c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing for Management Analysis Chapter 5

Learning Objectives 1. Describe and illustrate reporting income from operations under absorption and variable costing. 2. Describe and illustrate the effects of absorption and variable costing on analyzing income from operations. 3. Describe management’s use of absorption and variable costing. 4. Use variable costing for analyzing market segments, including product, territories, and salespersons segments. 5. Use variable costing for analyzing and explaining changes in contribution margin as a result of quantity and price factors. 6. Describe and illustrate the use of variable costing for service firms.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate reporting income from operations under absorption and variable costing. 1

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Absorption Costing o Absorption costing is required under generally accepted accounting principles for financial statements distributed to external users.

A BSORPTION C OSTING

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing o For internal use in decision making, managers often use variable costing, sometimes called direct costing. o The cost of goods manufactured includes only variable manufacturing costs.

V ARIABLE C OSTING

Period Expense Variable Costing Absorption Costing Cost of Goods Manufactured DirectMaterialsDirectLaborVariable Factory OH Fixed C OST OF M ANUFACTURING C OMPARISONS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing o Manufacturing margin is sales less variable cost of goods sold. o Variable cost of goods sold consists of direct materials, direct labor, and variable factory overhead for the units sold. o Contribution margin is manufacturing margin less variable selling and administrative expenses.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Comparing Variable and Absorption Costing o Assume that 15,000 units are manufactured and sold at a price $50.

U NITS M ANUFACTURED E QUAL U NITS S OLD

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Units Manufactured Exceed Units Sold o Assume that in the preceding example only 12,000 units of the 15,000 units manufactured were sold. Examine Exhibit 3 (next two slides) and you will see that income from operations using variable costing is $40,000, while absorption costing provides an income from operations of $70,000.

U NITS M ANUFACTURED E XCEED U NITS S OLD

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Operating Income: Absorption costing$70,000 Variable costing 40,000 Difference$30,000 Units Manufactured Exceed Units Sold o Why is absorption costing income higher when units manufactured exceed units sold?

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Analysis: Units manufactured15,000 Units sold 12,000 Ending inventory units3,000 Fixed cost per unitx $10 Difference$30,000 Operating Income: Absorption costing$70,000 Variable costing 40,000 Difference$30,000 Units Manufactured Exceed Units Sold

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Units Manufactured Less Than Units Sold o Assume that 5,000 units of inventory were on hand at the beginning of a period, 10,000 units were manufactured during the period, and 15,000 units were sold at $50 per unit.

U NITS M ANUFACTURED L ESS T HAN U NITS S OLD

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Effects on Income from Operations

E FFECTS ON I NCOME FROM O PERATIONS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate the effects of absorption and variable costing on analyzing income from operations. 2

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Frand Manufacturing Company o Frand Manufacturing Company has no beginning inventory, and sales are estimated to be 20,000 units at $75 per unit, regardless of production levels. o The management of Frand Manufacturing Company is evaluating whether to manufacture 20,000 units (Proposal 1) or 25,000 units (Proposal 2).

P ROPOSAL 1

P ROPOSAL 2

I NCOME A NALYSIS U NDER A BSORPTION AND V ARIABLE C OSTING

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe management’s use of absorption and variable costing. 3

U SING A BSORPTION AND V ARIABLE C OSTING

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Controlling Costs o For a specific level of management, controllable costs are costs that can be influenced by management at that level. o Noncontrollable costs are costs that another level of management controls.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Pricing Products o Many factors enter into determining the selling price of a product. o The cost of making the product is significant in all pricing decisions. o In the short run, fixed costs cannot be avoided. o In the long run, a company must set its selling price high enough to cover all costs and expenses and generate income.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Planning Production o In the short run, planning production is limited to existing capacity. o In the long run, planning production can consider expanding capacity.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Analyzing Contribution Margins o Managers often plan and control operations by evaluating the differences between planned and actual contribution margins.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Analyzing Market Segments o A market segment is a portion of a business that can be analyzed using sales, costs, and expenses to determine its profitability.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use variable costing for analyzing market segments, including product, territories, and salespersons segments. 4

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Analyzing Market Segments o Camelot Fragrance Company manufactures and sells Gwenevere perfume for women and the Lancelot cologne line for men. The company’s data for the month ended March 31, 2014, is shown in the next slide.

A NALYZING M ARKET S EGMENTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Sales Territory Profitability Analysis o Sales territory profitability analysis may lead management to do the following:  Reduce costs in lower-profit sales territories  Increase sales efforts in higher-profit territories

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Sales Territory Profitability Analysis o To illustrate the analysis of profit differences by sales territory, Exhibit 8 shows the variable costing income statement by sales territories for Camelot Fragrance Company.

S ALES T ERRITORY P ROFITABILITY A NALYSIS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Contribution Margin Ratio = Contribution Margin Sales Northern Territory: 43% ($34,400/$80,000) Southern Territory: 50.5% ($40,400/$80,000) Sales Territory Profitability Analysis

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Sales Territory Profitability Analysis o Sales mix, sometimes referred to as product mix, is the relative amount of sales among the various products.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Product Profitability Analysis o A company should focus its sales efforts on products that will provide the maximum total contribution margin.

P RODUCT P ROFITABILITY A NALYSIS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Salesperson Profitability Analysis o A salesperson profitability report is useful in evaluating sales performance. o Such a report normally includes total sales, variable cost of goods sold, variable selling expenses, contribution margin, and contribution margin ratio for each salesperson.

S ALESPERSON P ROFITABILITY A NALYSIS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use variable costing for analyzing and explaining changes in contribution margin as a result of quantity and price factors. 5

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Contribution Margin Analysis o Contribution margin analysis focuses on explaining the differences between planned and actual contribution margins. o A difference between the planned and actual contribution margin may be caused by an increase or a decrease in:  Sales  Variable costs

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Contribution Margin Analysis o An increase or a decrease in sales or variable costs may in turn be due to an increase or a decrease in the:  Number of units sold  Unit sales price or unit cost

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Sales Quantity Factor Actual Units Sold Planned Units of Sales Planned Sales Price =–× Variable Cost Quantity Factor Planned Units of Sales Actual Units Sold Planned Unit Cost =–× Contribution Margin Analysis o Quantity factor is the effect of a difference in the number of units sold, assuming no change in unit sales price or unit cost.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Unit Price Factor Actual Selling Price per Unit Planned Selling Price per Unit Actual Units Sold = –× Unit Cost Factor Planned Cost per Unit Actual Cost per Unit Actual Units Sold = – × Contribution Margin Analysis o Unit price factor or unit cost factor is the effect of a difference in unit sales price or unit cost on the number of units sold.

C ONTRIBUTION M ARGIN A NALYSIS

Noble, Inc. For the Year Ended December 31, 2014

C ONTRIBUTION M ARGIN A NALYSIS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate the use of variable costing for service firms. 6

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing for Service Firms o Unlike a manufacturing company, a service company does not make or sell a product. o As a result, service companies do not have inventory and, thus, do not allocate fixed costs to inventory using absorption costing concepts.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing for Service Firms o Service firms can report and analyze contribution margin as the difference between revenues and variable costs. To analyze a service firm, we will use Blues Skies Airlines. The fixed and variable costs associated with operating Blue Skies are shown in Exhibit 13 (next slide).

V ARIABLE C OSTING FOR S ERVICE F IRMS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing for Service Firms o The variable costing income statement for Blue Skies Airlines is shown in Exhibit 14 (next slide). Blue Skies Airlines uses the activity base number of passengers for food and beverage service and selling expenses. The company uses number of miles flown for fuel and wages expenses.

V ARIABLE C OSTING FOR S ERVICE F IRMS

M ARKET S EGMENT A NALYSIS FOR S ERVICE C OMPANIES

Blue Skies Airlines, Inc.

M ARKET S EGMENT A NALYSIS FOR S ERVICE C OMPANIES

C ONTRIBUTION M ARGIN A NALYSIS Blue Skies Airlines, Inc.

C ONTRIBUTION M ARGIN A NALYSIS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Variable Costing for Management Analysis The End