Chapter 6

Levels of Segmented Income Statements

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Variable Costing FMOH

are considered to be period costs-just like selling and administrative costs and are taken immediately to the income statement as period expenses.

Variable costing of a unit of inventory does not include

fixed manufacturing overhead.

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.

Summary of differences

how they treat fixed manufacturing overhead.

Absorption Costing FMOH

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 to these costs flow through the income statements as part of Costs of Goods Sold.

In absorption costing only

includes only manufacturing costs.

Chapter explains how the contribution format can be used to prepare

segmented income statements.

Assigning costs to segment the key point is to resist the temptation to allocate costs

that are clearly common and 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.

When the units produced exceeded the

unit sales and hence inventories increase, net operating income is higher under absorption costing than under variable costing. This happens because it is deferred in inventories under absorption costing.

TOC: Variable costing income statements require one adjustment to support the TOC approach.

Direct labor costs need to be removed from variable production costs and reported as part of the FMOH costs that are entirely expensed in the period incurred.

Variable Costing (1)

Fixed MOH is treated as a period cost and expensed in full each period.

Traceable costs can become common costs

Fixed costs that are traceable to one segment may be a common cost of another segment.

The Practice of arbitrarily allocating common costs to segments is often justified on the grounds that "someone" has to "cover the common costs". Arbitrarily allocating common costs to segments does not ensure that this will happen.

It may make an otherwise profitable segment appear unprofitable.

Selling and Administrative Expenses

Selling and Admin are NEVER treated as product costs, regardless of the costing method. Does not matter whether they are variable or fixed.

Absorption Costing Income Statement

The only reason absorption income differs from variable costing is that the methods account for fixed manufacturing overhead differently. Under absorption costing, fixed manufacturing overhead is included in products costs.

A common fixed cost

is a fixed cost that supports the operations of more than one segment, but it is not traceable in whole or part to any one segment. Even if the segment were entirely eliminated. Example: Salary of the CEO of General Motors

Segment

is a part or activity of an organization about which managers would like cost, revenue or profit data. This chapter explains how to create contribution format income statements that report profit data for business segments, such as divisions, individual stores, geographic regions, customers, and product lines.

To avoid confusion

many companies use absorption costing through their segmented income statements.

Contribution Income Statement

net operating income is constant. The number of unit produced does not affect net operating income.

A traceable fixed cost

of a segment is a fixed cost that is incurred because of the existence of the segment-if the segment had never existed, the fixed cost would not have been incurred; and if the segment were eliminated, the fixed cost would disappear. Example: The maintenance cost for the Building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing.

Variable Costing

only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead. FIXED MANUFACTURING OVERHEAD is not treated as a product cost under this method. Rather, FMO is treated as a period cost, and it is expensed in its entirely each period.

An absorption costing income statement focuses on

period and product costs.

SPS Products has two divisions-Catalog Sales and Online Sales. For the last quarter the Catalog Sales segement margin was ($5000). Online sales were 100,00. Online Sales contribution margin was 60,000 and its segment margin was $40,000. If Cataog Sales are discontinued, it is estimated that online sales will increase by 10%. Calculate the expected profit impact of Discontinuing Catalog Sales.

$11,000 (New online sales contribution margin is 100,000 x 10% x 60,000/100,000) = $6,000 + 5,000 saved from stopping catalog sales = 11,000))

Three Key concepts

1. Both income statement formats include product costs and period costs, although they define these cost classifications differently. 2. Second, variable costing income statements are grounded in the contribution format. They categorize expenses based on cost behavior-variable costs are reported separately from fixed costs. Absorption costing income statements ignores variable and fixed cost distinctions. 3. Variable and absorption costing net operating income figures often differ from one another. The reason is always related to the way income statements account for fixed manufacturing overhead differently.

Comfy Cozy Chairs makes and sells rockers. The production of each rocker requires $45 direct material and 37 of direct labor. Variable manufacturing overhead amounts to 8 per unit, fixed manufacturing overhead totals 58000. What is the product cost using absorption?

119 (45+37+8) + (58000/2000)=119

Dollars to attain target profit

=(target profit + fixed expenses)/CM Ratio

Variable costing and absorption costing net operating incomes may differ.

Absorption costing: some FMOH is capitalized in inventories rather than currently expense d on the income statement. If inventories increase during the period, some FMOH will be deferred in ending inventories. If one is sold it will be part of COGS if not it is part of Finished goods inventories.

Enabling CVP analysis

CVP requires we break costs down into their fixed and variable components. Variable costing income statements categorize fixed costs as fixed and variable, it is much easier to use this income statement.

Failure to Trace Costs Directly

Costs that can be traced directly to a specific segment should be charged directly to that segment and should not be allocated to other segments.

The variable costing method correctly identifies the additional variable costs that will be incurred to make one more unit. It also emphasizes the impact of fixed costs on profits.

The total amount of fixed FMOH appears explicitly on the income statement highlighting that the whole amount of FMOH must be covered for the company to be truly profitable.

Companies often make mistakes when assigning costs to segments.

They omit some costs, inappropriately assign traceable fixed costs, and arbitrarily allocate common fixed costs. yet everything should be included.

General rule

Treat as traceable costs only those costs that would disappear over time if the segment itself disappeared.

Absorption Costing

Treats all manufacturing costs as product costs, regardless of whether they are variable or fixed. The cost of a unit of product under the absorption costing method consists of direct materials, direct labor and BOTH variable and fixed manufacturing overhead.

Absorption IS

can be confusing and easily misinterpreted, due to how inventory is deferred. Sometimes there are more units produced than sold which may indicate negative figures (wrong interpretation)

To avoid mistakes when absorption costing is used, readers of financial statements should be alert to

changes in inventory levels. Under absorption costing, if inventories increased, FMOH are deferred in inventories, which in turn decreases net operating income. If inventories decreases, FMOH are released from inventories, which decreases net income.

Abosrption costing (1)

FMOH is treated as part of the product cost and expensed as units are sold.

Absorption Equation for Fixed MOH

FMOH per unit=Total fixed manufacturing overhead/ Units produced.

The segment margin

is obtained by deducting the traceable fixed costs of segment from the segment's contribution margin. It represents the margin available after a segment has covered all of its own costs. The best guage of the long run profitability segment because it includes only those costs that are caused by the segment. if a segment cannot cover its own costs it should be dropped.