Chapter 6: Variable Costing & Segment Reporting Accounting Terms

Segment

Any part or activity of an organization about which managers seek cost, revenue, or profit data.

Absorption Costing and Faulty CVP Analysis

Because absorption costing treats fixed manufacturing overhead as a variable cost, faulty pricing decisions are likely to be made. Because absorption costing assigns per unit fixed manufacturing overhead costs to production, it is possible to compute a positive net operating income even when the number of units sold is less than the breaking point

How is assigning overhead determined under traditional costing?

Under traditional costing, overhead costs are assigned to products using a plant-wide, predetermined overhead rate. This rate, which is usually calculated at the beginning of the year, is determined by making estimates of total overhead costs and total activity

Using an activity-based costing system, how do you apply overhead costs to a product?

You multiply the activity rate by the number of that cost pool

How to prepare a firm's variable costing contribution form income statement?

1. Compute the unit product cost. 2. Compute the variable costing cost of goods sold using the monthly variable production cost 3. Combine variable selling & admin. expenses with fixed selling & admin. expenses to derive total selling and admin. expense 4. Organize the income statement into the contribution format (Sales, Variable Exp.,, Contribution Margin, Fixed Exp., Net Operating Income) 5. Make sure the monthly manufacturing overhead cost is recorded as a period expense for the month incurred under variable costing

Preparing a Absorption Costing Income Statement

1. Determine the company's unit product costs for each month as follows

Computing the Variable Contribution Margin

1. Determine the sales price of an item. For example, assume a company sells a widget for $5. 2. Determine all of the variable costs associated with producing the product. Variable costs are those costs that change based on the volume of a product produced. For example, raw materials and hourly labor are variable costs, but the cost of the machine used to produce the product represents a fixed cost. For example, assume that the total variable costs to produce the widget are $2. 3. Subtract the variable costs from the sales price. Continuing the same example, $5 - $2 = $3. This figure represents the variable contribution margin of the product.

A contribution margin income statement varies from a normal income statement in the following three ways:

1.) Fixed production costs are aggregated lower in the income statement, after the contribution margin; 2.) Variable selling and administrative expenses are grouped with variable production costs, so that they are a part of the calculation of the contribution margin; and 3.) The gross margin is replaced in the statement by the contribution margin.

Absorption Costing

A costing method that includes all manufacturing costs—direct materials, direct labor, and both variable and fixed manufacturing overhead—in unit product costs. Under absorption and variable costing, variable and fixed selling and administrative expenses are always treated as period costs and are expended as incurred.

Traceable Fixed Cost

A fixed cost that is incurred because of the existence of a particular business segment and that would be eliminated if the segment were eliminated.

Common Fixed Cost

A fixed cost that supports more than one business segment, but is not traceable in whole or in part to any one of the business segments.

How does activity-based costing assign overhead?

ABC allocates overhead costs in two stages: 1.) Overhead costs are allocated to activity cost pools 2.) The overhead costs allocated to the cost pool are assigned to products using cost drivers

Segmented Income Statement: Common Mistakes

All of the costs attributable to a segment—and only those costs—should be assigned to the segment. Unfortunately, companies often make mistakes when assigning costs to segments. They omit some costs, inappropriately assign traceable fixed costs, and arbitrarily allocate common fixed costs.

Traceable Fixed Costs Can Become Common Costs

Fixed costs that are traceable to one segment may be a common cost of another segment. For example, United Airlines might want a segmented income statement that shows the segment margin for a particular flight from Chicago to Paris further broken down into first-class, business-class, and economy-class segment margins. The airline must pay a substantial landing fee at Charles DeGaulle airport in Paris. This fixed landing fee is a traceable cost of the flight, but it is a common cost of the first-class, business-class, and economy-class segments. Even if the first-class cabin is empty, the entire landing fee must be paid. So the landing fee is not a traceable cost of the first-class cabin. But on the other hand, paying the fee is necessary in order to have any first-class, business-class, or economy-class passengers. So the landing fee is a common cost of these three classes.

CVP Equation

Operating Income = Sales - Total Variable Costs - Total Fixed Costs Operating Income = (Price X #Units Sold)- (Variable Cost Per Unit X Number of Units Sold) - Total Fixed Costs

Identifying Traceable Fixed Costs

The distinction between traceable and common fixed costs is crucial in segment reporting because traceable fixed costs are charged to segments and common fixed costs are not. In an actual situation, it is sometimes hard to determine whether a cost should be classified as traceable or common. The general guideline is to treat as traceable costs only those costs that would disappear over time if the segment itself disappeared. For example, if one division within a company were sold or discontinued, it would no longer be necessary to pay that division manager's salary. Therefore the division manager's salary would be classified as a traceable fixed cost of the division. On the other hand, the president of the company undoubtedly would continue to be paid even if one of many divisions was dropped. In fact, he or she might even be paid more if dropping the division was a good idea. Therefore, the president's salary is common to the company's divisions and should not be charged to them. When assigning costs to segments, the key point is to resist the temptation to allocate costs (such as depreciation of corporate facilities) that are clearly common and that will continue regardless of whether the segment exists or not. Any allocation of common costs to segments reduces the value of the segment margin as a measure of long-run segment profitability and segment performance.

Difference Between Absorption & Variable Costing

The essential difference between variable costing and absorption costing is how each method accounts for fixed manufacturing overhead costs. all other costs are treated the same under the two methods. Under absorption costing, fixed manufacturing overhead is included in product costs. In variable costing, fixed manufacturing overhead is not included in product costs and instead is treated as a period expense just like selling and administrative expenses. In absorption costing, fixed manufacturing overhead costs are included as part of the costs of work in process inventories. When units are completed, these costs are transferred to finished goods and only when the units are sold do these costs flow through to the income statement as part of cost of goods sold. In variable costing, fixed manufacturing overhead costs are considered to be period costs—just like selling and administrative costs—and are taken immediately to the income statement as period expenses. AKA: Under absorption costing, fixed manufacturing overhead is included in product costs. In variable costing, fixed manufacturing overhead is not included in product costs and instead is treated as a period expense just like selling and administrative expenses.

BASIC EXAMPLE: Determining a Absorption Costing Company's Unit Product Costs

Unit Product Cost = DM+DL+Var. Manu.OH+Fixed Manu.OH Fixed Manu.OH = Total Fixed Manufacturing Overhead / number of units produced

Differences in net operating income under variable and absorption costing

Variable costing and absorption costing usually produce different net operating income figures. The reason is that the fixed manufacturing overhead cost is not treated the same way under two costing methods. The net operating income is higher under absorption costing than variable costing when the closing inventory is higher than the opening inventory. This difference is because of fixed manufacturing overhead that becomes the part of ending inventory under absorption costing system. The ending inventory absorbs a portion of fixed manufacturing overhead and reduces the burden of the current period. In this way a portion of fixed cost that relates to the current period is transferred to the next period. Under variable costing, the fixed manufacturing overhead cost is not included in the product cost but charged to the income statement of the relevant period in its entirety. Therefore no portion of fixed cost is absorbed by the ending inventory. The net operating income under absorption costing systems is always higher than variable costing system when inventory increases. The net operating income under variable costing systems is always higher than absorption costing system when inventory decreases. When inventory increases, the fixed manufacturing overhead cost is deferred to inventory. When inventory decreases, the fixed manufacturing overhead cost is released from inventory.

CVP & Variable Costing

Variable costing is used for CVP analysis because CVP analysis is based on the assumption that profits are calculated using variable costing. Variable costing facilitates profit analysis as it separates variable and fixed costs and treats fixed costs as a period expense rather than attempting to allocate them to products.

Reconciling Income Differences between Absorption & Variable Costing

Variable costing net operating income is added/deducted with the amount of fixed manu. overhead deferred in or released from inventory to obtain the absorption costing net operating income. The amount of manufactured overhead that deferred in or released from inventories can be determined as follows: M.OH Deferred in Inventory = Fixed Manu. OH in ending inventories - Fixed manufacturing overhead in beginning inventories

Rules about Absorption Costing versus Variable Costing

a. When production is equal to sales, then absorption costing and variable costing will give the same amount of net income. b. When production is greater than sales, then Net Income under absorption costing will be greater than net income under variable costing because a portion of the fixed costs was deferred to other years under the absorption method. c. When production is less than sales, then Net Income under absorption costing will be less than net income under variable costing because a portion of the fixed costs that were deferred from previous years will be absorbed into this years cost of goods sold. d. The value of inventory will be greater under the absorption method because of the deferred costs, however the total unit count will be the same for each accounting method. e. Over the long-term, net income will be equal under both methods.

Variable Costing

A costing method that includes only variable manufacturing costs—direct materials, direct labor, and variable manufacturing overhead—in unit product costs. Under absorption and variable costing, variable and fixed selling and administrative expenses are always treated as period costs and are expensed as incurred.

Segment Margin

A segment's contribution margin less its traceable fixed costs. It represents the margin available after a segment has covered all of its own traceable costs. The segment margin is the best gauge of the long-run profitability of a segment because it includes only those costs that are caused by the segment. If a segment can't cover its own costs, then that segment probably should be dropped (unless it has important side effects on other segments). Notice, common fixed costs are not allocated to segments. From a decision-making point of view, the segment margin is most useful in major decisions that affect capacity such as dropping a segment. By contrast, as we noted earlier, the contribution margin is most useful in decisions involving short-run changes in volume, such as pricing special orders that involve temporary use of existing capacity.

Variable Costing: Advantages & Disadvantages

Advantages 1.) Variable costing provides a better understanding of the effect of fixed costs on the net profits because total fixed cost for the period is shown on the income statement. 2.) Various methods of controlling costs such as standard costing system and flexible budgets have close relation with the variable costing system. Understanding variable costing system makes the use of those methods easy. 3.) Companies using variable costing system prepare income statement in contribution margin format that provides necessary information for cost volume profit (CVP) analysis. This data cannot be directly obtained from a traditional income statement prepared under absorption costing system. 4.) The net operating income figure produced by variable costing is usually close to the flow of cash. It is useful for businesses with a problem of cash flows. 5.) Under absorption costing system, income of different periods changes with the change of inventory levels. Sometime income and sales move in opposite directions. But it does not happen under variable costing. Disadvantages 1.) Financial statements prepared under variable costing method do not conform to generally accepted accounting principles (GAAP). The auditors may refuse to accept them. 2.) Tax laws of various countries require the use of absorption costing. 3.) Variable costing does not assign fixed cost to units of products. So the production costs cannot be truly matched with revenues. 4.) Absorption costing is usually the base for evaluating top executive's efficiency.

Format of the Variable Costing Income Statement vs. The Format of the Absorption Costing Income Statement

Also note that The format of the variable costing income statement differs from the absorption costing income statement. An absorption costing income statement categorizes costs by function—manufacturing versus selling and administrative. All of the manufacturing costs flow through the absorption costing cost of goods sold and all of the selling and administrative expenses are listed separately as period expenses. In contrast, in the contribution approach, costs are categorized according to how they behave. All of the variable expenses are listed together and all of the fixed expenses are listed together. The variable expenses category includes manufacturing costs (i.e., variable cost of goods sold) as well as selling and administrative expenses. The fixed expenses category also includes both manufacturing costs and selling and administrative expenses.

What is the purpose of preparing a contribution format segmented income statements?

Break-Even Analysis: One of the primary uses of the contribution income statement is the break-even analysis of a particular segment. The contribution margin is first calculated by taking sales revenue minus the variable selling and manufacturing costs to get the contribution margin. The contribution margin is then compared to fixed costs. When contribution margin minus fixed costs equals zero, the break-even point has been reached. If a company has additional sales revenue beyond the break-even point, it makes profit. If the contribution margin is less than the break-even point, the company is operating at a loss. Cost-Volume-Profit Analysis: Cost-Volume-Profit analyses consist of different versions of the basic equation "profit equals sales minus variable expenses minus fixed expenses." Managers manipulate this equation in various ways in order to help them create sales goals in both units and revenue dollars and set up sales-commission structures. The equation is also used to calculate a company's margin of safety, which is the amount that sales can decline before the company begins to take a loss instead of make profits. Segment-Performance Evaluation: Most businesses have different segments, which can be classified based on product lines, departments, manufacturing or sales sites. The contribution income statement can be used to evaluate how each of these segments is performing based on the factors within that department's control. Unprofitable segments can sometimes be hidden by the entire corporation's profits, or segments that are doing well may look bad because of corporate overhead, which is outside their control. The contribution margin of each segment represents a given business unit's ability to control its variable costs in order to create a profitable operation.

CVP Analysis Techniques

CVP analysis highlights contribution as a key factor of an organization operations. Contribution is defined as total sales revenue minus total variable costs. This represents the amount that is contributed towards covering total fixed costs and generating a profit.If an organization has sufficient contribution to cover total fixed costs but not generate a profit, or incur a loss, this is called break-even point (BEP). Break-Even Analysis: An important element of CVP. The break-even point is the level of sales the firm must reach to break even (cover their costs so there are no operating losses). Past the break-even point, operating income increases by the contribution margin of each additional unit sold. The difference between the organization's current or expected sales volume (or revenue) and its BEP sales volume (or revenue) is called the margin of safety (MOS). It shows by how much current (or expected) sales volume (or revenue) call fall before the organization starts to make losses. Using CVP analysis an organization may also calculate the total sales revenue (or sales volume) required to generate a particular level of profit, called target profit.

CVP Analysis

Cost-volume-profit analysis estimates how much changes in a company's costs, both fixed and variable, sales volume, and price, affect a company's profit. In cost-volume-profit analysis, we are looking at the effect of three variables on one variable -- profit. Cost-Volume-Profit (CVP) analysis examines the relationships between changes in activity and changes in total sales revenue, costs and profit. CVP analysis assists by determining how many units of a product must be sold so that the business 'breaks even' i.e. total costs, both fixed and variable are covered by total sales revenue. It allows the business to consider the effect on profits of various changes in operating costs and revenues such as a reduction in selling price or an increase in fixed costs; to determine the sales volume required to achieve a specific profit level and to establish the amount by which the current sales level can decrease before losses are incurred.

Absorption Costing: Advantages & Disadvantages

One of the advantages of absorption costing is that it is the costing method required for a company to be in compliance with generally accepted accounting principles (GAAP). Even if a company decides to use variable costing in-house, it is required by law to use absorption costing in any external financial statements it publishes. Absorption costing is also the costing method that a company is required to use for calculating and filing its taxes. Absorption costing provides a more accurate accounting of net profitability, especially when a company doesn't sell all of its products in the same accounting period when they are manufactured. Absorption costing is not as helpful as variable costing for comparing profitability of different product lines. ADVANTAGES 1. the fact that it recognizes all of the costs involved in production (including fixed costs) 2. it does a better job of accurately tracking profit during an accounting period 3. it is in compliance with the generally accepted accounting principles (GAAP). DISADVANTAGES 1.the fact that it's not particularly helpful for analysis designed to improve operational or financial efficiency 2.it's not useful for comparing product lines 3. it can skew the picture of a company's profitability.

What is a first stage allocation in an ABC system?

The first stage allocation in an ABC system is the process of assigning functionally organized overhead costs from a company's general ledger to the activity cost pools

Variable Contribution Margin

The variable contribution margin, also known as the contribution margin or gross profit, describes the amount of profit generated by the sale of an item for a company. The variable contribution margin considers the variable costs associated with a product but does not consider any of the fixed costs associated with the item. You can manually calculate the variable contribution margin for any product. It is used to compute the Variable Costing New Operating Income

Computing the Variable Costing New Operating Income

The variable costing net operating income for each period can always be computed by multiplying the number of units sold by the contribution margin per unit and then subtracting total fixed costs.