6-2

L
Learning
i Obj
Objective
ti 1

Explain how variable

Variable Costing and Segment costing differs from
Reporting: Tools for Management absorption costing and
Chapter
p 6 compute unit product
costs under each
PowerPoint Authors:
method.
method
Susan Coomer Galbreath, Ph.D., CPA
Charles WW. Caldwell
Caldwell, D
D.B.A.,
B A CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights rese

6-3 6-4

Overview of Variable and

Absorption Costing Q i k Ch
Quick Check
k
Variable Absorption Which method will produce the highest values
Costing Costing for
o work
o in pprocess
ocess a
and
d finished
s ed goods
Direct Materials inventories?
Product
Direct Labor Product
P d t a Absorption costing
a. costing.
Costs
Variable Manufacturing Overhead Costs
b. Variable costing.
Fixed Manufacturing Overhead c. They produce the same values for these
Period inventories.
Variable Selling and Administrative Expenses Period
Costs
Fixed Selling and Administrative Expenses Costs d. It depends. . .
 6-5 6-6

U it C
Unit Costt C
Computations
t ti U it C
Unit Costt C
Computations
t ti
U it product
Unit d t costt is
i determined
d t i d as follows:
f ll
Harvey Company produces a single product
with the following
g information available:

Under absorption costing

costing, all production costs
costs, variable
and fixed, are included when determining unit product
cost. U
cost Under
de variable
a ab e cost
costing,g, o
only
y tthe
e variable
a ab e
production costs are included in product costs.

6-7 6-8

Variable and Absorption Costing

L
Learning
i Obj
Objective
ti 2 Income Statements
Let’s assume the following additional information
for Harvey Company.
Prepare income ▫ 20,000 units were sold during the year at a price
statements using both of $30 each.
▫ There is no beginning inventory.
variable and absorption
costing.
costing
Now, let’s compute net operating
income using g both absorption
p
and variable costing.
 6-9 6-10

Variable Costing Contribution Format

Ab
Absorption
ti C Costing
ti IIncome St
Statement
t t
Income Statement All fixed
Unit product
p
manufacturing
Variable cost.
overhead is
manufacturing
expensed.
costs only.
Variable Costing
Sales ((20,000 × $30)) $ 600,000
Less variable expenses:
Variable cost of goods sold (20,000 × $10) $ 200,000
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Total variable expenses
Contribution margin 340 000
340,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed manufacturingg overhead deferred in
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
inventory is 5,000 units × $6 = $30,000.

6-11 6-12

L
Learning
i Obj
Objective
ti 3 Comparing the Two Methods

Reconcile variable costing

and absorption costing
net operating incomes
and explain why the two
amounts differ.
 6-13 6-14

Comparing the Two Methods Extended Comparisons of Income

Data Harvey Company – Year Two
We can reconcile
W il the
th difference
diff between
b t
absorption and variable income as follows:

Variable costing net operating income $ 90,000

Add: Fixed mfg
mfg. overhead costs
deferred in inventory
(5 000 units × $6 per unit)
(5,000 30 000
30,000
Absorption costing net operating income $ 120,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units

6-15 6-16

Variable Costing Contribution Format

U it C
Unit Costt C
Computations
t ti
Income Statement All fixed
manufacturing
f t i
Variable
overhead is
manufacturing
expensed.
costs only.
only
Variable Costing
Sales (30
(30,000
000 × $30) $ 900,000
900 000
Less variable expenses:
Variable cost of goods sold (30,000 × $10) $ 300,000
Variable selling & administrative
expenses (30,000 × $3) 90,000 390,000
Since the variable costs per unit, total fixed costs, Total variable expenses
and the number of units produced remained Contribution margin 510,000
unchanged, the unit cost computations also Less fixed expenses:
remain unchanged
unchanged. Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 260,000
 6-17 6-18

Ab
Absorption
ti C Costing
ti IIncome St
Statement
t t Comparing the Two Methods
Unit product
p
cost. We can reconcile
W il the
th difference
diff between
b t
absorption and variable income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5 000 units
(5,000 it × $6 per unit)
it) 30 000
30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000

Fixed manufacturing overhead released from = = $6 per unit
Units produced 25,000 units
inventory is 5,000 units × $6 = $30,000.

6-19 6-20

Comparing the Two Methods S

Summary off Key
K Insights
I i ht
 6-21 6-22

Explaining Changes in Net Operating

E bli CVP A
Enabling Analysis
l i
Income
Variable costing categorizes costs as fixed and
variable so it is much easier to use this income Variable costing income is only affected by
statement format for CVP analysis.
analysis changes in unit sales. It is not affected by
the number of units produced. As a general
rule, when sales go up, net operating
Because absorption costing assigns fixed income goes up, and vice versa.
manufacturing overhead costs to units produced ($6
per unit for Harvey Company), a portion of fixed Absorption costing income is influenced by
manufacturing overhead resides in inventory when changes in unit sales and units of
units remain unsold. The potential result is positive production. Net operating income can be
operating income when the number of units sold is increased simply by producing more units
less than the breakeven point. even if those units are not sold.

6-23 6-24

Variable Costing and the Theory of

S
Supporting
ti D Decision
i i M Making
ki Constraints (TOC)
Variable
V i bl costing ti correctly
tl id
identifies
tifi th
the additional
dditi l Companies involved in TOC use a form of variable
variable costs incurred to make one more unit ($10 costing. However, one difference of the TOC
per unitit ffor Harvey
H C
Company). ) It also
l emphasizes
h i approach is that it treats direct labor as a fixed cost
the impact of total fixed costs on profits. for three reasons:
 Many companies have a commitment to guarantee
Because absorption costing assigns fixed
workers a minimum number of paid hours.
manufacturing overhead costs to units produced ($6
per unit for Harvey Company), it gives the impression  Direct labor is usually not the constraint.
that fixed manufacturing overhead is variable with  TOC emphasizes the role direct laborers play in driving
respect to the number of units produced, but it is not. continuous improvement. Since layoffs often devastate
The result can be inappropriate pricing decisions and morale, managers involved in TOC are extremely
reluctant to lay off employees.
product discontinuation decisions.
 6-25 6-26

Decentralization and Segment

L
Learning
i Obj
Objective
ti 4
Reporting
An Individual Store

Prepare a segmented
Quick Mart

i
income statement that
h A segment is any part A Sales Territory
differentiates traceable or activity of an
organization about
fixed costs from common
which a manager
fixed costs and use it to seeks cost, revenue,
make decisions. or profit data. A Service Center

6-27 6-28

K
Keys to
t SSegmented
t d IIncome St
Statements
t t Id tif i T
Identifying Traceable
bl Fi
Fixed
dCCosts
t
T
Traceable
bl fixed
fi d costst arise
i because
b off the
th
There are two keys to building existence of a particular segment and would
segmented income statements: disappear over time if the segment itself
disappeared.
A contribution format should be used
because it separates fixed from variable
No computer No computer
costs and it enables the calculation of a
contribution
t ib ti margin.
i division means . . . division manager
manager.

Traceable fixed costs should be separated

from common fixed costs to enable the
calculation
l l ti off a segmentt margin.
i
 6-29 6-30

Traceable Costs Can Become

Id tif i C
Identifying Common Fi
Fixed
dCCosts
t
Common Costs
Common fixed costs arise because of the
overall operation of the company and would It is important to realize that the traceable
not disappear if any particular segment were fixed costs of one segment may be a
eliminated. common fixed cost of another segment.

No computer We still have a For example, the landing fee

division but . . . company president.
president paid to land an airplane at an
airport is traceable to the
particular flight, but it is not
traceable to first-class,
business-class, and
economy-class passengers.

6-31 6-32

S
Segment
tMMargin
i T
Traceable
bl and
d Common
C Costs
C t
The segment margin
margin, which is computed by
subtracting the traceable fixed costs of a segment
from its contribution margin, is the best gauge of Fixed Don
Don’tt allocate
the long-run profitability of a segment. Costs common costs to
segments.
Profits

Traceable Common
P

Time
 6-33 6-34

L
Levels
l off Segmented
S t d St
Statements
t t L
Levels
l off Segmented
S t d St
Statements
t t
Webber Inc
Webber, Inc. has two divisions
divisions. Our approach to segment reporting uses the
contribution format.
W bb
Webber, Inc.
I Income Statement Costt off goods
C d
Contribution Margin Format sold consists of
Television Division variable
Sales $ 300,000 manufacturing
Computer Division Television Division Variable COGS 120,000 costs.
Other variable costs 30,000
Fixed and
Total variable costs 150,000
variable costs
Contribution margin 150,000
Let’s look more closely at the Television are listed in
Traceable fixed costs 90,000
Division’s
Division s income statement. p
separate
Di i i
Division margin
i $ 60,000
60 000
sections.

6-35 6-36

L
Levels
l off Segmented
S t d St
Statements
t t L
Levels
l off Segmented
S t d St
Statements
t t
Our approach to segment reporting uses the Income Statement
contribution format. Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Income Statement
Contribution margin Variable costs 230,000 150,000 80,000
Contribution Margin Format
is computed
p by
y CM 270,000 150,000 120,000
Television Division
taking sales minus Traceable FC 170,000 90,000 80,000
Sales $ 300,000 Division margin 100,000 $ 60,000 $ 40,000
variable costs.
Variable COGS 120,000
C
Common costs
t
Other variable costs 30,000 Net operating
Total variable costs 150,000 Segment
g marging income
Contribution margin 150,000 is Television’s
Traceable fixed costs 90,000 contribution
Di i i
Division margin
i $ 60,000
60 000 to profits.
 6-37 6-38

Traceable Costs Can Become

L
Levels
l off Segmented
S t d St
Statements
t t
Common Costs
Income Statement
Company Television Computer As previously mentioned, fixed costs that
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000 are traceable to one segment can become
CM 270,000 150,000 120,000 p y is divided into
common if the company
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000 smaller segments.
C
Common costs
t 25 000
25,000
Common costs should not
Net operating
be allocated to the Let’s see how this works
income $ 75 000
75,000 di i i
divisions. These
Th costs
t
would remain even if one
using the Webber, Inc.
of the divisions were example!
eliminated.

6-39 6-40

Traceable Costs Can Become Traceable Costs Can Become

Common Costs Common Costs
Webber’s Television Division Income Statement
Television
Di i i
Division R
Regular
l Big Screen
Bi S
Television
Sales $ 200,000 $ 100,000
Division
Variable costs 95,000
, 55,000
,
CM 105,000 45,000
Traceable FC 45,000 35,000
Regular Big Screen Product line margin $ 60,000
60 000 $ 10,000
10 000
Common costs
Divisional margin
g

Product We obtained the following

g information from
Lines the Regular and Big Screen segments.
 6-41 6-42

Traceable Costs Can Become Segmented Income Statements and

Common Costs Decision Making 5% increase in sales
Income Statement Income Statement
Television Television
Division Regular Big Screen Di i i
Division R
Regular
l Big Screen
Bi S
Sales $ 300,000 $ 200,000 $ 100,000 Sales $ 315,000 $ 210,000 $ 105,000
Variable costs 150,000
, 95,000
, 55,000
, Variable costs 157,500 99,750 57,750
CM 157,500 110,250 47,250
CM 150,000 105,000 45,000
Traceable FC 80,000 45,000 35,000
Traceable FC 80,000 45,000 35,000
Product line margin 77,500 $ 65,250 $ 12,250
Product line margin 70 000
70,000 $ 60,000
60 000 $ 10,000
10 000
Common costs 15,000
Common costs 10,000 Divisional margin $ 62,500
Divisional margin
g $ 60,000
,
$5,000 additional Division margin Margin Margin
Fixed costs directly traced
advertising increases by increases increases
to the Television Division
$80,000 + $10,000 = $90,000 $2,500 by $5,250 by $2,250

6-43 6-44

Inappropriate Methods of Allocating

O i i off Costs
Omission C t
Costs Among Segments
Costs assigned to a segment should include
all costs attributable to that segment
g from the Failure to trace
company’s entire value chain.
chain costs directly Inappropriate
allocation base
Business Functions
Making Up The
Value Chain

Product Customer
R&D Design Manufacturing Marketing Distribution Service
Segment Segment Segment Segment
1 2 3 4
 6-45 6-46

C
Common C
Costs
t and
d SSegments
t Q i k Ch
Quick Check
k
Common costs should not be arbitrarily allocated to segments Income Statement
based on the rationale that “someone has to cover the
common costs” for two reasons: Hoagland's
1. This practice may make a profitable business segment appear Lakeshore Bar Restaurant
to be unprofitable. Sales $ 800,000 $ 100,000 $ 700,000
Variable costs 310,000 60,000 250,000
CM 490,000 40,000 450,000
2. Allocating common fixed costs forces managers to be held
Traceable FC 246,000 26,000 220,000
y cannot control.
accountable for costs they
S
Segment t margin
i 244 000
244,000 $ 14,000
14 000 $ 230,000
230 000
Common costs 200,000
Profit $ 44,000
,

Segment Segment Segment Segment

1 2 3 4
Assume that Hoagland's Lakeshore prepared its
segmented
t d income
i statement
t t t as shown.
h

6-47 6-48

Q i k Ch
Quick Check
k Q i k Ch
Quick Check
k
How much of the common fixed cost of Suppose square feet is used as the basis for
$200,000 can be avoided by eliminating the allocating the common fixed cost of $200,000.
bar? How much would be allocated to the bar if the
a. None of it. bar occupies 1,000 square feet and the
b. Some of it. restaurant 9,000 square feet?
c. All of it. a. $20,000
b. $30,000
c. $40,000
d. $50,000
 6-49 6-50

Q i k Ch
Quick Check
k All
Allocations
ti off Common
C C
Costs
t
If Hoagland's
Hoagland s allocates its common Income Statement
costs to the bar and the restaurant,
Hoagland's
what would be the reported profit of Lakeshore Bar Restaurant
each segment? Sales $ 800,000 $ 100,000 $ 700,000
Variable costs 310 000
310,000 60 000
60,000 250 000
250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
S
Segment t margin
i 244 000
244,000 14 000
14,000 230 000
230,000
Common costs 200,000 20,000 180,000
Profit $ 44,000 $ ((6,000)) $ 50,000

Hurray now everything adds up!!!

Hurray,

6-51 6-52

Companywide Income
Q i k Ch
Quick Check
k Global View
Statements
Should the bar be eliminated?
a. Yes
b. No Both U
U.S.
S GAAP and
IFRS require absorption costing
for external reports
reports.

Since absorption costing is required for

external reporting
reporting, most companies also use
it for internal reports rather than incurring the
additional cost of maintaining a separate
variable cost system for internal reporting.
 6-53 6-54

Segmented Financial
V i bl versus Ab
Variable Absorption
ti C Costing
ti Global View
Information
Fixed
Fi d manufacturing
f t i Both
B th U
U.S.
S GAAP and d IFRS require
i publically
bli ll
costs must be assigned Fixed manufacturing traded companies to include segmented
to products to properly costs are capacity costs financial data in their annual reports.
reports
match revenues and and will be incurred 1. Companies must report segmented results to
costs. even if nothing is shareholders using the same methods that are used
produced. for internal segmented reports.
2 Thi
2. This requirement
i t motivates
ti t managers to t avoid
id using
i
the contribution approach for internal reporting
purposes because if they did they would be required
to:
Absorption
p Variable a. Share this sensitive data with the public.
Costing Costing b. Reconcile these reports with applicable
rules for consolidated reporting purposes.

6-55

E d off Chapter
End Ch t 6