Variable Costing & Segment Reporting: Managerial Acc. Ch. 6

Formula to calculate variable costing net operating income

(number of units sold * contribution margin per unit) - total fixed expenses.

Variable Costing Vs. Absorption Costing

- Under Variable Costing, only those manufacturing costs that VARY are treated as product costs - Fixed MOH becomes a period cost (like selling and admin. expenses) rather than a product cost like it is in absorption costing --> expense as incurred - Under Absorption Costing, ALL manufacturing costs are treated as product costs (move to COGS when item is sold)

What are the two keys to building segmented income statements?

1. A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. 2. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

What are two other names for variable costing?

1. Direct costing 2. Marginal costing

What are the Inappropriate Methods of Allocating Costs Among Segments

1. Failure to trace costs directly: 2. Inappropriate allocation base: 3. Arbitrarily dividing common costs among segments

Traceable fixed cost of a segment

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. ex) - The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo. - The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing

Segment

A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. Ex) individual store, service center, a sales territory

Which method produces the highest values for work in process and finished good inventories?

Absorption costing

What method does US GAAP and IFRS require for external reports?

Absorption costing (Most companies also use it for internal reports rather than incurring the additional cost of maintaining a separate variable cost system for internal reporting).

Absorption vs Variable costing (thoughts on it)

Absorption costing is attractive to many accountants and managers because they believe it better matches costs with sales. They argue that all manufacturing costs must be assigned to products in order to properly match the costs of producing units of product with their sales. The fixed costs of depreciation, taxes, insurance, supervisory salaries, and so on, are just as essential to manufacturing products as are the variable costs. Advocates of variable costing argue that fixed manufacturing costs are not really the costs of any particular unit of product. These costs are incurred to have the capacity to make products during a particular period and will be incurred even if nothing is made during the period. Moreover, whether a unit is made or not, the fixed manufacturing costs will be exactly the same. Therefore, variable costing advocates argue that fixed manufacturing costs are not part of the costs of producing a particular unit of product, and thus, the matching principle dictates that fixed manufacturing costs should be recognized as an expense in the current period.

What income statement is easier to use to perform a CVP analysis?

Because CVP analysis requires breaking down costs into variable and fixed components, variable costing income statement is easier since it categorizes costs as variable and fixed.

Segmented Financial Information

Both U.S. GAAP and IFRS require publicalytraded companies to include segmented financial data in their annual reports. 1. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. 2. This requirement motivates managers to avoid using the contribution approachfor internal reporting purposes 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.

Common fixed cost

Common fixed costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. Ex) - The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors. - The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments.

Failure to trace costs directly

Costs that can be traced directly to specific segments of a company should not be allocated to other segments.

What is another name for absorption costing and why?

Full cost method because it includes all manufacturing costs in product costs

Which method has a higher operating profit when units produced > units sold?

If the company produces more units than it sells, then operating profit will be higher under Absorption Costing (compared to Variable Costing). This is because inventory increases and, with Absorption Costing, some of the fixed manufacturing overhead is deferred to a future period (this reduces expenses and thereby increases operating profit in the current period).

What happens when units produced = units sold?

If the number of units produced is equal to the number of units sold, operating profit will be the same whether Absorption Costing or Variable Costing is used.

Inappropriate allocation base

Some companies allocate costs to segments using arbitrary bases. Costs should be allocated to segments only when the allocation base actually drives the cost being allocated.

What is the issue with arbitrarily dividing common costs among segments?

The practice of assigning nontraceable costs to segments leads to distorted segment costs. For example, some companies allocate the common costs of the corporate headquarters building to products on segment reports. However, in a multiproduct company, no single product is likely to be responsible for any significant amount of this cost. Even if a product were eliminated entirely, there would usually be no significant effect on any of the costs of the corporate headquarters building. As a consequence, any allocation of the cost of the corporate headquarters building to the products must be arbitrary. The practice of arbitrarily allocating common costs to segments is often justified on the grounds that "someone" has to "cover the common costs." While it is undeniably true that a company must cover its common costs to earn a profit, arbitrarily allocating common costs to segments does not ensure that this will happen. In fact, adding a share of common costs to the real costs of a segment may make an otherwise profitable segment appear to be unprofitable. If a manager eliminates the apparently unprofitable segment, the common fixed costs that were allocated to the segment don't disappear; they are reallocated to the remaining segments of the company. That makes all of the remaining segments appear to be less profitable— possibly resulting in dropping other segments. Also, allocating common fixed costs forces managers to be held accountable for costs they cannot control.

Segment Margin

The segment margin, which is computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment. --> Common fixed expenses should notbe allocated to the divisions. These expenses would remain even if one of the divisions were eliminated.

Why is variable costing method better for decision making?

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 manufacturing costs appears explicitly on the income statement, highlighting that the whole amount of fixed manufacturing costs must be covered for the company to be truly profitable. Because absorption costing assigns fixed manufacturing overhead costs to units produced ($6 per unit for Harvey Company), it gives the impression that fixed manufacturing overhead is variable with respect to the number of units produced, but it is not. The result can be inappropriate pricing decisions and product discontinuation decisions.

A traceable fixed costs of one segment may be a common fixed cost of another segment. True or False?

True 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.

Absorption costing income statements can be confusing and are easily misinterpreted. A manager might wonder why net operating income went up from January to February even though sales were exactly the same. Reasoning?

Under absorption costing, if inventories increase, fixed manufacturing overhead costs are deferred in inventories, which in turn increases net operating income. If inventories decrease, fixed manufacturing overhead costs are released from inventories, which in turn decreases net operating income. Thus, when absorption costing is used, fluctuations in net operating income can be caused by changes in inventories as well as changes in unit sales.

Which method has a higher operating profit when units produced < units sold?

Variable Costing! If the company produces fewer units than it sells, then operating profit will be lower under Absorption Costing (compared to Variable Costing). This is because inventory decreases, and under Absorption Costing, some of the fixed manufacturing overhead that had been deferred from prior periods is expensed in the current period (this increases expenses and thereby reduces operating profit)

company-widebreak-even point (dollar sales)

computed by dividing the sum of the company's traceable fixed expenses and common fixed expenses by the company's overall contribution margin ratio.

Omission of costs

costs assigned to a segment should include all costs attributable to that segment from the company's entire value chain

business segment's break-even point

dividing its traceable fixed expenses by its contribution margin ratio.

What is a consequence of variable costing?

the cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed costs