1. Variable Costing and Segment Reporting: Tools for Management
Chapter 6

2. 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.

3. 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

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

5. 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?

6. 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
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.

7. Income Statement Comparison

8. 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.

9. 6-1 #2 Solution

10. 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.

11. 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

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

13. 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.

14. 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
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.

15. 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

16. 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…

17. 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. . .

18. 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.

19. 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.

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

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

22. Comparing the Two Methods

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

24. Extended Comparisons of Income Data Harvey Company – Year Two

25. 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.

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

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

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

29. Comparing the Two Methods

30. Summary of Key Insights (pg 241)

31. BREAK

32. 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

33. 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

34. 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.

35. 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

36. 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.

37. 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.

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

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

40. 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.

41. 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.

42. Levels of Segmented Statements

43. 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.

44. 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!

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

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

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

48. 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

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

50. 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.

51. 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.

52. 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

53. 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.

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

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

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

57. 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!

58. 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.

59. 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, Would you recommend the increased advertising? Show computations to support your answer.

60. 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.

61. 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