1. Variable Costing and Segment Reporting: Tools for Management – Chapter 6
Introduction to Managerial Accounting, Brewer, Garrison,Noreen
Power Points from website - adapted by Cynthia Fortin, CPA, CMA

2. Variable Costing vs Absorption Costing
Product Costs
Period Costs
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Product Costs
Period Costs
Variable costing (also called direct costing or marginal costing) treats only those costs of production that vary with output as product costs. This approach dovetails with the contribution approach income statement and supports CVP analysis because of its emphasis on separating variable and fixed costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred.
Absorption costing (also called the full cost method) treats all costs of production as 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. Under absorption costing, the cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred.

3. Variable costing Absorption costing DM+DL+ V OH+ FOH
units produced
= Unit product Cost
Variable costing
DM+DL+ V OH
units produced
= Unit product Cost

4. Unit Cost Computations
Harvey Company produces a single product with the following information available:
Harvey Company produces 25,000 units of a single product. Variable manufacturing costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000 and fixed selling and administrative expenses for the year are $100,000.

5. Unit Cost Computations
Unit product cost is determined as follows:
The unit product costs under absorption and variable costing would be $16 and $10, respectively. Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs.

6. Income Statements
Assume the following additional information
20,000 units were sold during the year at a price of $30 each.
There is no beginning inventory.
We need some additional information to allow us to prepare income statements for Harvey Company:
20,000 units were sold during the year.
The selling price per unit is $30.
There is no beginning inventory.
Now let’s prepare income statements for Harvey Company. We will start with an absorption income statement.

7. Variable Costing Contribution Format Income Statement
Contribution margin = Sales – Variable expenses.
Let’s examine a variable costing contribution format income statement. First, we subtract all variable expenses from sales to get contribution margin. At a product cost of $10 per unit, the variable cost of goods sold for 20,000 units is $200,000. The next variable expense is the variable selling and administrative expense. After computing contribution margin, we subtract fixed expenses to get the $90,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.

8. Absorption Costing Income Statement
Gross margin is not Contribution margin
Now, let’s examine an absorption costing income statement. Harvey sold only 20,000 of the 25,000 units produced, leaving 5,000 units in ending inventory. At a sales price of $30 per unit, sales revenue for the 20,000 units sold is $600,000. At a unit product cost of $16, cost of goods sold for the 20,000 units sold is $320,000. Subtracting cost of goods sold from sales, we find the gross margin of $280,000. After subtracting selling and administrative expenses from the gross margin, we see that net operating income is $120,000.
Fixed manufacturing overhead deferred in inventory, as a result of the 5,000 unsold units at $6 of fixed overhead per unit, is $30,000.
Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

9. Comparing the Two Methods
5000*$10
5000*$6
Under absorption costing, $120,000 of fixed manufacturing overhead is included in cost of goods sold and $30,000 is deferred in ending inventory as an asset on the balance sheet. Under variable costing, the entire $150,000 of fixed manufacturing overhead is treated as a period expense.
The variable costing ending inventory is $30,000 less than absorption costing, thus explaining the difference in net operating income between the two methods.

10. Variable Costing
Absorption Costing
Income Statement Format
Contribution margin
Gross margin
Net Income
F Mfg O/H not included in ending inventory. Included in period expense.
Portion F Mfg O/H included in ending inventory units.

11. Summary of Key Insights
On your screen is a summary of what we have observed from the Harvey Company’s two years:
When units produced equal units sold, the two methods report the same net operating income.
When units produced are greater units sold, as in year 1 for Harvey, absorption income is greater than variable costing income. 
When units produced are less than units sold, as in year 2 for Harvey, absorption costing income is less than variable costing income. 

13. Decentralization and Segment Reporting
Quick Mart
An Individual Store
Segment part of an organization about which management seeks cost, revenue, or profit data.
A Sales Territory
A segment is a part or activity of an organization about which managers would like cost, revenue, or profit data. Examples of segments include divisions of a company, sales territories, individual stores, service centers, manufacturing plants, marketing departments, individual customers, and product lines.
A Service Center

14. Segmented Income Statement
Contribution format
Separates Variable
From Fixed expenses
Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.
There are two keys to building segmented income statements.
First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders.
Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

15. Identifying Traceable Fixed Costs
Traceable fixed costs Disappear if the segment itself disappeared.
No computer
division means . . .
No computer
division manager.
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. Examples of traceable fixed costs include the following:
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.

16. Dazong Wang, former CEO of one of China’s largest automakers
Common fixed costs
overall operation would not disappear if any particular segment were eliminated.
No computer
division but . . .
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. Examples of common fixed costs include the following:
The salary of the CEO of is a common fixed cost of the various divisions of General Motors.
The cost of heating a Carrefour grocery store is a common fixed cost of the various departments: groceries, produce, and bakery.
Dazong Wang, former CEO of one of China’s largest automakers
We still had the CEO

17. Heating a Carrefour store is common to all departments

18. traceable to flight not
First class
business
landing fee
traceable to flight not
classes
economy
It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to a particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

19. Segment Margin =
Contribution margin - traceable fixed costs of a segment
best gauge of the long-run profitability of a segment.
A segment margin is computed by subtracting the traceable fixed costs of a segment from its contribution margin. The segment margin is a valuable tool for assessing the long-run profitability of a segment.

20. Traceable and Common Costs
Fixed
Costs
Don’t allocate
common costs to segments.
Traceable
Common
Allocating common costs to segments reduces the value of the segment margin as a guide to long-run segment profitability.
As a result, common costs should not be allocated to segments.

21. Levels of Segmented Statements
Webber, Inc., has two divisions.
Assume that Webber, Inc., has two divisions: the Computer Division and the Television Division.

22. Levels of Segmented Statements
Our approach to segment reporting uses the contribution format.
Cost of goods
sold consists of
variable mfg costs.
The contribution format income statement for the Television Division is as shown. Notice that:
Cost of goods sold consists of variable manufacturing costs; and
Fixed and variable costs are listed in separate sections.
Fixed and
variable costs
are listed in
separate
sections.

23. Levels of Segmented Statements
The Television Division’s results can be rolled into Webber, Inc.’s overall results as shown. Notice that the results of the Television and Computer Divisions sum to the results shown for the whole company.

24. Levels of Segmented Statements
Common costs should not be allocated to the divisions. These costs would remain even if one of the divisions were eliminated.
The common costs for the company as a whole ($25,000) are not allocated to the divisions. Common costs are not allocated to segments because these costs would remain even if one of the divisions were eliminated.

25. Omission of Costs
Costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain.
Business Functions
Making Up The
Value Chain
The costs assigned to a segment should include all the costs attributable to that segment from the company’s entire value chain. The value chain consists of all major business functions that add value to a company’s products and services.
Since only manufacturing costs are included in product costs under absorption costing, those companies that choose to use absorption costing for segment reporting purposes will omit from their profitability analysis all “upstream” and “downstream” costs. “Upstream” costs include research and development and product design costs. “Downstream” costs include marketing, distribution, and customer service costs. Although these “upstream” and “downstream” costs are not manufacturing costs, they are just as essential to determining product profitability as are manufacturing costs. Omitting them from profitability analysis will result in the undercosting of products.
Product Customer
R&D Design Manufacturing Marketing Distribution Service

26. Inappropriate Methods of Allocating Costs Among Segments
Failure to trace
costs directly
Inappropriate
allocation base
Costs that can be traced directly to specific segments of a company should not be allocated to other segments. Rather, such costs should be charged directly to the responsible segment. For example, the rent for a branch office of an insurance company should be charged directly against the branch office rather than included in a companywide overhead pool and then spread throughout the company.
Some companies allocate costs to segments using arbitrary bases. Costs should be allocated to segments for internal decision-making purposes only when the allocation base actually drives the cost being allocated. For example, sales is frequently used to allocate selling and administrative expenses to segments. This should only be done if sales drive these expenses.
Segment 1
Segment 2
Segment 3
Segment 4

27. Common Costs should not be arbitrarily allocated to segments
May make a profitable business segment appear to be unprofitable.
Allocating common fixed costs forces managers to be held accountable for costs they cannot control.
Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons:
First, this practice 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.
Second, allocating common fixed costs forces managers to be held accountable for costs that they cannot control.
Segment 2
Segment 3
Segment 4

28. Companywide Income Statements
Both U.S. GAAP and IFRS require absorption costing for external reports.
Practically speaking, absorption costing is required for external reports in the United States. International Financial Reporting Standards (IFRS) also require absorption costing for external reports.  
Probably because of the cost of maintaining two separate costing systems, most companies use absorption costing for their external and internal reports.

29. Variable versus Absorption Costing
Fixed manufacturing costs must be assigned to products to properly match revenues and costs.
Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.
With all of these advantages, why is absorption costing still so prevalent? One reason (in addition to the external reporting issue) relates to the matching principle.
Advocates of absorption costing argue that it better matches costs with revenues. They contend that fixed manufacturing costs are just as essential to manufacturing products as are the variable costs. However, advocates of variable costing view fixed manufacturing costs as capacity costs. They argue that fixed manufacturing costs would be incurred even if no units were produced.
Absorption Costing
Variable Costing

30. Segmented Financial Information
Both U.S. GAAP and IFRS require publically traded companies to include segmented financial data in their annual reports.
U.S. GAAP and IFRS require publicly traded companies to include segmented financial data in their annual reports. These rulings have implications for internal segment reporting because they mandate that companies must prepare external segmented reports using the same methods that they use for internal segmented reports. 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.

31. But
Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports.

32. This requirement motivates managers to avoid using the contribution approach for internal reporting purposes.

33. because if they did they would be required to:
Share this sensitive data with the public.
b. Reconcile these reports with applicable rules for consolidated reporting purposes.