chapter 6

What is a segment of an organization? Give several examples of segments.

A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. Examples of segments include departments, operations, sales territories, divisions, and product lines.

Distinguish between a traceable fixed cost and a common fixed cost. Give several examples of each.

A traceable fixed cost of a segment is a cost that arises specifically because of the existence of that segment. If the segment were eliminated, the cost would disappear. A common fixed cost, by contrast, is a cost that supports more than one segment, but is not traceable in whole or in part to any one of the segments. If the departments of a company are treated as segments, then examples of the traceable fixed costs of a department would include the salary of the department's supervisor and depreciation of machines used exclusively by the department. Examples of common fixed costs would include the salary of the general counsel of the entire company, the lease cost of the headquarters building, corporate image advertising, and depreciation of machines shared by several departments.

What is the difference between absorption costing and variable costing?

Absorption and variable costing differ in how they handle fixed manufacturing overhead. Under absorption costing, fixed manufacturing overhead is treated as a product cost and hence is an asset until products are sold. Under variable costing, fixed manufacturing overhead is treated as a period cost and is immediately expensed on the income statement.

What are the arguments in favor of treating fixed manufacturing overhead costs as product costs?

Absorption costing advocates argue that absorption costing does a better job of matching costs with revenues than variable costing. They argue that all manufacturing costs must be assigned to products to properly match the costs of producing units of product with the revenues from the units when they are sold. They believe that no distinction should be made between variable and fixed manufacturing costs for the purposes of matching costs and revenues

What are the arguments in favor of treating fixed manufacturing overhead costs as period costs?

Advocates of variable costing argue that fixed manufacturing costs are not really the cost of any particular unit of product. If a unit is made or not, the total fixed manufacturing costs will be exactly the same. Therefore, how can one say that these costs are part of the costs of the products? These costs are incurred to have the capacity to make products during a particular period and should be charged against that period as period costs according to the matching principle.

How does Lean Production reduce or eliminate the difference in reported net operating income between absorption and variable costing?

Differences in reported net operating income between absorption and variable costing arise because of changing levels of inventory. In Lean Production, goods are produced strictly to customers' orders. With production tied to sales, inventories are largely (or entirely) eliminated. If inventories are completely eliminated, they cannot change from one period to another and absorption costing and variable costing will report the same net operating income.

Why aren't common fixed costs allocated to segments under the contribution approach?

If common fixed costs were allocated to segments, then the costs of segments would be overstated and their margins would be understated. As a consequence, some segments may appear to be unprofitable and managers may be tempted to eliminate them. If a segment were eliminated because of the existence of arbitrarily allocated common fixed costs, the overall profit of the company would decline and the common fixed cost that had been allocated to the segment would be reallocated to the remaining segments—making them appear less profitable.

If fixed manufacturing overhead costs are released from inventory under absorption costing, what does this tell you about the level of production in relation to the level of unit sales?

If fixed manufacturing overhead cost is released from inventory, then inventory levels must have decreased and therefore production must have been less than sales.

If the units produced exceed the units sold, which method would you expect to show the higher net operating income, variable costing or absorption costing? Why?

If production exceeds sales, absorption costing will usually show higher net operating income than variable costing. When production exceeds sales, inventories increase and under absorption costing part of the fixed manufacturing overhead cost of the current period is deferred in inventory to the next period. In contrast, all of the fixed manufacturing overhead cost of the current period is immediately expensed under variable costing.

Should a company allocate its common fixed costs to business segments when computing the break-even point for those segments? Why?

No, a company should not allocate its common fixed costs to business segments. These costs are not traceable to individual segments and will not be affected by segment-level decisions.

Are selling and administrative expenses treated as product costs or as period costs under variable costing?

Selling and administrative expenses are treated as period costs under both variable costing and absorption costing.

Explain how the contribution margin differs from the segment margin.

The contribution margin is the difference between sales revenue and variable expenses. The segment margin is the amount remaining after deducting traceable fixed expenses from the contribution margin. The contribution margin is useful as a planning tool for many decisions, particularly those in which fixed costs don't change. The segment margin is useful in assessing the overall profitability of a segment.

How is it possible for a fixed cost that is traceable to a segment to become a common fixed cost if the segment is divided into further segments?

There are often limits to how far down an organization a cost can be traced. Therefore, fixed costs that are traceable to a segment may become common as that segment is divided into smaller segment units. For example, the costs of national TV and print advertising might be traceable to a specific product line, but be a common fixed cost of the geographic sales territories in which that product line is sold.

Under absorption costing, how is it possible to increase net operating income without increasing sales?

Under absorption costing net operating income can be increased by simply increasing the level of production without any increase in sales. If production exceeds sales, units of product are added to inventory. These units carry a portion of the current period's fixed manufacturing overhead costs into the inventory account, reducing the current period's reported expenses and causing net operating income to increase.

Explain how fixed manufacturing overhead costs are shifted from one period to another under absorption costing.

Under absorption costing, fixed manufacturing overhead costs are included in product costs, along with direct materials, direct labor, and variable manufacturing overhead. If some of the units are not sold by the end of the period, then they are carried into the next period as inventory. When the units are finally sold, the fixed manufacturing overhead cost that has been carried over with the units is included as part of that period's cost of goods sold.

What costs are assigned to a segment under the contribution approach?

Under the contribution approach, costs are assigned to a segment if and only if the costs are traceable to the segment (i.e., could be avoided if the segment were eliminated). Common costs are not allocated to segments under the contribution approach.

If the units produced equals the units sold, which method would you expect to show the higher net operating income, variable costing or absorption costing? Why?

If production and sales are equal, net operating income should be the same under absorption and variable costing. When production equals sales, inventories do not increase or decrease and therefore under absorption costing fixed manufacturing overhead cost cannot be deferred in inventory or released from inventory.