Accounting 711 Garrison Chapter 6

Why is variable costing useful for Cost-Volume-Profit?

-Variable costing income statements categorize costs as variable and fixed -Absorption costing net operating income may or may not agree with Cost-Volume Profit analysis because of distorted changes in inventories.

3 Advantages of Variable Costing

1. Enabling CVP (Cost-Volume-Profit) Analysis 2. Explaining Changes in Net Income 3. Supporting Decision Making

What are the two inappropriate methods for assigning traceable costs?

1. Failure to Trace Costs Directly to the right segment. 2. Innapropriate Allocation Base: Using arbitrary allocation bases to allocate costs to segments. Costs should be allocated to segments when the allocation base drives the costs being allocated.

Three Common Segmented Income Statement Mistakes

1. Omission of Costs 2. Inappropriate Methods for Assigning Traceable Costs 3. Arbitrarily Dividing Common Costs among Segments

Common Fixed Costs

A fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Even if segment costs were entirely eliminated, there would be no change in a true common fixed cost. These costs are not designated to segments.

How does absorption costing report expenses?

Absorption costing ignores fixed and variable cost distinctions

What costs should be assigned to a segment to avoid omission of cost errors

All costs attributable to that segment from the company's entire value chain. If either upstream or downstream costs are omitted, then the product is undercosted and management may unwillingly develop and maintain products that in the long run result in losses.

What does an allocation of common cost do to segment margin?

Allocating common costs to segments reduce the value of the segment margin as a measure of long-run segment profitability and segment performance.

What does allocating common costs do?

Artificially inflates break-even points for the segments

What types of costs do Variable and Absorption Income Statements report?

Both income statement formats include product costs and period costs, although they define those costs differently.

What is the best gauge of short-term profitability and why?

Contribution margin is most useful in decisions involving short-run changes in sales volume, such as pricing special orders that involve temporary use of existing capacity because it only incudes sales and variable costs.

How does variable costing method support decision making?

Correctly identifies additional variable costs that will be incurred to make one more unit. It also emphasizes impact of fixed costs on profits. Under absorption costing, fixed manufacturing cots appear to be variable with respect to number of units sold, but they are not.

Do asorption and variable costing income statements differ in the amount of net income reported?

Differences in net income are reported because fixed manufacturing overhead is accounted for differently in the absorption and variable costing income statements.

What is included in Variable Costing

Direct Costing or Marginal Costing: Only those manufacturing costs that vary with output are treated as product costs: direct materials, direct labor, & variable portion of manufacturing overhead. Fixed manufacturing overhead is treated like a period cost in the same way as administrative and selling. Consequently, cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing cost.

Absorption Costing Unit Product Cost

Direct Materials +Direct Labor +Variable Manufacturing Overhead + Fixed Manufacturing Overhead/Units = Unite Product Costs

Variable Costing Unit Product Cost

Direct Materials +Direct Labor +Variable Manufacturing Overhead =Unit Product Cost

Fixed Manufacturing Overhead Deferred in or Released Inventories under Absorption Costing

Fixed Mfg Overhead in End Inventory -Fixed Mfg Overhead in Begin Inventory

How are period expenses taken in the absorption costing method?

Fixed manufacturing overhead costs are included in work in process inventory. When units are completed, these products are transferred to finished goods inventory and only when the units are sold do these costs flow through to the income statement as part of cost of goods sold.

What is in included in absorption costing?

Full Cost Method: All manufacturing costs are treated as product costs, regardless of whether they are variable or fixed. Cost of unit include direct materials, direct labor, and both variable and fixed manufacturing overhead.

What problems can misinterpreting absorption unit costs cause?

Inappropriate pricing decisions and decisions to drop products that are in fact profitable.

How do you determine Variable Costing Net Operating Income?

Number of Units x Contribution Margin - Fixed Expenses

Segment Margin

Obtained by deducting the traceable fixed costs of a segment from the segment's contribution margin. It represents the margin available after a segment has covered all of its own costs.

What is the general guideline to treat a cost as traceable?

Only costs that would disappear over time if the segment itself disappeared

Variable Costing

Only those manufacturing costs that vary with output are treated as product costs; referred to as direct costing or marginal costing.

What kind of cost are selling and administrative expenses?

Period Costs regardless of which method is used.

What is the best gauge of long-run profitability of a segment and why?

Segment Margin because it includes only those costs that are caused by the segment. It is most useful in major decisions that affect capacity such as dropping a segment

Dollar Sales for company to break even

Traceable Fixed Expenses + Common Fixed Expenses/Overall CM Ratio

Variable Costing Cost of Goods Sold

Unit Product Cost x Units Sold

When is net operating income higher in absorption costing than variable costing?

Units produced exceed units sold and hence inventories increase, not net operating income. This occurs because fixed manufacturing overhead is deferred.

When is net operating income lower in absorption costing than variable costing?

Units sold exceed the units produced and hence inventories decrease, net operating income is lower. This occurs because some of the fixed manufacturing overhead of previous periods is released from inventories when sold.

How does variable costing report expenses?

Variable costing income statements are grounded in contribution format. They categorize expenses based on cost behavior-variable expenses are reported separately from fixed expenses.

How does variable costing explain changes in net operating income?

When sales go up, net operating income goes up. When sales go down, net operating income goes down. When sales are constant, net operating income is constant.

When will net operating income from absorption costing and variable costing be the same?

When units produced=units sold

Traceable fixed costs

a segment of a fixed cost that is incurred because of the existence of the segment-if the segment never existed, the fixed costs would not have been incurred; and if the segment were eliminated, the fixed cost would disappear.

How are period expenses taken in the variable costing method?

fixed manufacturing overhead costs, selling and administrative costs are taken immediately to the income statement as period expenses.

segment

part of activity of an organization about which managers would like cost, revenue, or profit data

Dollar Sales for a segment to break even

segment traceable fixed expenses/segment CM ration

Absorption Costing

treats all manufacturing costs as product costs, regardless of whether they are variable or fixed; also know an full cost method