variable costing and segment explain how variableexplain how variable ... · pdf file6-13...

Variable Costing and Segment Reporting: Tools for ManagementChapter 6

Reporting: Tools for Managementp

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W Caldwell D B A CMACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights rese

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L i Obj ti 1Learning Objective 1

Explain how variableExplain how variable costing differs from

absorption costing and compute unit productcompute unit product

costs under each methodmethod.

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Overview of Variable andOverview of Variable and Absorption Costing

VariableCosting

AbsorptionCosting

Direct Materials

Direct LaborProductProductP d tP d tDirect Labor

Variable Manufacturing OverheadCostsCosts ProductProduct

CostsCosts

Fixed Manufacturing Overhead

Variable Selling and Administrative ExpensesPeriodPeriodCostsCosts PeriodPeriod

Fixed Selling and Administrative ExpensesCostsCosts PeriodPeriod

CostsCosts

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Q i k Ch k Quick Check

Which method will produce the highest values for work in process and finished goods o o p ocess a d s ed goodsinventories? a Absorption costinga. Absorption costing.

b. Variable costing.

c. They produce the same values for theseinventories.

d. It depends. . .

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U it C t C t tiUnit Cost Computations

Harvey Company produces a single product with the following information available:g

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U it C t C t tiU it d t t i d t i d f ll

Unit Cost ComputationsUnit product cost is determined as follows:

Under absorption costing all production costs variableUnder absorption costing, all production costs, variable and fixed, are included when determining unit product

cost. Under variable costing, only the variable cost U de a ab e cost g, o y t e a ab eproduction costs are included in product costs.

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Prepare income statements using bothstatements using both

variable and absorption costingcosting.

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Variable and Absorption CostingVariable and Absorption Costing Income Statements

Let’s assume the following additional information for Harvey Company.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 operatingincome using both absorptiong pand variable costing.

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Variable Costing Contribution FormatAll fixed

manufacturing

Variable Costing Contribution Format Income Statement

Variablemanufacturing

costs only.

manufacturingoverhead isexpensed.

Variable CostingSales (20,000 × $30) 600,000$

costs only.

( )Less variable expenses:Variable cost of goods sold (20,000 × $10) 200,000$ Variable selling & administrativeVariable selling & administrative expenses (20,000 × $3) 60,000 260,000 Total variable expenses Contribution margin 340 000Contribution margin 340,000 Less fixed expenses: Fixed manufacturing overhead 150,000$ Fixed selling & administrative expenses 100,000 250,000 Net operating income 90,000$

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Ab ti C ti I St t tAbsorption Costing Income StatementUnit product p

cost.

Fixed manufacturing overhead deferred in ginventory is 5,000 units × $6 = $30,000.

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Reconcile variable costing and absorption costingand absorption costing net operating incomes

and explain why the twoand explain why the two amounts differ.

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Comparing the Two MethodsComparing the Two Methods

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Comparing the Two Methods

W il th diff b t


We can reconcile the difference betweenabsorption and variable income as follows:

Variable costing net operating income 90,000$ Add: Fixed mfg overhead costsAdd: Fixed mfg. overhead costs deferred in inventory

(5 000 units × $6 per unit) 30 000 (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 120,000$

Fixed mfg. overhead $150,000 = = $6 per unitUnits produced 25,000 units= = $6 per unit

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Extended Comparisons of IncomeExtended Comparisons of Income Data Harvey Company – Year Two

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U it C t C t tiUnit Cost Computations

Since the variable costs per unit, total fixed costs, Since the variable costs per unit, total fixed costs, and the number of units produced remainedand the number of units produced remainedand the number of units produced remained and the number of units produced remained unchanged, the unit cost computations also unchanged, the unit cost computations also

remain unchangedremain unchangedremain unchanged.remain unchanged.

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Variable Costing Contribution FormatVariable Costing Contribution Format Income Statement All fixed

f t iVariablemanufacturing

costs only

manufacturingoverhead isexpensed.

Variable CostingSales (30 000 × $30) 900 000$

costs only.

Sales (30,000 × $30) 900,000$ Less variable expenses:Variable cost of goods sold (30,000 × $10) 300,000$ Variable selling & administrativeVariable selling & administrative expenses (30,000 × $3) 90,000 390,000 Total variable expenses Contribution margin 510,000 Less fixed expenses: Fixed manufacturing overhead 150,000$ Fixed selling & administrative expenses 100,000 250,000 Net operating income 260,000$

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Ab ti C ti I St t tAbsorption Costing Income StatementUnit product p

cost.

Fixed manufacturing overhead released fromFixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.

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W il th diff b t


We can reconcile the difference betweenabsorption and variable income as follows:

Variable costing net operating income 260,000$ Deduct: Fixed manufacturing overhead costs released from inventory

(5 000 it $6 it) 30 000 (5,000 units × $6 per unit) 30,000 Absorption costing net operating income 230,000$

Fixed mfg. overhead $150,000 = = $6 per unitUnits produced 25,000 units= = $6 per unit

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Comparing the Two MethodsComparing the Two Methods

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S f K I i htSummary of Key Insights

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E bli CVP A l iEnabling CVP AnalysisVariable costing categorizes costs as fixed andVariable costing categorizes costs as fixed and variable so it is much easier to use this income

statement format for CVP analysisstatement format for CVP analysis.

Because absorption costing assigns fixed manufacturing overhead costs to units produced ($6manufacturing overhead costs to units produced ($6

per unit for Harvey Company), a portion of fixed manufacturing overhead resides in inventory whenmanufacturing overhead resides in inventory when units remain unsold. The potential result is positive operating income when the number of units sold isoperating income when the number of units sold is

less than the breakeven point.

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Explaining Changes in Net OperatingExplaining Changes in Net Operating Income

Variable costing income is only affected by changes in unit sales. It is not affected bychanges in unit sales. It is not affected by

the number of units produced. As a general rule, when sales go up, net operatingrule, when sales go up, net operating

income goes up, and vice versa.

Absorption costing income is influenced by changes in unit sales and units ofchanges in unit sales and units of

production. Net operating income can be increased simply by producing more unitsincreased simply by producing more units

even if those units are not sold.

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S ti D i i M kiSupporting Decision Making V i bl ti tl id tifi th dditi lVariable costing correctly identifies the additional

variable costs incurred to make one more unit ($10 it f H C ) It l h iper 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 ($6manufacturing overhead costs to units produced ($6 per unit for Harvey Company), it gives the impression

that fixed manufacturing overhead is variable withthat fixed manufacturing overhead is variable with respect to the number of units produced, but it is not. The result can be inappropriate pricing decisions andThe result can be inappropriate pricing decisions and

product discontinuation decisions.

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Variable Costing and the Theory ofVariable Costing and the Theory of Constraints (TOC)Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons: Many companies have a commitment to guarantee

workers a minimum number of paid hours.

Direct labor is usually not the constraint.

TOC emphasizes the role direct laborers play in driving TOC emphasizes the role direct laborers play in drivingcontinuous improvement. Since layoffs often devastatemorale, managers involved in TOC are extremelymorale, managers involved in TOC are extremelyreluctant to lay off employees.

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Prepare a segmented i hincome statement that differentiates traceable

fixed costs from common fixed costs and use it tofixed costs and use it to

make decisions.

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Decentralization and SegmentDecentralization and Segment Reporting

An Individual StoreQuick MartQuick Mart

An Individual Store

A segmentsegment is any part or activity of an

A Sales Territory

organization about which a manager

seeks cost, revenue, or profit data. A Service Center

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K t S t d I St t tKeys to Segmented Income Statements

There are two keys to building segmented income statements:segmented income statements:

A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a

t ib ti icontribution margin.

Traceable fixed costs should be separated from common fixed costs to enable the

l l ti f t icalculation of a segment margin.

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Id tif i T bl Fi d C tIdentifying Traceable Fixed CostsT bl fi d t i b f thTraceable fixed costs arise because of the

existence of a particular segment and would disappear over time if the segment itselfdisappear over time if the segment itself

disappeared.

No computer division means

No computerdivision managerdivision means . . . division manager.

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Id tif i C Fi d C tIdentifying Common Fixed CostsCommon fixed costs arise because of theCommon fixed costs arise because of the

overall operation of the company and would not disappear if any particular segment werenot disappear if any particular segment were

eliminated.

No computer division but

We still have acompany presidentdivision but . . . company president.

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Traceable Costs Can BecomeTraceable Costs Can Become Common Costs

It is important to realize that the traceable fixed costs of one segment may be afixed 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.

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S t M iSegment MarginThe segment margin which is computed byThe segment margin, which is computed by

subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge offrom its contribution margin, is the best gauge of

the long-run profitability of a segment.

Prof

itsP

Time

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T bl d C C tTraceable and Common Costs

Fixed Don’t allocateDon’t allocateCosts

Don t allocateDon t allocatecommon costs to common costs to

segments.segments.segments.segments.

Traceable Common

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L l f S t d St t tLevels of Segmented StatementsWebber Inc has two divisionsWebber, Inc. has two divisions.

W bb IWebber, Inc.

Computer Division Television DivisionComputer Division Television Division

Let’s look more closely at the Television Division’s income statement.

Let’s look more closely at the Television Division’s income statement.Division s income statement.Division s income statement.

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L l f S t d St t tLevels of Segmented StatementsOur approach to segment reporting uses the

C t f d

Our approach to segment reporting uses the contribution format.

Income StatementContribution Margin Format

Television Division

Cost of goodssold consists of

variableTelevision DivisionSales 300,000$ Variable COGS 120,000

variable manufacturing

costs.Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Fixed and

variable costsContribution margin 150,000 Traceable fixed costs 90,000 Di i i i 60 000$

variable costsare listed in

separateDivision margin 60,000$ psections.

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L l f S t d St t tLevels of Segmented StatementsOur approach to segment reporting uses theOur approach to segment reporting uses the

contribution format.

Contribution marginis computed by

Income StatementContribution Margin Format

Television Division p ytaking sales minus

variable costs.

Television DivisionSales 300,000$ Variable COGS 120,000

Segment margin

Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 g g

is Television’s contribution

Contribution margin 150,000 Traceable fixed costs 90,000 Di i i i 60 000$ to profits.Division margin 60,000$

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L l f S t d St t tLevels of Segmented StatementsIncome StatementIncome Statement

Company Television ComputerSales 500,000$ 300,000$ 200,000$Sales 500,000$ 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$ C tCommon costsNet operating

income income

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L l f S t d St t tLevels of Segmented StatementsIncome StatementIncome Statement

Company Television ComputerSales 500,000$ 300,000$ 200,000$Sales 500,000$ 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$ C t 25 000Common costs 25,000 Net operating

income 75 000$

Common costs should notbe allocated to the

di i i Th t income 75,000$ divisions. These costs would remain even if one

of the divisions were eliminated.

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As previously mentioned, fixed costs that are traceable to one segment can become

common if the company is divided intop ysmaller smaller segments.

Let’s see how this works using the Webber, Inc.

example!example!

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Webber’s Television Division

TelevisionDivision

Regular Big ScreenRegular Big Screen

ProductProductProductProductLinesLines

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Income StatementTelevision

Di i i R l Bi SDivision Regular Big ScreenSales 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$Product line margin 60,000$ 10,000$ Common costsDivisional margin

We obtained the following information from

g

gthe Regular and Big Screen segments.

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Income StatementTelevision

Division Regular Big ScreenSales 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$Product line margin 70,000 60,000$ 10,000$ Common costs 10,000 Divisional margin 60,000$ g ,

Fixed costs directly tracedto the Television Divisionto the Television Division

$80,000 + $10,000 = $90,000

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Segmented Income Statements andSegmented Income Statements and Decision Making 5% increase in sales

Income StatementTelevision Di i i R l Bi SDivision Regular Big Screen

Sales 315,000$ 210,000$ 105,000$ Variable costs 157,500 99,750 57,750 CM 157,500 110,250 47,250 Traceable FC 80,000 45,000 35,000 Product line margin 77,500 65,250$ 12,250$ Common costs 15,000 Divisional margin 62,500$

$5,000 additionaladvertising

Marginincreases

Marginincreases

Division marginincreases by

by $2,250by $5,250increases by

$2,500

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O i i f C tOmission of Costs

Costs assigned to a segment should include all costs attributable to that segment from the g

company’s entire value chainvalue chain.Business Functions

Making Up TheValue Chain

Product Customer

Value Chain

R&D Design Manufacturing Marketing Distribution Service

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Inappropriate Methods of AllocatingInappropriate Methods of Allocating Costs Among Segments

Failure to traceInappropriate

allocation base

Failure to tracecosts directly

Segment1

Segment3

Segment4

Segment2

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C C t d S tCommon Costs and Segments Common costs should not be arbitrarily allocated to segmentsCommon 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.y

Segment1

Segment3

Segment4

Segment2

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Q i k Ch kIncome Statement

Quick Check Income Statement

Hoagland's Lakeshore Bar Restaurant

Sales 800,000$ 100,000$ 700,000$ Variable costs 310,000 60,000 250,000Variable costs 310,000 60,000 250,000 CM 490,000 40,000 450,000 Traceable FC 246,000 26,000 220,000 S t i 244 000 14 000$ 230 000$Segment margin 244,000 14,000$ 230,000$ Common costs 200,000 Profit 44,000$ ,$

Assume that Hoagland's Lakeshore prepared its t d i t t t hsegmented income statement as shown.

6-47

Q i k Ch kQuick 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.

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Q i k Ch kQuick 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. $20,000b. $30,000c. $40,000d. $50,000

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Q i k Ch kQuick Check If Hoagland's allocates its commonIf Hoagland s allocates its common costs to the bar and the restaurant, what would be the reported profit ofwhat would be the reported profit of

each segment?

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All ti f C C tIncome Statement

Allocations of Common CostsIncome Statement

Hoagland's Lakeshore Bar Restaurant

Sales 800,000$ 100,000$ 700,000$ Variable costs 310 000 60 000 250 000Variable costs 310,000 60,000 250,000 CM 490,000 40,000 450,000 Traceable FC 246,000 26,000 220,000 S t i 244 000 14 000 230 000Segment margin 244,000 14,000 230,000 Common costs 200,000 20,000 180,000 Profit 44,000$ (6,000)$ 50,000$ ( )

Hurray now everything adds up!!!Hurray now everything adds up!!!Hurray, now everything adds up!!!Hurray, now everything adds up!!!

6-51

Q i k Ch kQuick Check Should the bar be eliminated?Should the bar be eliminated?a. Yesb. Nob. No

6-52

Companywide IncomeCompanywide Income Statements

Global View

Both U S GAAP andBoth U S GAAP andBoth U.S. GAAP andBoth U.S. GAAP andIFRS require absorption costingIFRS require absorption costing

for external reportsfor external reportsfor external reports. for external reports.

Since absorption costing is required for external reporting most companies also useexternal reporting, most companies also use it for internal reports rather than incurring the

additional cost of maintaining a separateadditional cost of maintaining a separate variable cost system for internal reporting.

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V i bl Ab ti C tiVariable versus Absorption CostingFi d f t iFixed manufacturing

costs must be assignedto products to properly

Fixed manufacturingcosts are capacity coststo products to properly

match revenues andcosts.

costs are capacity costsand will be incurredeven if nothing iseven if nothing is

produced.

VariableAbsorptionCosting

pCosting

6-54

Segmented FinancialSegmented Financial InformationB th U S GAAP d IFRS i bli ll

Global View

Both U.S. GAAP and IFRS require publically traded companies to include segmented

financial data in their annual reportsfinancial data in their annual reports.

1. Companies must report segmented results to shareholders using the same methods that are usedshareholders using the same methods that are used for internal segmented reports.

2 Thi i t ti t t id i2. This requirement motivates managers to avoid using the contribution approach for internal reporting purposes because if they did they would be requiredpurposes 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.

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E d f Ch t 6End of Chapter 6

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