Chapter 4: Variable Costing and Segment Reporting: Tools For Management
Super-Variable Costing:
is a variation on variable costing in which DL and manufacturing overhead costs are considered to be fixed. --> Classifies all DL and man. OH costs as fixed period costs and ONLY DM as a variable product cost. --> Assume that SG&A are fixed too.
Units Produced < Units sold
= absorption costing operating income<Variable costing operating income
3. Arbitrarily dividing common costs among segments
- Common costs should not be arbitrarily allocated to segments based on the rationale that "someone has to cover the common costs" for two reasons: 1. This practice may make a profitable business segment appear to be unprofitable. 2. Allocating common fixed costs forces managers to be held accountable for costs they cannot control.
Segmented income statements is useful for: (3)
1. Analyzing the profitability of segments 2. Making decisions 3. Measuring the performance of segment managers
Segmented Income Statements- Common Mistakes: (3)
1. Omission of costs 2. Inappropriate Methods for assigning traceable costs among segments 3. Arbitrarily Dividing Common Costs among Segments→ assigning non-traceable costs to segments.
Reconcile Variable and Absorption Costing: 1. Income can vary per period even if the same number of units sold because the fixed costs is divided by the number of unit _____________ in that period 2. In general when units produced exceeds unit sales (inventory increase) net operating income is higher under ______________ than __________ occurs because... 3. When unit sales exceed units produced (inventory decrease) net operating income is lower under ______________ and higher under __________ occurs because... 4. When units produced and unit sales are equal the variable and absorption income are _____________ . 5. Net operating income for both costing methods can be reconciled by...
1. Produced 2. absorption than variable costing--> occurs because some of the fixed MOH of the period is deferred in inventory under absorption costing. 3. absorption and higher under variable (fixed MOH is released from inventory under absorption) 4. The variable and absorption income are the same 5. Determining how much fixed MOH was deferred/released from inventory
Segment Margin: (3)
= Obtained by deducting the traceable fixed costs of a segment from the segments contribution margin 1. Represents the margin available after a segment has covered all of its own costs 2. Best gauge of the long run profitability of a segment 3. Common fixed costs are not allocated to segments
Units Produced > Units sold
= absorption costing operating income>Variable costing operating income
Sometimes referred to as full cost method
Absorption Costing
Dollar sales for a segment to break even =
Dollar sales for a segment to break even = segment traceable fixed expenses/segment CM ratio - the sum of the segment break-even sales is less than the companywide break-even point because the segment break even calc do not include common fixed expenses (can be shown using segment break even income statement that will have the net operating loss equal the total company common fixed expenses)
Dollar sales for company to break even =
Dollar sales for company to break even = traceable fixed expenses + common fixed expenses/overall CM ratio CM ratio = Contribution margin/sales
- The variable costing NOI for each period can always be computed by
Multiplying the number of units sold by the contribution margin per unit then subtract total fixed costs NOI = (Unit CM x Unit Sold) - Fixed Costs
In Variable Costing, Fixed Manufacturing Overhead is:
Treated as period cost and is reported as an expense on the income statement in its entirety each period. -->NOT a product costs under this method.
CVP analysis
Variable costing categorizes costs as fixed and variable so it is much easier to use this income statement format for CVP analysis.
Rely on the contribution format, for internal decision making purposes
Variable costing income statements:
Units Produced = Units sold
absorption costing operating income=Variable costing operating income
Company Wide Income Statement
o Many accountants and managers believe the absorption costing better matches costs with sales. Advocates argue that all costs must be assigned and that fixed costs are just as essential to manufacturing products as variable costs. o Advocates for Variable Costing argue that fixed man. Cost are not really the costs of any particular unit of product, but merely the cost incurred to have the capacity to make products during a period of time and will be even if nothing is made. Whether a unit is made or not, the fixed cost will remain the same. - Both U.S. GAAP and IFRS require absorption costing for external reports. - Since absorption costing is required for external reporting, most companies also use it for internal reports rather than incurring the additional cost of maintaining a separate variable cost system for internal reporting.
Advantages of Variable Costing and the Contribution Approach: (3)
1. Enabling CVP Analysis 2. Explaining Changes in Net Operating Income --> Variable costing income statements are clear and easy to understand. o All things the same, when sales go up→ NOI goes up o The number of units produced doesn't affect net operating income. --> When Absorption costing is used fluctuations in net operating income can be caused by changes in inventories as well as changes in unit sales. 3. Supporting Decision Making --> Variable costing method correctly identifies the additional variable costs that will be incurred to make one more unit. o Emphasizes the impact fixed costs on profits. --> Absorption costing→ fixed cost appears to be variable with respect to the number of units sold, but they aren't. o Misinterpreting absorption unit product costs as variable can lead to many problems, including inappropriate pricing decisions and decisions to drop products that are in fact profitable
Segmented Financial Information
- Both U.S. GAAP and IFRS require publicly traded 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 approach for 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.
Variable Costing (2)
- Only manufacturing costs that vary with output are treated as product costs (direct material, direct labor, and variable MOH) - Period costs include fixed MOH, and fixed and variable S&A (expensed in its entirety each period)
Traceable Fixed Costs
A fixed cost that is incurred because of the existence of the segment (if the segment had never existed then the fixed cost would have never been incurred) -EX: the salary of a Fritos product manager at PepsiCo = traceable fixed cost of the Fritos business segment of PepsiCo
1. Omission of Costs
Costs assigned to a segment should include all costs attributable to that segment from the company's entire value chain (this may not occur when a company uses absorption costing for both internal and external reports)
Sometimes referred to as direct costing or marginal costing
Variable Costing
Segment
is any part or activity of an organization about which a manger seeks cost, revenue, or profit data
Segment Margin vs. Contribution Margin:
- Segment margin = most useful in major decisions that affect capacity such as dropping a segment b/c it's best at gauging the long run profitability of a segment. - Contribution margin = most useful in decisions involving short-run changes in sales volumes, such as pricing special orders that involve temporary use of existing capacity.
Differences in Variable and Absorption Costing:
- The essential differences is how each method accounts for fixed MOH --> In absorption costing fixed MOH is included as a part of work in process, then finished goods, and only when the units are sold are moved to the IS as COGS --> In variable costing fixed MOH are taken immediately to the I/S as period expense (variable costing income statement are grounded in the contribution format IS bc they categorize expenses based on cost behavior - variable vs fixed) - Because of this...the two costing methods often have different net operating income figures
lean production
- The number of units produced tends to always equal the number of units sold because making units per order so their is usually a small or no difference between the costing methods
Identifying Traceable Fixed Costs:
- This is important because in segment reporting traceable fixed costs are charged to segments and common fixed costs are not. - They arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. (EX: No computer division means no computer division manager) -If you allocate common costs to segments it reduced the value of the segment margin as a measure of long-run profitability and performance
Selling and administrative expenses
- always treated as period costs and are expensed as they are incurred
absorption costing
- treats all manufacturing costs as product costs also consists of direct material and direct labor (allocates a portion of fixed MOH to each unit) - period costs include variable and fixed S&A
How to Build a Segmented Income Statement
-A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. ( deduct variable expenses from sales to get contribution margin) - Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.
Common Fixed Cost
-A fixed costs that supports the operations of more than one segment but is not traceable in whole or in part to any one segment. Even if the segment were eliminated there would be no change in a true common fixed cost. - EX: the salary of General Motors CEO= common fixed cost of the various divisions of GM
How traceable costs can become common costs: (2)
-Fixed costs traceable to one segment may be a common cost of another segment - EX: The landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.
why their is change in the net operating income of fixed verse variable costing
-Variable costing income is only affected by changes in unit sales. It is not affected by the number of units produced. As a general rule, when sales go up, net operating income goes up, and vice versa - Absorption costing income is influenced by changes in unit sales and units of production. Net operating income can be increased simply by producing more units even if those units are not sold. (because absorption costing assigns fixed MOH to units produced it gives impression that fixed MOH is variable with respect to the number of units produced which is false) The potential result is positive operating income when the number of units sold is less than the breakeven point.
Prepare an IS using Variable Costing: (contribution format)
1) Compute the unit product cost Unit Product Cost = Direct materials + Direct labor + Variable Manufacturing Overhead 2) Compute Variable Costing COGS Variable Costing COGS = Unit Product Cost x Unit Sold 3) Next compute Total SG&A Expense Total SG&A Expense= Variable SG&A + Fixed SG&A 3) Then put together in IS (using contribution margin format) --> To understand better find contribution margin per unit Selling Price per unit - (Variable COGS per unit + Variable SG&A) = Contribution Margin
Prepare an IS Using Absorption Costing:
1) Determine Unit Product costs: Unit Product costs= Direct materials + direct labor + variable MOH + (fixed MOH/units sold)) 2) Create IS: Sales = the same as variable - COGS (Using cost found in first) = Gross margin - SG&A = NOI **Do not need to split it up as fixed and variable. --> Costs are categorized as manufacturing verse S&A
Income Statements-- An External Reporting Perspective: (2)
1. Company Wide Income Statement 2. Segmented Financial Information
2. Inappropriate methods for allocating costs among segments: (2)
1. Failure to trace costs directly→ Costs that can be traced directly to a segment should be charged directly to that segment and shouldn't be allocated to other segments. → EX: rent for a branch office should be charged directly to that branch office rather than included in a company-wide overhead pool. 2. Inappropriate Allocation Base → Costs should be allocated to segments for internal decision-making purposes only when allocation base actually drives the cost being allocated. → EX: Sales should be used to allocated selling & administrative expenses only if a 10% increase in sales will result in a 10% increase in SG&A. To the extent that SG&A expenses are not driven by sales volume, these expenses will be improperly allocated- with a disproportionately high percentage of SG&A expenses assigned to the segment with the largest sales.
