Variable Costing and Segment

Reporting: Tools for Management

Chapter 6

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright2015McGrawHillEducation.Allrightsreserved.NoreproductionordistributionwithoutthepriorwrittenconsentofMcGrawHillEducation
 6-2

Learning Objective 1

Explain how variable

costing differs from
absorption costing and
compute unit product
costs under each
method.
 6-3

Overview of Variable and

Absorption Costing
Variable Absorption
Costing Costing
Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs
Fixed Manufacturing Overhead
Period
Variable Selling and Administrative Expenses Period
Costs
Fixed Selling and Administrative Expenses Costs
 6-4

Quick Check
Which
Which method
method will
will produce
produce thethe highest
highest values
values
for
for work
work in
in process
process and
and finished
finished goods
goods
inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends
depends
 6-5

Quick Check
Which
Which method
method will
will produce
produce thethe highest
highest values
values
for
for work
work in
in process
process and
and finished
finished goods
goods
inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the
the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..
 6-6

Unit Cost Computations

Harvey Company produces a single product
with the following information available:
 6-7

Unit Cost Computations

Unit product cost is determined as follows:
Absorption
Absorption Variable
Variable
Costing
Costing Costing
Costing
Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead $$ 10
10 $$ 10
10
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00025,000
25,000units)
units) 66 --
Unit
Unitproduct
productcost
cost $$ 16
16 $$ 10
10

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.
 6-8

Learning Objective 2

Prepare income
statements using both
variable and absorption
costing.
 6-9

Variable and Absorption Costing

Income Statements
Lets 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, lets compute net operating

income using both absorption
and variable costing.
 6-10

Variable Costing Contribution Format

Income Statement All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.
 6-11

Absorption Costing Income Statement

Unit product

cost.

Fixed manufacturing overhead deferred in

inventory is 5,000 units $6 = $30,000.
 6-12

Learning Objective 3

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

Comparing the Two Methods

Cost
Costof
of
Goods
Goods Ending
Ending Period
Period
Sold
Sold Inventory
Inventory Expense
Expense Total
Total
Absorption
Absorptioncosting
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000 $$ 50,000
50,000 $$ -- $$250,000
250,000
Fixed
Fixedmfg.
mfg.costs
costs 120,000
120,000 30,000
30,000 -- 150,000
150,000
$$320,000
320,000 $$ 80,000
80,000 $$ -- $$400,000
400,000

Variable
Variable costing
costing
Variable
Variable mfg.
mfg.costs
costs $$200,000
200,000 $$ 50,000
50,000 $$ -- $$250,000
250,000
Fixed
Fixedmfg.
mfg.costs
costs -- -- 150,000
150,000 150,000
150,000
$$200,000
200,000 $$ 50,000
50,000 $$150,000
150,000 $$400,000
400,000
 6-14

Comparing the Two Methods

We can reconcile the difference between
absorption and variable income as follows:

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
 6-15

Extended Comparisons of Income

Data Harvey Company Year Two
 6-16

Unit Cost Computations

Absorption
Absorption Variable
Variable
Costing
Costing Costing
Costing
Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead $$ 10
10 $$ 10
10
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,00025,000
25,000units)
units) 66 --
Unit
Unitproduct
productcost
cost $$ 16
16 $$ 10
10

Since the variable costs per unit, total fixed costs,

and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
 6-17

Variable Costing Contribution Format

Income Statement All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.
 6-18

Absorption Costing Income Statement

Unit product

cost.

Fixed manufacturing overhead released from

inventory is 5,000 units $6 = $30,000.
 6-19

Comparing the Two Methods

We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 260,000

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

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
 6-20

Comparing the Two Methods

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000
 6-21

Summary of Key Insights

 6-22

Enabling CVP Analysis

Variable costing categorizes costs as fixed and
variable so it is much easier to use this income
statement format for CVP analysis.

Because absorption costing assigns fixed

manufacturing overhead costs to units produced ($6
per unit for Harvey Company), a portion of fixed
manufacturing overhead resides in inventory when
units remain unsold. The potential result is positive
operating income when the number of units sold is
less than the breakeven point.
 6-23

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.
 6-24

Supporting Decision Making

Variable costing correctly identifies the additional
variable costs incurred to make one more unit ($10
per unit for Harvey Company). It also emphasizes
the impact of total fixed costs on profits.

Because absorption costing assigns fixed

manufacturing overhead costs to units produced ($6
per unit for Harvey Company), it gives the impression
that fixed manufacturing overhead is variable with
respect to the number of units produced, but it is not.
The result can be inappropriate pricing decisions and
product discontinuation decisions.
 6-25

Learning Objective 4

Prepare a segmented
income statement that
differentiates traceable
fixed costs from
common fixed costs and
use it to make decisions.
 6-26

Decentralization and Segment

Reporting An Individual Store

Quick Mart

A segment is any part A Sales Territory

or activity of an
organization about
which a manager
seeks cost, revenue,
or profit data. A Service Center
 6-27

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.
 6-28

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 No computer
division means . . . division manager.
 6-29

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 We still have a

division but . . . company president.
 6-30

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.
 6-31

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.
Profits

Time
 6-32

Traceable and Common Costs

Fixed Dont allocate

Costs common costs to
segments.

Traceable Common
 6-33

Levels of Segmented Statements

Webber, Inc. has two divisions.
W e b b e r , In c .

C o m p u te r D iv is io n T e le v is io n D iv is io n
 6-34

Levels of Segmented Statements

Our approach to segment reporting uses the
contribution format.
Income Statement Cost
Cost of
of goods
goods
Contribution Margin Format sold
sold consists
consists of
of
Television Division variable
variable
Sales $ 300,000 manufacturing
manufacturing
Variable COGS 120,000 costs.
costs.
Other variable costs 30,000
Fixed
Fixed and
and
Total variable costs 150,000
variable
variable costs
costs
Contribution margin 150,000
are
are listed
listed in
in
Traceable fixed costs 90,000
separate
separate
Division margin $ 60,000
sections.
sections.
 6-35

Levels of Segmented Statements

Our approach to segment reporting uses the
contribution format.
Income Statement
Contribution Margin Format
Contribution
Contribution margin
margin
is
is computed
computed byby
Television Division
taking
taking sales
sales minus
minus
Sales $ 300,000
variable
variable costs.
costs.
Variable COGS 120,000
Other variable costs 30,000
Total variable costs 150,000 Segment
Segment margin
margin
Contribution margin 150,000 is
is Televisions
Televisions
Traceable fixed costs 90,000 contribution
contribution
Division margin $ 60,000 to
to profits.
profits.
 6-36

Levels of Segmented Statements

Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs
Net operating
income
 6-37

Levels of Segmented Statements

Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs 25,000
Net operating Common
Common costs
costs should
should notnot
be
be allocated
allocated to
to the
the
income $ 75,000
divisions.
divisions. These
These costs
costs
would
would remain
remain even
even ifif one
one
of
of the
the divisions
divisions were
were
eliminated.
eliminated.
 6-38

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.

Lets see how this works

using the Webber, Inc.
example!
 6-39

Traceable Costs Can Become

Common Costs
Webbers Television Division
Television
Division

Regular Big Screen

Product
Lines
 6-40

Traceable Costs Can Become

Common Costs
Income Statement
Television
Division Regular Big Screen
Sales $ 200,000 $ 100,000
Variable costs 95,000 55,000
CM 105,000 45,000
Traceable FC 45,000 35,000
Product line margin $ 60,000 $ 10,000
Common costs
Divisional margin

We obtained the following information from

the Regular and Big Screen segments.
 6-41

Traceable Costs Can Become

Common Costs
Income Statement
Television
Division Regular Big Screen
Sales $ 300,000 $ 200,000 $ 100,000
Variable costs 150,000 95,000 55,000
CM 150,000 105,000 45,000
Traceable FC 80,000 45,000 35,000
Product line margin 70,000 $ 60,000 $ 10,000
Common costs 10,000
Divisional margin $ 60,000

Fixed
Fixed costs
costs directly
directly traced
traced
to
to the
the Television
Television Division
Division
$80,000
$80,000 ++ $10,000
$10,000 == $90,000
$90,000
 6-42

Segmented Income Statements

Decision Making and Break-even
Analysis
Once a company prepares
contribution format segmented
income statements, it can use
those statements to make
decisions and perform break-
even analysis.
 6-43

Segmented Income Statements

Decision Making 5% increase in sales

$5,000 additional Division margin Margin Margin

advertising increases by increases increases
$2,500 by $5,250 by $2,250
 6-44

Learning Objective 5

Compute companywide
and segment break-even
points for a company
with traceable fixed
costs.
 6-45

Segmented Income Statements

Break-even Analysis
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs 25,000
Net operating
income $ 75,000
 6-46

Segmented Income Statements

Break-even Analysis
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs 25,000
Net operating
income $ 75,000

The companywide break-even point is computed by dividing the

sum of the companys traceable fixed costs and common fixed
costs by the companys overall contribution margin ratio.
 6-47

Segmented Income Statements

Break-even Analysis

Break-even $170,000 + $25,000

= = $361,111
Point 0.54

Contribution Margin $270,000

= = 0.54
Ratio $500,000

The companywide break-even point is computed by dividing the

sum of the companys traceable fixed costs and common fixed
costs by the companys overall contribution margin ratio.
 6-48

Segmented Income Statements

Break-even Analysis
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs 25,000
Net operating
income $ 75,000

A business segments break-even point is computed by dividing its

traceable fixed costs by its contribution margin ratio.
 6-49

Segmented Income Statements

Break-even Analysis
Television Break-even $90,000
= = $180,000
Point 0.50

Contribution Margin $150,000

= = 0.50
Ratio $300,000

Computer Break-even $80,000

= = $133,333
Point 0.60

Contribution Margin $120,000

= = 0.60
Ratio $200,000

A business segments break-even point is computed by dividing its

traceable fixed costs by its contribution margin ratio.
 6-50

Segmented Income Statements

Break-even Analysis
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs 25,000
Net operating
income $ 75,000
Notice the $25,000 of companywide common fixed costs are
excluded from the segment break-even calculations because the
common fixed costs are not traceable to segments and are not
influenced by segment-level decisions.
 6-51

Omission of Costs
Costs assigned to a segment should include
all costs attributable to that segment from the
companys entire value chain.
chain
Business Functions
Making Up The
Value Chain

Product Customer
R&D Design Manufacturing Marketing Distribution Service
 6-52

Inappropriate Methods of Allocating

Costs Among Segments

Failure to trace
costs directly Inappropriate
allocation base

Segment Segment Segment Segment

1 2 3 4
 6-53

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:
1. This practice may make a profitable business segment appear
to be unprofitable.

2. Allocating common fixed costs forces managers to be held

accountable for costs they cannot control.

Segment Segment Segment Segment

1 2 3 4
 6-54

Quick Check

Assume that Hoagland's Lakeshore prepared its

segmented income statement as shown.
 6-55

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.
 6-56

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.
 6-57

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
 6-58

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 The bar would be
b. $30,000 allocated 1/10 of the cost
c. $40,000
or $20,000.
d. $50,000
 6-59

Quick Check
If Hoagland's allocates its common
costs to the bar and the restaurant,
what would be the reported profit of
each segment?
 6-60

Allocations of Common Costs

Hurray, now everything adds up!!!

 6-61

Quick Check
Should the bar be eliminated?
a. Yes
b. No
 6-62

Quick Check
Should the bar be eliminated?
a. Yes
The profit was $44,000 before
b. No
eliminating the bar. If we eliminate
the bar, profit drops to $30,000!
 6-63

Companywide Income Global View

Statements

Both
Both U.S.
U.S. GAAP
GAAP and
and
IFRS
IFRS require
require absorption
absorption costing
costing
for
for external
external reports.
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.
 6-64

Variable versus Absorption Costing

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

Variable
Costing
 6-65

Segmented Financial Global View

Information
Both U.S. GAAP and IFRS require publically
traded companies to include segmented
financial data in their annual reports.
1. Companies must report segmented results to
shareholders using the same methods that are used for
internal segmented reports.
2. This requirement motivates managers to avoid using
the contribution approach for internal reporting
purposes because if they did they would be required
to:
a. Share this sensitive data with the public.
b. Reconcile these reports with applicable
rules for consolidated reporting purposes.
 6-66

End of Chapter 6