Variable Costing & Segmented Reporting November 18, 2015 Variable Costing & Segmented Reporting Chapter 6: Cost-Volume-Profit Relationships Cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit by focusing their attention on the interactions among the prices of products, volume of activity, per unit variable costs, total fixed costs, and mix of products sold. It is a vital tool used in many business decisions such as deciding what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.

Agenda Variable vs Absorption (or Full) Costing Cost classifications under each Income statement comparison and income effects Advantages of variable costing Segmented reporting Traceable and common fixed costs Cautions on allocating fixed costs

Overview of Variable and Absorption Costing Variable Costing Absorption Costing Product Costs Period Costs Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Product Costs Period Costs Variable costing (also called direct costing or marginal costing) treats only those costs of production that vary with output as product costs. This approach dovetails with the contribution approach income statement and supports CVP analysis because of its emphasis on separating variable and fixed costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred. Absorption costing (also called the full cost method) treats all costs of production as product costs, regardless of whether they are variable or fixed. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for CVP computations. Under absorption costing, the cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred.

Unit Cost Computations Hy Company produces a single product with the following information available: Harvey Company produces 25,000 units of a single product. Variable manufacturing costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000 and fixed selling and administrative expenses for the year are $100,000.

Unit Cost Computations Unit product cost is determined as follows: The unit product costs under absorption and variable costing would be $16 and $10, respectively. Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs. Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs.

Variable and Absorption Costing Income Statements Assume the following additional information for Hy Company. 20,000 units were sold during the year at a price of $30 each. There is no beginning inventory. Compute net operating income using both absorption and variable costing. We need some additional information 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 let’s prepare income statements for Harvey Company. We will start with an absorption income statement.

Variable Costing Contribution Format Income Statement All fixed manufacturing overhead is expensed. Variable manufacturing costs only. Let’s examine a variable costing contribution format income statement. First, we subtract all variable expenses from sales to get contribution 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 administrative expense. After computing contribution margin, we subtract fixed expenses to get the $90,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.

Absorption Costing Income Statement Unit product cost. Now, let’s examine an absorption costing income statement. Hy 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. Subtracting cost of goods sold from sales, we find the gross margin of $280,000. After subtracting selling and administrative expenses from the gross margin, we see that net operating income is $120,000. Fixed manufacturing overhead deferred in inventory, as a result of the 5,000 unsold units at $6 of fixed overhead per unit, is $30,000. Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

Extended Comparisons of Income Data Hy Company – Year Two In the second year, Harvey Company sells 30,000 units. The selling price per unit, variable costs per unit, total fixed costs, and number of units produced remain unchanged. Five thousand units are in beginning inventory, left from last year.

Variable Costing Contribution Format Income Statement All fixed manufacturing overhead is expensed. Variable manufacturing costs only. First, let’s examine a variable costing contribution 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. After computing contribution margin, we subtract fixed expenses to get the $260,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.

Absorption Costing Income Statement Unit product cost. 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 fixed manufacturing overhead deferred into inventory in the first year is released from inventory this year as part of the $16 unit product cost. Selling and administrative expenses are deducted from gross margin to obtain the net operating 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 first year. The amount released is $30,000 (5,000 units at $6 of fixed overhead per unit). Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.

Summary of Key Insights On your screen is a summary of what we have observed from the Hy Company’s two years: When units produced equal units sold, the two methods report the same net operating income. When units produced are greater units sold, as in year 1 for Harvey, absorption income is greater than variable costing income.  When units produced are less than units sold, as in year 2 for Harvey, absorption costing income is less than variable costing income. 

Explaining Changes in Net Operating Income Variable costing income is only affected by changes in unit sales. It is not affected by the number of units produced. As a general rule, when sales go up, net operating income goes up, and vice versa. Absorption costing income is influenced by changes in unit sales and units of production. Net operating income can be increased simply by producing more units even if those units are not sold. Variable costing income is only affected by changes in unit sales. It is not affected by the number of units produced. As a general rule, when sales go up, net operating income goes up, and vice versa.   Absorption costing income is influenced by changes in unit sales and units of production. Net operating income can be increased simply by producing more units even if those units are not sold.

Inventory as a lever to Net Income Net Income can be increased by increasing production The more produced, and unsold, inventory is built As inventory is built, product costs are held on the balance sheet, in inventory Not expensed in COGS Variable product costs of excess production will have no impact Incremental costs all transfer into inventory Fixed product costs, however, get defrayed into inventory Unit fixed costs will have decreased The unit costs in COGS will decrease Net income increases There are two keys to building segmented income statements.   First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Inventory as a lever to Net Income Financial Accounting vs Managerial Accounting Financial Accounting requires certain inventory valuation methods which leads towards absorption costing Managerial Accounting gives latitude to use variable costing to aid in CVP analysis and business decisions Given the reporting benefits of increasing production on Net Income, why wouldn’t a company endlessly increase production? There are two keys to building segmented income statements.   First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Inventory as a lever to Net Income Given the reporting benefits of increasing production on Net Income, why wouldn’t a company endlessly increase production? Impact on cash? Cost of borrowing? Potential obsolescence? Incremental step function fixed costs? Ethics? There are two keys to building segmented income statements.   First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Inventory as a lever to Net Income Given the reporting benefits of increasing production on Net Income, why wouldn’t a company endlessly increase production? Impact on cash? Cost of borrowing? Potential obsolescence? Incremental step function fixed costs? Ethics? Inventory is a “use” of cash Interest costs reduce NI Inventory write-down New fixed costs, backfire Do what’s best for the business, not what drives a performance measure There are two keys to building segmented income statements.   First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Inventory as a lever to Net Income Given the reporting benefits of increasing production on Net Income, why wouldn’t a company endlessly increase production? Impact on cash? Cost of borrowing? Potential obsolescence? Incremental step function fixed costs? Ethics? Inventory is a “use” of cash Interest costs reduce NI Inventory write-down New fixed costs, backfire Do what’s best for the business, not what drives a performance measure There are two keys to building segmented income statements.   First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Keys to Segmented Income Statements There are two keys to building segmented income statements: A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. There are two keys to building segmented income statements.   First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders. Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Identifying Traceable Fixed Costs Traceable fixed costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. A traceable fixed cost of a segment is a fixed cost that is incurred because of the existence of the segment. If the segment were eliminated, the fixed cost would disappear. Examples of traceable fixed costs include the following: The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo. The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing.

Identifying Traceable Fixed Costs Traceable fixed costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. No computer division means . . . No computer division manager. A traceable fixed cost of a segment is a fixed cost that is incurred because of the existence of the segment. If the segment were eliminated, the fixed cost would disappear. Examples of traceable fixed costs include the following: The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo. The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing.

Identifying Common Fixed Costs Common fixed costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Examples of common fixed costs include the following: The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors. The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments: groceries, produce, and bakery.

Identifying Common Fixed Costs Common fixed costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. No computer division but . . . We still have a company president. A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Examples of common fixed costs include the following: The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors. The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments: groceries, produce, and bakery.

Common vs Traceable Costs Tax on only factory building Tax on bike factory building of conglomerate EVP Marketing Supply Chain Management Dept. Quality control department Research & Development Delivery truck Raw materials Bicycle assembler A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Examples of common fixed costs include the following: The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors. The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments: groceries, produce, and bakery.

Common vs Traceable Costs Traceable or Common? Common Traceable to Bike Segment Common, most likely Dependent on dept. Structure Is QC testing one or all products? Should be traceable by time spent Should be traceable by # of deliveries Not a fixed cost Cost Tax on only factory building Tax on bike factory building of conglomerate EVP Marketing Supply Chain Management Dept. Quality control department Research & Development Delivery truck Raw materials Bicycle assembler A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Examples of common fixed costs include the following: The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors. The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments: groceries, produce, and bakery.

Traceable Costs Can Become Common Costs It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment, or sub-segment. It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to a particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

Traceable Costs Can Become Common Costs It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment, or sub-segment. For example, the landing fee 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. It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to a particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

Segment Margin The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. A segment margin is computed by subtracting the traceable fixed costs of a segment from its contribution margin. The segment margin is a valuable tool for assessing the long-run profitability of a segment. Profits Time

Common Costs and Segments Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons: This practice may make a profitable business segment appear to be unprofitable. Allocating common fixed costs forces managers to be held accountable for costs they cannot control. Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons:   First, this practice may make a profitable business segment appear to be unprofitable. If the segment is eliminated the revenue lost may exceed the traceable costs that are avoided. Second, allocating common fixed costs forces managers to be held accountable for costs that they cannot control. Segment 1 Segment 2 Segment 3 Segment 4

Common Costs and Segments There is no perfect solution for common cost allocation Just as there was no perfect solution for allocating the overhead portion of product costs Remember POHR and ABC? Each company will conduct a full analysis, negotiate with its managers and arrive at a reasonable and motivating allocation method Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons:   First, this practice may make a profitable business segment appear to be unprofitable. If the segment is eliminated the revenue lost may exceed the traceable costs that are avoided. Second, allocating common fixed costs forces managers to be held accountable for costs that they cannot control. Segment 1 Segment 2 Segment 3 Segment 4

Review Variable versus Absorption Costing (or Full Costing) Cost classifications under each Income statement comparison and income effects Advantages of variable costing Segmented reporting Traceable and common fixed costs Cautions on allocating fixed costs