Variable Costing and Segment Reporting: Tools for Management Chapter 6

Variable Costing Variable Costing – only manufacturing costs that vary with output are treated as product costs. Direct materials, direct labor and variable manufacturing costs are treated as product costs. DM DL VMOH Fixed manufacturing OH costs are treated as period costs and are expensed like selling and administrative costs in their entirety each period. Great tool for internal decision-making purposes. Variable costing uses the contribution format income statement.

Overview of Variable and Absorption Costing Variable 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

Unit Cost Computations Harvey Company produces a single product with the following information available:

VC: Unit Cost Computations Unit product cost is determined as follows: Under variable costing, only the variable production costs are included in product costs. Fixed Mfg OH is treated how?

Ex 6-1: Ida Sidha Karya Company is a family-owned company located in the village of Gianyar on the island of Bali in Indonesia. The company produces a handcrafted Balinese musical instrument called a gamelan that is similar to a xylophone. The gamelans are sold for $850. Selected data for the company’s operations last year follow: 2.Under variable costing, only the variable manufacturing costs are included in product costs. Direct materials $100 Direct labor 320 Variable manufacturing overhead 40 Variable costing unit product cost $460 Note that selling and administrative expenses are not treated as product costs under either absorption or variable costing. These expenses are always treated as period costs and are charged against the current period’s revenue. 2. Assume that the company uses variable costing. Compute the unit product cost for one gamelan.

Income Statement Comparison

Ex 6-2: Refer to the data in Exercise 6–1 for Ida Sidha Karya Company Ex 6-2: Refer to the data in Exercise 6–1 for Ida Sidha Karya Company. The absorption costing (GAAP) income statement prepared by the company’s accountant for last year appears below: 2. Prepare an income statement for the year using variable costing.

6-1 #2 Solution

Absorption Costing Absorption Costing – assigns all 3 manufacturing costs as product costs, including both variable and fixed MOH. DM DL VMOH FMOH Each unit product cost contains a piece of the fixed MOH. This is the portion of MOH that VC leaves off.

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

Unit Cost Computations Harvey Company produces a single product with the following information available:

Unit Cost Computations Unit product cost is determined as follows: 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.

Ex 6-1: Ida Sidha Karya Company is a family-owned company located in the village of Gianyar on the island of Bali in Indonesia. The company produces a handcrafted Balinese musical instrument called a gamelan that is similar to a xylophone. The gamelans are sold for $850. Selected data for the company’s operations last year follow: 1. Under absorption costing, all manufacturing costs (variable and fixed) are included in product costs. Direct materials $100 Direct labor 320 Variable manufacturing overhead 40 Fixed manufacturing overhead ($60,000 ÷ 250 units) 240 Absorption costing unit product cost $700 1. Assume that the company uses absorption costing. Compute the unit product cost for one gamelan.

2. Explain the difference in NI between the methods Ex 6-2: Refer to the data in Exercise 6–1 for Ida Sidha Karya Company. The absorption costing (GAAP) income statement prepared by the company’s accountant for last year appears below: The difference in net operating income between variable and absorption costing can be explained by the deferral of fixed manufacturing overhead cost in inventory that has taken place under the absorption costing approach. Note from part (1) that $6,000 of fixed manufacturing overhead cost has been deferred in inventory to the next period. Thus, net operating income under the absorption costing approach is $6,000 higher than it is under variable costing. 2. Explain the difference in NI between the methods

Quick Check  Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends…

Quick Check  Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. . .

Deferred Fixed MOH under AC Absorption costing defers the expensing of fixed MOH costs by keeping them in the inventory account(s) until the units are sold. i.e., under absorption costing, fixed MOH costs don’t go to the income statement until the units are sold and COGS is reported. But variable costing expenses the entire amount of fixed MOH costs in the period incurred.

Variable and Absorption Costing Income Statements Let’s assume the following additional information for Harvey Company. 20,000 units were sold during the year at a price of $30 each. There is no beginning inventory. Now, let’s compute net operating income using both absorption and variable costing.

Variable Costing Contribution Format Income Statement All fixed manufacturing overhead is expensed. Variable manufacturing costs only.

Absorption Costing Income Statement Unit product cost. Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

Comparing the Two Methods

Comparing the Two Methods We can reconcile the difference between absorption and variable income as follows: Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6 per unit

Extended Comparisons of Income Data Harvey Company – Year Two

Unit Cost Computations Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged.

Variable Costing Contribution Format Income Statement All fixed manufacturing overhead is expensed. Variable manufacturing costs only.

Absorption Costing Income Statement Unit product cost. Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.

Comparing the Two Methods We can reconcile the difference between absorption and variable income as follows: Fixed mfg. overhead $150,000 Units produced 25,000 units = = $6 per unit

Comparing the Two Methods

Summary of Key Insights (pg 241)

BREAK

Decentralization and Segment Reporting Quick Mart An Individual Store A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A Sales Territory example: Yum! Foods operates or licenses Taco Bell, KFC, Pizza Hut, and Wingstreet restaurants worldwide. A Service Center

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. Segment manager salary

Identifying Common Fixed Costs Common fixed costs arise because of the overall operation of the company (more than one segment) and would not disappear if any one segment were eliminated. No computer division but . . . We still have a company president.

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. The segment margin is the best gauge of the long-run profitability of a segment because it is calculated with only the costs caused by that segment If a segment can’t cover its own costs, then that segment probably should be dropped. Profits Time

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. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

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. 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.

Traceable and Common Costs Fixed Costs Don’t allocate common costs to segments. Traceable Common

Levels of Segmented Statements Webber, Inc. has two divisions. Let’s look more closely at the Television Division’s income statement.

Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Cost of goods sold consists of variable manufacturing costs. Fixed and variable costs are listed in separate sections.

Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Contribution margin is computed by taking sales minus variable costs. Segment margin is Television’s contribution to profits.

Levels of Segmented Statements

Levels of Segmented Statements Common costs should not be allocated to the divisions. These costs would remain even if one of the divisions were eliminated.

Traceable Costs Can Become Common Costs As previously mentioned, fixed costs that are traceable to one segment can become common if the company is divided into smaller segments. Let’s see how this works using the Webber, Inc. example!

Traceable Costs Can Become Common Costs Webber’s Television Division Regular Big Screen Television Division Product Lines

Traceable Costs Can Become Common Costs We obtained the following information from the Regular and Big Screen segments.

Traceable Costs Can Become Common Costs Fixed costs directly traced to the Television Division $80,000 + $10,000 = $90,000

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. Segment 1 Segment 2 Segment 3 Segment 4

Quick Check  Assume that Hoagland's Lakeshore prepared its segmented income statement as shown.

Quick Check  How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? a. None of it. b. Some of it. c. All of it.

Quick Check  How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? a. None of it. b. Some of it. c. All of it. A common fixed cost cannot be eliminated by dropping one of the segments.

Quick Check  Suppose square feet is used as the basis for allocating the common fixed 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? a. $20,000 b. $30,000 c. $40,000 d. $50,000

The bar would be allocated 1/10 of the cost or $20,000. Quick Check  Suppose square feet is used as the basis for allocating the common fixed 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? a. $20,000 b. $30,000 c. $40,000 d. $50,000 The bar would be allocated 1/10 of the cost or $20,000.

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

Allocations of Common Costs Hurray, now everything adds up!!!

Quick Check  Should the bar be eliminated? a. Yes b. No

Quick Check  Should the bar be eliminated? a. Yes b. No The profit was $44,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000!

Ex 6-11: Wingate Company, a wholesale distributor of electronic equipment, has been experiencing losses for some time, as shown by its most recent monthly contribution format income statement, which follows: In an effort to isolate the problem, the president has asked for an income statement segmented by division. Accordingly, the Accounting Department has developed the following information: 1. Prepare a contribution format income statement segmented by divisions, as desired by the president.

Ex 6-11 #2 As a result of a marketing study, the president believes that sales in the West Division could be increased by 20% if monthly advertising in that division were increased by $15,000. Would you recommend the increased advertising? Show computations to support your answer.

Companywide Income Statements Global View Both U.S. GAAP and IFRS require absorption costing for external reports. Since absorption costing is required for external 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.

Variable versus Absorption Costing Fixed manufacturing costs must be assigned to products to properly match revenues and costs. Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced. Absorption Costing Variable Costing