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CHAPTER 6 VARIABLE COSTING AND SEGMENT

REPORTING: TOOLS FOR MANAGEMENT

Key Terms and Concepts to Know

Variable vs. Absorption Costing

Absorption Costing is required by GAAP for external reporting purposes. This is the costing method used for the traditional income statement.

Absorption costing classifies costs based on their function: product or period costs. Variable Costing is often used for internal decision making. This is the costing

method used for the contribution format income statement. Variable costing classifies costs based on their behavior when the activity level

changes: variable or fixed costs. The difference between the two methods is how they account for fixed

manufacturing overhead. Product Costs:

Product costs are the manufacturing costs incurred to produce the products to be sold.

Product costs flow through the raw materials, work-in-process and finished goods inventory account to cost of goods sold when the products are sold.

Product costs under absorption costing include both variable and fixed manufacturing costs.

Product costs under variable costing include only variable manufacturing costs. Absorption costing includes fixed manufacturing overhead as a product cost

whereas variable costing does not. Period Costs:

Period costs are the non-manufacturing costs incurred to operate the company. Period costs are accounted for as expenses in the period incurred.

Period costs under absorption costing include both variable and fixed non-manufacturing costs, i.e., selling and administrative costs.

Period costs under variable costing include both variable and fixed non-manufacturing costs, i.e., selling and administrative costs plus fixed manufacturing overhead.

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Variable costing includes fixed manufacturing overhead as a period cost whereas absorption costing does not.

Fixed Costs:

Traceable fixed costs are incurred for the benefit of one business segment and are controllable by the segment

Common fixed costs are incurred for the benefit of more than one segment and are not traceable to or controllable by any one segment.

There are numerous approaches to the allocation of common fixed expenses to business segments

Problems caused by arbitrarily dividing common costs among segments Segment Performance Evaluation:

Segment Income Statement

Key Topics to Know

Product vs. Period Costs and variable vs. Fixed Costs

Absorption costing accounts for fixed manufacturing overhead as a product cost. Variable costing accounts for fixed manufacturing overhead as a period cost.

In Chapter 1, the traditional and contribution format income statements were presented as follows:

Traditional Contribution Sales Sales

Cost of Goods Sold

Variable Expenses: Production Selling Administrative

Gross Margin Contribution Margin Operating Expenses: Fixed Expenses:

Selling Production

Administrative Selling Administrative Operating Income Operating Income

Stays the same Variable cost Fixed cost

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Expanding the expense portions of these income statements in Chapter 6 terms:

Absorption Costing Variable Costing Product Costs: Variable Costs: Variable: Product Costs:

Direct materials Direct materials Direct labor Direct labor Variable overhead Variable overhead

Fixed: Period Costs: Fixed overhead Variable selling expenses

Variable administrative expenses Period Costs: Fixed Costs: Variable: Product Costs:

Variable selling expenses Period Costs: Variable administrative expenses Fixed overhead

Fixed: Fixed selling expenses Fixed selling expenses Fixed administrative expenses Fixed administrative expenses

Under Variable Costing: o Only those costs of production that vary with output are product costs. This

is consistent with the contribution format income statement and cost-volume-profit analysis because of the emphasis on separating variable and fixed costs.

o The cost of a unit of product consists of direct materials, direct labor, and variable overhead.

o Fixed manufacturing overhead and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred.

Under Absorption Costing: o All costs of production are product costs, regardless of whether they are

variable or fixed. Since no distinction is made between variable and fixed costs, absorption costing is not well suited for CVP computations.

o The cost of a unit of product consists of direct materials, direct labor, and

both variable and fixed overhead. o Variable and fixed selling and administrative expenses are treated as period

costs and are deducted from revenue as incurred.

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Example #1: Assume Harvey Company produces a single product with available information for 2010 as follows:

a) The unit product costs under absorption and variable costing would be $16 and $10, respectively.

b) 25,000 units were produced and 20,000 units were sold during the year. c) The selling price per unit is $30. d) There is no beginning inventory. e) The unit product cost is $10 for variable costing and $16 for absorption costing. f) Fixed manufacturing cost was $150,000 in the current period. g) Selling and administrative expenses were 50% fixed in the current period. h) The net operating income is $90,000 under variable costing.

Required:

a) Prepare income statements using both variable and absorption costing. b) Reconcile variable costing and absorption costing net operating incomes

and explain why the two amounts differ. c) Determine the amount of fixed overhead deferred in ending inventory.

Solution #1:

a) Absorption Variable Sales $600,000 Sales $600,000

Cost of Goods Sold

Variable Expenses:

320,000

Production 200,000 Selling & Administrative 80,000

Gross Margin 280,000 Contribution Margin 320,000 Operating Expenses: Fixed Expenses:

Production 150,000 Selling & Administrative 160,000

Selling & Administrative 80,000

Operating Income $120,000 Operating Income $90,000

b) Operating income absorption costing $120,000 Less: fixed overhead deferred in ending inventory 30,000 Operating income variable costing $90,000

c)

Units produced and not sold 25,000 20,000 = 5,000 Fixed overhead cost per unit $16 - $10 = $6.00 Fixed overhead deferred in ending inventory $30,000

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Example #2: Assume Harvey Company produces a single product with available information for 2011 as follows:

a) 25,000 units were produced and 30,000 units were sold during the year. b) The selling price per unit, variable costs per unit, total fixed costs and selling and

administrative expenses remained unchanged from the prior year. c) 5,000 units are in beginning inventory from 2010. d) The net operating income is $230,000 under absorption costing.

Required:

a) Prepare income statements using both variable and absorption costing. b) Reconcile variable costing and absorption costing net operating incomes

and explain why the two amounts differ. c) Determine the amount of fixed overhead deferred in ending inventory. d) Determine the total operating income for the 2 years under both

methods.

Solution #2: a)

Absorption Variable Sales $900,000 Sales $900,000

Cost of Goods Sold

Variable Expenses:

480,000

Production 300,000 Selling & Administrative 80,000

Gross Margin 420,000 Contribution Margin 520,000 Operating Expenses: Fixed Expenses:

Production 150,000 Selling & Administrative 160,000

Selling & Administrative 80,000

Operating Income $260,000 Operating Income $290,000

b)

Operating income absorption costing $260,000 plus: fixed overhead released from ending inventory 30,000 Operating income variable costing $290,000

c)

Units sold but not produced 25,000 30,000 = 5,000 Fixed overhead cost per unit $16 - $10 = $6.00 Fixed overhead released from ending inventory $30,000

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Summary of Examples #1 and #2:

The difference in net operating income between the two methods can be reconciled by multiplying the number of units of increase or decrease in inventory by the fixed manufacturing overhead per unit.

For the two-years in total, both methods reported the same total net operating income because the units produced equaled the units sold, i.e., inventory did not change.

Relationship Between Inventory levels and Operating Income

When units produced equals units sold, the two methods report the same net operating income.

When units produced are greater than units sold, i.e., units in inventory increase, absorption income is greater than variable costing income.

When units produced are less than units sold, units in inventory decrease, absorption costing income is less than variable costing income.

Absorption costing assigns per unit fixed manufacturing overhead costs to production. This can potentially produce positive net operating income even when the number of units sold is less than the breakeven point.

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.

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Theory of Constraints Approach

Companies involved in TOC use a form of variable costing. One significant difference in the TOC approach is that it treats direct labor as a

fixed cost for three reasons: o Although direct laborers are paid an hourly wage, many companies are

required by a labor contract or law, to guarantee workers a minimum number of paid hours.

o Direct labor is not usually the constraint; therefore, there is no reason to increase the number of direct laborers.

o TOC emphasizes the role direct laborers play in driving continuous improvement.

Segment Income Statements and

The Contribution Approach

A segment is simply a part or activity of an organization about which managers would like cost, revenue, or profit data. Business segments could be the divisions of the company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual customers, and product lines.

Segment income statements are typically used for internal decision making and are prepared using the contribution format.

Revenues and variable costs are usually under the control of the segment manager; this is not true for fixed costs.

Traceable fixed costs are controlled by the segment manager. Common fixed costs are controlled at a level in the company above the segment

manager.

Income statements calculate contribution margin in the usual manner and then subtract traceable fixed costs to determine segment margin. The segment margin is a valuable tool for assessing the long-run profitability of a segment.

Each segment may prepare a Segment Income Statement income statement which reports the revenue, variable expenses, contribution margin and traceable

fixed expenses controllable by segment management. The highlight of the segment income statement is the Segment Margin, computed as segment contribution margin less the segments traceable fixed costs. It represents the segments income after all the traceable fixed costs have been covered. Some companies then deduct the segments share of common or allocated fixed expenses to calculate the segments operating income.

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Traceable and Common Fixed Costs

A traceable fixed cost of a segment is a fixed cost that is incurred because of the existence of the segment. If the segment were eliminated, the fixed cost would disappear.

A common fixed cost is 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.

The traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the salary of a division manager is traceable to that division but is a common fixed cost for each of the plants within the division.

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

Profitability of various segments is often interrelated, meaning that eliminating one segment may have an effect on the profitability of other divisions.

Eliminating an unprofitable segment generally does not have much effect of common fixed costs.

Allocating Common Fixed Costs

Allocating common costs to segments is an arbitrary process reduces the value of the segment margin as a measure of long-run segment profitability.

Common fixed costs are perhaps best left unallocated at their lowest traceable level within the company. For example, the salary of a division manager is traceable to that division but is a common fixed cost for each of the plants within the division. It should appear on the income statement for the entire division as a deduction from total segment margin to determine operating income. It would not be deducted on the income statement of any of the plants as it is not controllable at the plant level.

Costs should be allocated to segments for internal decision making purposes only when the allocation base actually drives the cost being allocated.

Allocating common fixed costs may make a profitable business segment appear to be unprofitable. If the segment is eliminated the revenue lost may exceed the

traceable costs that are avoided.

Allocating common fixed costs forces managers to be held accountable for costs that they cannot control.

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Example #3: Home Base, Inc. reports the following production cost information:

Units produced 97,000 units Units sold 92,000 units Direct labor $17.00 per unit Direct materials $34.00 per unit Variable overhead $2,522 Fixed overhead $1,940

Required:

a) Compute production cost per unit under variable costing.

b) Compute production cost per unit under absorption costing. c) Determine the cost of ending inventory using variable costing. d) Determine the cost of ending inventory using absorption costing.

Solution #3:

a) $34.00 DM + $17.00 DL + $2,522,000/97,000 VOH = $77.00 per unit under variable costing

b) $77.00 + $1,940,000/97,000 FOH = $97.00 per unit under absorption costing

c) 97,000 units - 92,000 units = 5,000 units x $77.00 per unit = $385,000 ending inventory under variable costing

d) 97,000 units - 92,000 units = 5,000 units x $97.00 per unit = $485,000 ending inventory under absorption costing

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Practice Problems

Practice Problem #1: Identify the treatment of each of the following costs under variable costing and absorption costing. Variable Costing Absorption Costing Product

Cost Period Cost

Product Cost

Period Cost

Direct materials

Direct labor

Variable overhead

Fixed overhead

Variable selling

Fixed selling

Variable administrative

Fixed administrative

Practice Problem #2: How will net income under variable costing compare to net income under absorption costing in the following three situations? Will fixed overhead be deferred or released from inventory?

a) Units produced equal units sold b) Units produced exceed units sold c) Units produced are less than units sold

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Practice Problem #3: Castaway Company reports the following first year production cost information.

Units produced 53,000 units Units sold 51,000 units Sales price $150.00 per unit Direct labor $8.00 per unit Direct materials $4.00 per unit Variable overhead $2,173,000 Fixed overhead $3,339,000 Operating expenses $1,000,000

Required:

a) Determine the net income using variable costing. b) Determine the net income using absorption costing. c) Reconcile the two net incomes.

Practice Problem #4: Stonehenge Inc., a manufacturer of landscaping blocks, began operations on April 1 of the current year. During this time, the company produced 750,000 units and sold 720,000 units at a sales price of $9 per unit. Cost information for this period is shown below.

Production costs: Direct labor $.30 per unit Direct materials $1.80 per unit Variable overhead $495,000 Fixed overhead $450,000

Non-production costs: Variable selling expense $18,000 Fixed administrative expenses $53,000

Required:

a) Prepare Stonehenge's income statement under absorption costing.

b) Prepare Stonehenge's income statement under variable costing. c) Reconcile the two net incomes.

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Practice Problem #5: Stockholm Company produces and sells two packaged products, Product W and Product Z. Revenue and cost data relating to the two products is as follows: and in addition common fixed expenses not traceable in the company total $44,000 per year. Last year the company produced and sold 18,000 units of Product W and 30,000 units of Product Z. The selling price of W is $8 per unit and the selling price of Z is $12 per unit. Variable expenses of W are $5.50 per unit and Z $8.75 per unit. Traceable fixed expenses per year are $15,000 for W and $65,000 for Z. Required: Prepare a contribution format income statement segmented by product lines.

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Sample True / False Questions

1. The use of absorption costing can result in misleading product cost information.

True False

2. Variable costing treats fixed overhead cost as a period cost. True False

3. Under absorption costing a company had the following unit costs when 10,000 units were produced.

The total production cost per unit under absorption costing if 25,000 units had been produced would be $9.

True False

4. Given the following data, total product cost per unit under absorption costing will be greater than total product cost per unit under variable costing.

True False

5. Given the following data, total product cost per unit under absorption costing will be $700 greater than total product cost per unit under variable costing.

True False

6. The absorption costing income statement classifies costs based on cost behavior rather than function.

True False

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7. When units produced equal units sold, reported income is identical under absorption costing and variable costing.

True False

8. When units produced exceed the units sold, income under absorption costing is higher than income under variable costing.

True False

9. When units produced are less than units sold, income under absorption costing is higher than income under variable costing.

True False

10. To convert variable costing income to absorption costing income, management

will need to change the way fixed overhead costs are treated. True False

11. The most common method of evaluating a profit center manager is the segmented income statement.

True False

12. Segment margin and operating income are identical terms. True False

13. All other things the same, if a division's traceable fixed expenses decrease the division's segment margin will increase.

True False

14. The same cost can be traceable or common depending on how the segment is defined.

True False

15. In general, common fixed costs should be assigned to segments. True False

16. If a company eliminates a segment of its business, the costs that were

traceable to that segment should disappear. True False

17. If four segments share $800,000 in common fixed costs and one segment is eliminated, the common fixed costs will decrease by $200,000.

True False

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18. Expense allocations cannot always avoid some arbitrariness. True False

19. Variable costing is the only acceptable basis for both external reporting and tax reporting.

True False

20. Reporting contribution margin by market segment is useful in assessing the profitability of each segment.

True False

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Sample Multiple Choice Questions

1. Which of the following statements is true regarding absorption costing?

a) It is not the traditional costing approach.

b) It is not permitted to be used for financial reporting.

c) It assigns all manufacturing costs to products.

d) It assigns all manufacturing costs to products.

2. Which of the following statements is true regarding variable costing?

a) It is a traditional costing approach.

b) Only manufacturing costs that change in total with changes in production level are included in product costs.

c) It is not permitted to be used for managerial reporting. d) It treats overhead in the same manner as absorption costing.

3. Which of the following statements is true?

a) Variable costing treats fixed overhead as a period cost.

b) Absorption costing treats fixed overhead as a period cost.

c) Absorption costing treats fixed overhead as an expense in the period it is incurred.

d) Variable costing excludes all overhead from product costs.

4. Under absorption costing, a company had the following unit costs when 8,000 units were produced.

Direct labor $8.50 Direct materials 9.00 Variable overhead 6.75 Fixed overhead $60,000/8,000 units 7.50

Total unit cost $31.750 Compute the total production cost per unit under absorption costing if 30,000 units had been produced.

a) $31.75

b) $27.25

c) $26.25

d) $24.25

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5. Which of the following statements is true?

a) A per unit cost that is constant at all production levels is a variable cost per unit.

b) Reported income under variable costing is affected by production level changes.

c) A per unit cost that is constant at all production levels is a fixed cost per unit.

d) Reported income under absorption costing is not affected by production level changes.

6. Under absorption costing, a company had the following unit costs when

8,000 units were produced.

Direct labor $8.50 Direct materials 9.00 Variable overhead 6.75 Fixed overhead $60,000/8,000 units 7.50

Total unit cost $31.750 Compute the total production cost per unit under variable costing if 20,000 units had been produced.

a) $31.75 b) $27.25 c) $26.25 d) $24.25

7. Which of the following best describes costs assigned to the product under the absorption costing method? Direct labor (DL) Direct materials (DM) Variable selling and administrative Variable manufacturing overhead Fixed selling and administrative Fixed manufacturing overhead

a) DL, DM, variable selling and administrative costs and variable manufacturing overhead.

b) DL, DM, and variable manufacturing overhead. c) DL, DM, variable manufacturing overhead and fixed manufacturing

overhead. d) DL and DM.

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8. Which of the following best describes costs assigned to the product under the variable costing method? Direct labor (DL) Direct materials (DM) Variable selling and administrative Variable manufacturing overhead Fixed selling and administrative Fixed manufacturing overhead

a) DL, DM, variable selling and administrative costs and variable manufacturing overhead.

b) DL, DM, and variable manufacturing overhead. c) DL, DM, variable manufacturing overhead and fixed manufacturing

overhead. d) DL and DM. Use the following information for questions 9 through 14:

Advanced Company reports the following information for the current year. There was no beginning inventory this year.

Units produced 25,000 Units sold 15,000 Direct materials $9.00/unit Direct labor $11.00/unit Variable overhead $75,000 Fixed overhead $137,500

9. Given Advanced Company's data, compute cost per unit of finished goods under variable costing.

a) $20.00 b) $25.00 c) $21.88 d) $23.00

10. Given Advanced Company's data, compute cost per unit of finished goods under absorption costing.

a) $20.00 b) $34.17 c) $25.32 d) $28.50

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11. Given Advanced Company's data, compute cost of finished goods in inventory under absorption costing.

a) $285,000 b) $712,500 c) $427,500 d) $230,000

12. Given Advanced Company's data, compute cost of finished goods in inventory under variable costing.

e) $285,000 f) $712,500 g) $427,500

h) $230,000

13. Given Advanced Company's data, and the knowledge that the product is sold for $50 per unit and operating expenses are $200,000, compute the net income under absorption costing.

a) $55,000 b) $67,500 c) $80,500 d) $122,500

14. Given Advanced Company's data, and the knowledge that the product is sold for $50 per unit and operating expenses are $200,000, compute the net income under variable costing.

e) $55,000 f) $67,500 g) $80,500 h) $122,500

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15. A company reports the following information for its first year of operations.

Units produced 650 Units sold 500 Direct materials $750.00/unit Direct labor $1,000.00/unit Variable overhead ? Fixed overhead $308,750

If the company's cost per unit of finished goods using variable costing is $2,375, what is total variable overhead?

a) $237,500 b) $75,000 c) $312,500 d) $406,250

16. A company reports the following information for its first year of operations.

Units produced ? Units sold 1,500 Direct materials $9.00/unit Direct labor $5.00/unit Variable overhead $7.00/unit Fixed overhead $24,000

If the company's cost per unit of finished goods using absorption costing is $27, how many units were produced?

a) 4,000 units. b) 3,600 units. c) 1,846 units. d) 2,667 units.

17. A difficult problem in calculating the total costs and expenses of a department is:

a) Determining how to allocate cost of goods sold to the department. b) Determining how to allocate variable costs to the department. c) Determining how to allocable traceable fixed expenses to the

department. d) Determining how to allocate common fixed costs to the department.

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18. Costs that the manager has the power to determine or at least strongly influence are called:

a) Uncontrollable costs. b) Joint costs c) Traceable costs d) Common costs

19. The most useful evaluation of a manager's cost performance is based on: a) Controllable costs. b) Joint costs

c) Fixed costs d) Common costs

20. The salaries of employees who spend all their time working in one department are:

a) Variable expenses. b) Indirect expenses. c) Traceable fixed expenses. d) Common fixed expenses.

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Solutions to Practice Problems Practice Problem #1 Variable Costing Absorption Costing Product

Cost Period Cost

Product Cost

Period Cost

Direct materials X X

Direct labor X X

Variable overhead X X

Fixed overhead X X

Variable selling X X

Fixed selling X X

Variable administrative X X

Fixed administrative X X

Practice Problem #2

a) Income is identical under variable costing and absorption costing when the units produced equal the units sold.

b) When units produced exceed units sold, income under variable costing is less than income under absorption costing. This is because some of fixed overhead was allocated to ending inventory under absorption costing, but all of fixed overhead was expensed under variable costing.

c) When units produced are less than units sold, income under variable costing is greater than income under absorption costing. This is because absorption costing is expensing some of a prior period's fixed overhead in addition to the current period's fixed overhead, while variable costing is only expensing the current period's fixed overhead.

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Practice Problem #3:

Units produced 53,000 units Units sold 50,000 units Sales price $150.00 per unit Direct labor $8.00 per unit Direct materials $4.00 per unit Variable overhead $2,173,000 Fixed overhead $3,339,000 Operating expenses $1,000,000

Absorption Variable

Sales $7,500,000 Sales $7,500,000

Cost of goods sold $8 + $4 + $104 = $116 $5,512,000 = $104 53,000

5,800,000 Variable costs $8 + $4 + $41 = $53 $2,173,000 = $41 53,000

2,650,000

Gross margin 1,700,000 Contribution margin 4,850,000 Operating expenses 1,000,000 Fixed cost

3,339,000 + 1,000,000 4,339,000

Net income 700,000 511,000 Proof: 3,000 units produced and not sold x ($104 - $41) = $189,000 Net income: absorption $700,000 variable 189,000 = $189,000

Practice Problem #4:

Absorption Variable Sales $6,480,000 Sales $6,480,000 Cost of goods sold $1.80 + $.30 + $1.26 = $3.36 $945,000 = $1.26 750,000

2,419,200 Variable production $1.80 + $.30 + $.66 = $2.76 $495,000 = $.66 750,000

1,987,200

Variable selling 18,000 Gross margin 4,060,800 Contribution margin 4,478,800 Operating expenses 53,000 + 18,000

71,000 Fixed cost 450,000 + 53,000

503,000

Net income $3,989,800 $3,971,800 Proof: 30,000 units produced and not sold x ($3.36 - $2.76) = $18,000 Net income: absorption $3,989,800 variable 3,971,800 = $18,000

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Practice Problem #5

W Z Total Sales $ 144,000 $ 360,000 $ 504,000 Variable Expenses 99,000 262,500 361,500 Contribution Margin 45,000 97,500 142,500 Traceable Fixed Expenses 15,000 65,000 80,000 Product Segment Margin $ 30,000 $ 32,500 62,500 Common Fixed Expenses 44,000 Operating income $18,500

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Solutions to True / False Problems

1. True

2. True

3. False Production costs would be $9.00 = $50,000/25,000 = $11.00

4. True

5. False - $1,200,000 / 3,000 = $400

6. False variable costing classifies costs by behavior.

7. True

8. True

9. False When units produced are less than units sold, fixed overhead is released from inventory under absorption costing, resulting in the income under absorption costing which is less than income under variable costing.

10. True

11. True

12. False Segment margin minus traceable fixed costs = operating income

13. True

14. True

15. False - Common fixed costs should NOT be assigned to segments. These are costs that are incurred for the benefit of the entire organization and NOT easily traceable to any one particular segment.

16. True

17. False - Common fixed expenses should NOT be affected by the elimination of one segment. No decrease would be expected.

18. True

19. False Variable costing is not acceptable for external reporting since it is not GAAP.

20. True

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Solutions to Multiple Choice Questions

1. D

2. B

3. A

4. C

5. A

6. D

7. C

8. B

9. D

10. D

11. A

12. D

13. D

14. B

15. D

16. A

17. D

18. C

19. A

20. C