dis1nc1on is made between variable and xed costs, absorp1on cos1ng is not well suited for CVP computa1ons. Under absorp1on cos1ng, the cost of a unit of product consists of direct materials, direct labor, and both variable and xed overhead. Variable and xed selling and administra1ve expenses are treated as period costs and are deducted from revenue as incurred.

6-4

To answer this ques1on correctly, recall which method includes more manufacturing costs in the unit product cost.

6-5

Unit product costs are in both work in process and nished goods inventories. Absorp1on cos1ng results in the highest inventory values because it treats xed manufacturing overhead as a product cost. Using variable cos1ng, xed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.

6-6

Harvey Company produces 25,000 units of a single product. Variable manufacturing costs total $10 per unit. Variable selling and administra1ve expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000 and xed selling and administra1ve expenses for the year are $100,000.

6-7

The unit product costs under absorp1on and variable cos1ng would be $16 and $10, respec1vely. Under absorp1on cos1ng, all produc1on costs, variable and xed, are included when determining unit product cost. Under variable cos1ng, only the variable produc1on costs are included in product costs.

6-8

Learning objec1ve number 2 is to prepare income statements using both variable and absorp1on cos1ng.

6-9

We need some addi1onal informa1on to allow us to prepare income statements for Harvey Company: 20,000 units were sold during the year. The selling price per unit is $30. There is no beginning inventory. Now lets prepare income statements for Harvey Company. We will start with an absorp1on income statement.

6-10

Lets examine a variable cos1ng contribu1on format income statement. First, we subtract all variable expenses from sales to get contribu1on margin. At a product cost of $10 per unit, the variable cost of goods sold for 20,000 units is $200,000. The next variable expense is the variable selling and administra1ve expense. A[er compu1ng contribu1on margin, we subtract xed expenses to get the $90,000 net opera1ng income. Note that all $150,000 of xed manufacturing overhead is expensed in the current period.

6-11

Now, lets examine an absorp1on cos1ng income statement. Harvey sold only 20,000 of the 25,000 units produced, leaving 5,000 units in ending inventory. At a sales price of $30 per unit, sales revenue for the 20,000 units sold is $600,000. At a unit product cost of $16, cost of goods sold for the 20,000 units sold is $320,000. Subtrac1ng cost of goods sold from sales, we nd the gross margin of $280,000. A[er subtrac1ng selling and administra1ve expenses from the gross margin, we see that net opera1ng income is $120,000. Fixed manufacturing overhead deferred in inventory, as a result of the 5,000 unsold units at $6 of xed overhead per unit, is $30,000.

6-12

Learning objec1ve number 3 is to reconcile variable cos1ng and absorp1on cos1ng net opera1ng incomes and explain why the two amounts dier.

6-13

Under absorp1on cos1ng, $120,000 of xed manufacturing overhead is included in cost of goods sold and $30,000 is deferred in ending inventory as an asset on the balance sheet. Under variable cos1ng, the en1re $150,000 of xed manufacturing overhead is treated as a period expense. The variable cos1ng ending inventory is $30,000 less than absorp1on cos1ng, thus explaining the dierence in net opera1ng income between the two methods.

6-14

The dierence in net opera1ng income between the two methods ($30,000) can also be reconciled by mul1plying the number of units in ending inventory (5,000 units) by the xed manufacturing overhead per unit ($6) that is deferred in ending inventory under absorp1on cos1ng.

6-15

In the second year, Harvey Company sells 30,000 units. The selling price per unit, variable costs per unit, total xed costs, and number of units produced remain unchanged. Five thousand units are in beginning inventory, le[ from last year.

6-16

Since the variable costs per unit, total xed costs, and the number of units produced remained unchanged, the unit cost computa1ons also remain unchanged.

6-17

First, lets examine a variable cos1ng contribu1on format income statement for the second year. At a product cost of $10 per unit, the variable cost of goods sold for 30,000 units is $300,000. A[er compu1ng contribu1on margin, we subtract xed expenses to get the $260,000 net opera1ng income. Note that all $150,000 of xed manufacturing overhead is expensed in the current period.

6-18

Of the 30,000 units sold in the second year, 25,000 units were produced in the second year and 5,000 units came from beginning inventory. The $30,000 of xed manufacturing overhead deferred into inventory in the rst year is released from inventory this year as part of the $16 unit product cost. Selling and administra1ve expenses are deducted from gross margin to obtain the net opera1ng income of $230,000. Fixed manufacturing overhead is released from inventory as a result of the 5,000 units sold in the second year that were produced in the rst year. The amount released is $30,000 (5,000 units at $6 of xed overhead per unit).

6-19

The dierence in net opera1ng income between the two methods ($30,000) can be reconciled by mul1plying the number of units in beginning inventory (5,000 units) by the xed manufacturing overhead per unit ($6) that is released from beginning inventory under absorp1on cos1ng.

6-20

Across the two-year 1me frame, both methods reported the same total net opera1ng income ($350,000). This is because over an extended period of 1me sales cannot exceed produc1on, nor can produc1on much exceed sales. The shorter the 1me period, the more the net opera1ng income gures will tend to dier.

6-21

On your screen is a summary of what we have observed from the Harvey Companys two years: When units produced equal units sold, the two methods report the same net opera1ng income. When units produced are greater units sold, as in year 1 for Harvey, absorp1on income is greater than variable cos1ng income. When units produced are less than units sold, as in year 2 for Harvey, absorp1on cos1ng income is less than variable cos1ng income.

6-22

Variable cos1ng categorizes costs as xed and variable so it is much easier to use this income statement format for CVP analysis. Absorp1on cos1ng assigns per unit xed manufacturing overhead costs to produc1on. This can poten1ally produce posi1ve net opera1ng income even when the number of units sold is less than the breakeven point.

6-23

Variable cos1ng income is only aected by changes in unit sales. It is not aected by the number of units produced. As a general rule, when sales go up, net opera1ng income goes up, and vice versa. Absorp1on cos1ng income is inuenced by changes in unit sales and units of produc1on. Net opera1ng income can be increased simply by producing more units even if those units are not sold.

6-24

Variable cos1ng correctly iden1es the addi1onal variable costs incurred to make one more unit. It also emphasizes the impact of xed costs on prots. Absorp1on cos1ng gives the impression that xed manufacturing overhead is variable with respect to the number of units produced, but it is not. This can lead to inappropriate pricing decisions and product discon1nua1on decisions.

6-25

Companies involved in TOC use a form of variable cos1ng. However, one dierence of the TOC approach is that it treats direct labor as a xed cost for three reasons: Although direct laborers are paid an hourly wage, many companies have a commitment some1mes enforced by labor contracts or by the law to guarantee workers a minimum number of paid hours. Direct labor is usually not the constraint; therefore, there is no reason to increase the number of direct laborers. TOC emphasizes the role direct laborers play in driving con1nuous improvement. Since layos o[en devastate morale, managers involved in TOC are extremely reluctant to lay o employees.

6-26

Learning objec1ve number 4 is to prepare a segmented income statement that dieren1ates traceable xed costs from common xed costs and use it to make decisions.

6-27

A segment is a part or ac1vity of an organiza1on about which managers would like cost, revenue, or prot data. Examples of segments include divisions of a company, sales territories, individual stores, service centers, manufacturing plants, marke1ng departments, individual customers, and product lines.

6-28

There are two keys to building segmented income statements. First, a contribu1on format should be used because it separates xed from variable costs and it enables the calcula1on of a contribu1on margin. The contribu1on margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable xed costs should be separated from common xed costs to enable the calcula1on of a segment margin.

6-29

A traceable xed cost of a segment is a xed cost that is incurred because of the existence of the segment. If the segment were eliminated, the xed cost would disappear. Examples of traceable xed costs include the following: The salary of the Fritos product manager at PepsiCo is a traceable xed cost of the Fritos business segment of PepsiCo. The maintenance cost for the building in which Boeing 747s are assembled is a traceable xed cost of the 747 business segment of Boeing.

6-30

A common xed cost is a xed cost that supports the opera1ons of more than one segment, but is not traceable in whole or in part to any one segment. Examples of common xed costs include the following: The salary of the CEO of General Motors is a common xed cost of the various divisions of General Motors. The cost of hea1ng a Safeway or Kroger grocery store is a common xed cost of the various departments groceries, produce, and bakery.

6-31

It is important to realize that the traceable xed costs of one segment may be a common xed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to a par1cular ight, but it is not traceable to rst- class, business-class, and economy-class passengers.

6-32

A segment margin is computed by subtrac1ng the traceable xed costs of a segment from its contribu1on margin. The segment margin is a valuable tool for assessing the long-run protability of a segment.

6-33

Alloca1ng common costs to segments reduces the value of the segment margin as a guide to long-run segment protability. As a result, common costs should not be allocated to segments.

6-34

Assume that Webber, Inc. has two divisions the Computer Division and the Television Division.

6-35

The contribu1on format income statement for the Television Division is as shown. No1ce that: Cost of goods sold consists of variable manufacturing costs; and Fixed and variable costs are listed in separate sec1ons.

6-36

Also no1ce that: Contribu1on margin is computed by subtrac1ng variable costs from sales; and The divisional segment margin represents the Television Divisions contribu1on to overall company prots.

6-37

The Television Divisions results can be rolled into Webber, Inc.s overall results as shown. No1ce that the results of the Television and Computer Divisions sum to the results shown for the whole company.

6-38

The common costs for the company as a whole ($25,000) are not allocated to the divisions. Common costs are not allocated to segments because these costs would remain even if one of the divisions were eliminated.

6-39

The Television Divisions results can also be broken down into smaller segments. This enables us to see how traceable xed costs of the Television Division can become common costs of smaller segments.

6-40

Assume that the Television Division can be broken down into two major product lines Regular and Big Screen.

6-41

Assume that the segment margins for these two product lines are as shown.

6-42

Of the $90,000 of xed costs that were previously traceable to the Television Division, only $80,000 is traceable to the two product lines and $10,000 is a common cost.

6-43

The Television Divisions results can also be used for decision making. For example, assume Webber believes that if the Television Division spends $5,000 addi1onal dollars on adver1sing it will increase sales of Regular and Big Screen televisions by 5%. Webber can compute the prot impact of this course of ac1on as follows: a. The Regular contribu1on margin would increase by $5,250. b. The Big Screen contribu1on margin would increase by $2,250. c. The Television Divisions segment margin would increase by $2,500.

6-44

The costs assigned to a segment should include all the costs alributable to that segment from the companys en1re value chain. The value chain consists of all major business func1ons that add value to a companys products and services. Since only manufacturing costs are included in product costs under absorp1on cos1ng, those companies that choose to use absorp1on cos1ng for segment repor1ng purposes will omit from their protability analysis all upstream and downstream costs. Upstream costs include research and development and product design costs. Downstream costs include marke1ng, distribu1on, and customer service costs. Although these upstream and downstream costs are not manufacturing costs, they are just as essen1al to determining product protability as are manufacturing costs. Omimng them from protability analysis will result in the undercos1ng of products.

6-45

Costs that can be traced directly to specic segments of a company should not be allocated to other segments. Rather, such costs should be charged directly to the responsible segment. For example, the rent for a branch oce of an insurance company should be charged directly against the branch oce rather than included in a companywide overhead pool and then spread throughout the company. Some companies allocate costs to segments using arbitrary bases. Costs should be allocated to segments for internal decision making purposes only when the alloca1on base actually drives the cost being allocated. For example, sales is frequently used to allocate selling and administra1ve expenses to segments. This should only be done if sales drive these expenses.

6-46

Common costs should not be arbitrarily allocated to segments based on the ra1onale that someone has to cover the common costs for two reasons: First, this prac1ce may make a protable business segment appear to be unprotable. If the segment is eliminated the revenue lost may exceed the traceable costs that are avoided. Second, alloca1ng common xed costs forces managers to be held accountable for costs that they cannot control.

6-47

Assume that Hoagland's Lakeshore prepared the segmented income statement as shown.

6-48

How much of the common xed cost of $200,000 can be avoided by elimina1ng the bar?

6-49

None of it. A common xed cost cannot be eliminated by dropping one of the segments.

6-50

Suppose square feet is used as the basis for alloca1ng the common xed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet?

6-51

The bar would be allocated one tenth of the cost or $20,000.

6-52

If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported prot of each segment?

6-53

Take a minute and review this slide. No1ce that the common costs of $200,000 are allocated to the bar and restaurant.

6-54

Should the bar be eliminated?

6-55

No. The prot was $44,000 before elimina1ng the bar. If we eliminate the bar, prot drops to $30,000!

6-56

Prac1cally speaking, absorp1on cos1ng is required for external reports in the United States. Interna1onal Financial Repor1ng Standards (IFRS) also require absorp1on cos1ng for external reports. Probably because of the cost of maintaining two separate cos1ng systems, most companies use absorp1on cos1ng for their external and internal reports.

6-57

With all of these advantages, why is absorp1on cos1ng s1ll so prevalent? One reason (in addi1on to the external repor1ng issue) relates to the matching principle. Advocates of absorp1on cos1ng argue that it beler matches costs with revenues. They contend that xed manufacturing costs are just as essen1al to manufacturing products as are the variable costs. However, advocates of variable cos1ng view xed manufacturing costs as capacity costs. They argue that xed manufacturing costs would be incurred even if no units were produced.

6-58

U.S. GAAP and IFRS require publicly-traded companies to include segmented nancial data in their annual reports. These rulings have implica1ons for internal segment repor1ng because they mandate that companies must prepare external segmented reports using the same methods that they use for internal segmented reports. This requirement mo1vates managers to avoid using the contribu1on approach for internal repor1ng purposes because if they did they would be required to: a. Share this sensi1ve data with the public. b. Reconcile these reports with applicable rules for consolidated repor1ng purposes.

6-59

End of Chapter 6.