1. MANAGERIAL ACCOUNTING Eighth Canadian Edition GARRISON, CHESLEY, CARROLL, WEBB
Prepared by:
Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance

2. Variable Costing: A Tool for Management
8-2
Variable Costing: A Tool for Management
Chapter Eight
Two general approaches are used for valuing inventories and cost of goods sold. One approach, called absorption costing, is generally used for external reporting purposes. The other approach, called variable costing, is preferred by some managers for internal decision making and must be used when an income statement is prepared in the contribution format. This chapter shows how these two methods differ from each other.

3. 8-3
Learning Objective 1
Explain how variable costing differs from absorption costing and compute unit product costs under each method.
Learning objective number 1 is to explain how variable costing differs from absorption costing and compute unit product costs under each method.

4. Overview of Absorption and Variable Costing
8-4
Overview of Absorption and Variable Costing
Absorption Costing
Variable Costing
Product Costs
Period Costs
Direct Materials
Direct Labour
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Product Costs
Period Costs
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 labour, 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.
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 labour, 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.
Think about the impact of each method on inventory values, and then answer the following question.

5. 8-5
Quick Check 
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
To answer this question correctly, recall which method includes more manufacturing costs in the unit product cost.

6. 8-6
Quick Check 
Which method will produce the highest values for work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these inventories.
d. It depends. . .
Unit product costs are in both work in process and finished goods inventories. Absorption costing results in the highest inventory values because it treats fixed manufacturing overhead as a product cost. Using variable costing, fixed manufacturing overhead is expensed as incurred and never becomes a part of the product cost.

7. Unit Cost Computations
8-7
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 $3.00 per unit. Fixed manufacturing overhead for the year is $150,000 and fixed selling and administrative expenses for the year are $100,000.

8. Unit Cost Computations
8-8
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.
Under absorption costing, selling and administrative expenses are always treated as period expenses and deducted from revenue as incurred.

9. Prepare income statements using both variable and absorption costing.
8-9
Learning Objective 2
Prepare income statements using both variable and absorption costing.
Learning objective number 2 is to prepare income statements using both variable and absorption costing.

10. Income Comparison of Absorption and Variable Costing
8-10
Income Comparison of Absorption and Variable Costing
Let’s assume the following additional information for Harvey Company.
20,000 units were sold during the year at a price of $30 each.
There were no units in beginning inventory.
Now, let’s compute net operating income using both absorption and variable costing.
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.

11. 8-11
Absorption Costing
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.

12. Variable Costing Variable manufacturing costs only.
8-12
Variable Costing
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now let’s examine a variable cost income statement. Notice that this is a contribution format 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.

13. 8-13
Learning Objective 3
Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.
Learning objective number 3 is to reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.

14. Comparing the Two Methods
8-14
Comparing the Two Methods
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.

15. Comparing the Two Methods
8-15
Comparing the Two Methods
We can reconcile the difference between absorption and variable income as follows:
The difference in net operating income between the two methods ($30,000) can also be reconciled by multiplying the number of units in ending inventory (5,000 units) by the fixed manufacturing overhead per unit ($6) that is deferred in ending inventory under absorption costing.
Fixed mfg. Overhead $150,000
Units produced ,000 units
= = $6.00 per unit

16. Extended Comparisons of Income Data Harvey Company Year Two
8-16
Extended Comparisons of Income Data Harvey Company Year Two
In the second year, Harvey Company sells 30,000 units. The selling price per unit, variable costs per unit, total fixed costs, and number of units produced remain unchanged. Five thousand units are in beginning inventory, left from last year.

17. Unit Cost Computations
8-17
Unit Cost Computations
Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged.
Since there was no change in the variable costs per unit, total fixed costs, or the number of units produced, the unit costs remain unchanged.

18. produced in the current period.
8-18
Absorption Costing
These are the 25,000 units
produced in the current period.
Of the 30,000 units sold in the second year, 25,000 units were produced in the second year and 5,000 units came from beginning inventory. The $30,000 of fixed manufacturing overhead deferred into inventory in the first year is released from inventory this year as part of the $16 unit product cost.
Selling and administrative expenses are deducted from gross margin to obtain the net operating income of $230,000.

19. Variable Costing All fixed manufacturing overhead is expensed.
8-19
Variable Costing
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now, let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. At a product cost of $10 per unit, the variable cost of goods sold for 30,000 units is $300,000.
After computing contribution margin, we subtract fixed expenses to get the $260,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.

20. Comparing the Two Methods
8-20
Comparing the Two Methods
We can reconcile the difference between absorption and variable income as follows:
The difference in net operating income between the two methods ($30,000) can be reconciled by multiplying the number of units in beginning inventory (5,000 units) by the fixed manufacturing overhead per unit ($6) that is released from beginning inventory under absorption costing.
Fixed mfg. Overhead $150,000
Units produced ,000 units
= = $6.00 per unit

21. Comparing the Two Methods
8-21
Comparing the Two Methods
Across the two year time frame, both methods reported the same total net operating income ($350,000). This is because over an extended period of time sales cannot exceed production, nor can production much exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.

22. Summary of Key Insights
8-22
Summary of Key Insights
On your screen is a nice summary of what we have observed from the Harvey Company’s two years:
When production is greater than sales, as in year 1 for Harvey, absorption income is greater than variable costing income. 
When production is less than sales, as in year 2 for Harvey, absorption costing income is less than variable costing income. 
When production equals sales, the two methods report the same net operating income.

23. Effect of Changes in Production on Net Operating Income
8-23
Effect of Changes in Production on Net Operating Income
Let’s revise the Harvey Company example.
In the previous example, 25,000 units were produced each year, but sales increased from 20,000 units in year one to 30,000 units in year two.
In the previous Harvey Company example, units of production was constant and sales fluctuated. In the forthcoming example, units of production will fluctuate and sales in units will remain constant.
In this revised example, production will differ each year while sales will remain constant.

24. Effect of Changes in Production Harvey Company Year One
8-24
Effect of Changes in Production Harvey Company Year One
In the first year, Harvey Company produces 30,000 units and sells 25,000 units. There is no beginning inventory. The selling price per unit, variable costs per unit, and total fixed costs remain unchanged from the prior example.

25. Unit Cost Computations for Year One
8-25
Unit Cost Computations for Year One
Unit product cost is determined as follows:
Since the number of units produced increased in this example, while the fixed manufacturing overhead remained the same, the absorption unit cost is less.
The unit product costs under absorption and variable costing are $15 and $10, respectively. Note that the fixed manufacturing overhead cost per unit has declined from $6 in the previous example to $5 in this example. Since the number of units produced increased to 30,000 in this example, and the fixed manufacturing overhead remained the same, the unit cost is less.

26. Absorption Costing: Year One
8-26
Absorption Costing: Year One
Harvey sold only 25,000 of the 30,000 units produced, leaving 5,000 units in ending inventory. At a sales price of $30 per unit, sales revenue for the 25,000 units sold is $750,000. At a unit product cost of $15, cost of goods sold for the 25,000 units sold is $375,000. Subtracting cost of goods sold from sales, we find the gross margin of $375,000.
After subtracting selling and administrative expenses from the gross margin, we see that net operating income is $200,000.

27. Variable Costing: Year One
8-27
Variable Costing: Year One
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now, let’s examine a variable cost income statement prepared in the contribution format. 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 25,000 units is $250,000. The next variable expense is the variable selling and administrative expense.
After computing contribution margin, we subtract fixed expenses to get the $175,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.

28. Effect of Changes in Production Harvey Company Year Two
8-28
Effect of Changes in Production Harvey Company Year Two
In the second year, Harvey Company again sells 25,000 units, but produces only 20,000. Five thousand units are in beginning inventory, left from last year. The selling price per unit, variable costs per unit, and total fixed costs remain unchanged.

29. Unit Cost Computations for Year Two
8-29
Unit Cost Computations for Year Two
Unit product cost is determined as follows:
Since the number of units produced decreased in the second year, while the fixed manufacturing overhead remained the same, the absorption unit cost is now higher.
The unit product costs for the second year under absorption and variable costing are $17.50 and $10, respectively. Note that the fixed manufacturing overhead cost per unit has increased from $5 in year one to $7.50 in year two. Since the number of units produced decreased to 20,000 in year two, and the fixed manufacturing overhead remained the same, the unit cost is greater.

30. Absorption Costing: Year Two
8-30
Absorption Costing: Year Two
These are the 20,000 units produced in the current period at the higher unit cost of $17.50 each.
Of the 25,000 units sold in the second year, 20,000 units were produced in the second year and 5,000 units came from beginning inventory. The unit product cost for units in beginning inventory is $15. The unit product cost for goods manufactured in year two is $ The $25,000 of fixed manufacturing overhead deferred into inventory in the first year is released from inventory this year as part of the $15 unit product cost.
Selling and administrative expenses are deducted from gross margin to obtain the net operating income of $150,000.

31. Variable Costing: Year Two
8-31
Variable Costing: Year Two
Variable manufacturing costs only.
All fixed manufacturing overhead is expensed.
Now let’s examine a variable cost income statement for the second year. Again, notice that this is a contribution format statement. At a product cost of $10 per unit, the variable cost of goods sold for 25,000 units is $250,000.
After computing contribution margin, we subtract fixed expenses to get the $175,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.

32. Comparing the Two Methods
8-32
Comparing the Two Methods
 Net operating income is not affected by changes in production using variable costing.
 Net operating income is affected by changes in production using absorption costing even though the number of units sold is the same each year.
Conclusions
The difference in net operating income between the two methods ($25,000) can be reconciled by multiplying the number of units in beginning inventory (5,000 units) by the fixed manufacturing overhead per unit ($5) that is deferred in ending inventory and then released from beginning inventory in the next period under absorption costing.
Units sold, selling price, variable costs per unit, and total fixed costs remained constant across years 1 and 2. Thus, the contribution margin and variable costing net operating income did not change.
Across the two year time frame, both methods reported the same total net operating income ($350,000). This is because over an extended period of time sales cannot exceed production, nor can production much exceed sales. The shorter the time period, the more the net operating income figures will tend to differ.

33. 8-33
Learning Objective 4
Explain the advantages and disadvantages of both variable and absorption costing.
Learning objective number 4 is to explain the advantages and disadvantages of both variable and absorption costing.

34. 8-34
Impact on the Manager
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to faulty decisions.
These opponents argue that variable costing income statements are easier to understand because net operating income is only affected by changes in unit sales. This produces net operating income figures that are more consistent with managers’ expectations.
Opponents of absorption costing argue that shifting fixed manufacturing overhead costs between periods can lead to faulty decisions.
These opponents argue that variable costing income statements are easier to understand because net operating income is only affected by changes in unit sales. This produces net operating income figures that are more consistent with managers’ expectations.

35. CVP Analysis, Decision Making and Absorption costing
8-35
CVP Analysis, Decision Making and Absorption costing
Absorption costing does not support CVP analysis because it essentially treats fixed manufacturing overhead as a variable cost by assigning a per unit amount of the fixed overhead to each unit of production.
Treating fixed manufacturing overhead as a variable cost can:
Lead to faulty pricing decisions and keep-or-drop decisions.
Produce positive net operating income even when the number of units sold is less than the breakeven point.
Absorption costing does not dovetail with CVP analysis, nor does it support decision making. It treats fixed manufacturing overhead as a variable cost. This can lead to faulty pricing decisions and keep-or-drop decisions. It also 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.

36. External Reporting and Income Taxes
8-36
External Reporting and Income Taxes
To conform to GAAP requirements, absorption costing must be used for external financial reports in Canada.
Either variable or absorption costing can be used when filing income tax returns.
Since top executives are usually evaluated based on external reports to shareholders, they may feel that decisions should be based on absorption cost income.
Practically speaking, absorption costing is required for external reports in Canada. For income tax purposes in Canada, Interpretation Bulletin IT-473R permits both variable and absorption costing for the purposes of determining taxable income. Since top executives are typically evaluated based on earnings reported to shareholders in external reports, they may feel that decisions should be based on absorption costing data.

37. Advantages of Variable Costing and the Contribution Approach
8-37
Advantages of Variable Costing and the Contribution Approach
Consistent with
CVP analysis.
Management finds it more useful.
Net operating income
is closer to net cash flow.
Consistent with standard costs and flexible budgeting.
Advantages
Easier to estimate profitability of products and segments.
The advantages of variable costing and the contribution approach include:
The data required for CVP analysis can be taken directly from a contribution format income statement.
Profits move in the same direction as sales, assuming other things remain the same.
Managers often assume that unit product costs are variable. Under variable costing, this assumption is true.
Fixed costs appear explicitly on a contribution format income statement; thus the impact of fixed costs on profits is emphasized.
Variable costing data make it easier to estimate the profitability of products, customers, and other business segments.
Variable costing ties in with cost control methods, such as standard costs and flexible budgeting.
Variable costing net operating income is closer to net cash flow than absorption costing net operating income.
Profit is not affected by changes in inventories.
Impact of fixed
costs on profits
emphasized.

38. Variable versus Absorption Costing
8-38
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

39. 8-39
Learning Objective 5
Explain how the use of lean production reduces the difference between reported operating income under the variable and absorption costing methods.
Learning objective number 5 is to explain how the use of lean production reduces the difference between reported operating income under the variable and absorption costing methods.

40. Impact of Lean Production (JIT) Inventory Methods
8-40
Impact of Lean Production (JIT) Inventory Methods
In a lean production (JIT) inventory system . . .
Production tends to equal sales . . .
When companies use lean production (JIT – just-in-time) methods, the goal is to eliminate finished goods inventories and reduce work in process inventory to almost nothing. This causes absorption costing net operating income to essentially move in the same direction as sales. Therefore, the difference between absorption costing and variable costing income tends to disappear.
So, the difference between variable and
absorption income tends to disappear.

41. 8-41
Learning Objective 6
Prepare a segmented income statement using the contribution margin format and explain the difference between traceable fixed costs and common fixed costs.
Learning objective number 6 is to prepare a segmented income statement using the contribution margin format and explain the difference between traceable fixed costs and common fixed costs.

42. Decentralization and Segment Reporting
8-42
Decentralization and Segment Reporting
Quick Mart
An Individual Store
A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be . . .
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 Centre

43. Superior Foods: Geographic Regions
8-43
Superior Foods: Geographic Regions
Superior Foods Corporation could segment its business by geographic regions.

44. Superior Foods: Customer Channel
8-44
Superior Foods: Customer Channel
Or, Superior Foods could segment its business by customer channel.
Superior Foods Corporation could segment its business by customer channel.

45. Keys to Segmented Income Statements
8-45
Keys to Segmented Income Statements
There are two keys to building segmented income statements:
A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution 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.
Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

46. Identifying Traceable Fixed Costs
8-46
Identifying Traceable Fixed Costs
Traceable costs arise because of the existence of a particular segment and would disappear over time 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.

47. Identifying Common Fixed Costs
8-47
Identifying Common Fixed Costs
Common costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated.
No computer
division but . . .
We still have a
company president.
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 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 – groceries, produce, and bakery.

48. Traceable Costs Can Become Common Costs
8-48
Traceable Costs Can Become Common Costs
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 the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.
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.

49. 8-49
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.
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.
Profits
Time

50. Traceable and Common Costs
8-50
Traceable and Common Costs
Fixed
Costs
Don’t allocate
common costs to segments.
Traceable
Common
Part I
Allocating common costs to segments reduces the value of the segment margin as a guide to long-run segment profitability.
Part II
As a result, common costs should not be allocated to segments.

51. Activity-Based Costing
8-51
Activity-Based Costing
Activity-based costing can help identify how costs shared by more than one segment are traceable to individual segments.
Assume that three products, 9-inch, 12-inch, and 18-inch pipe, share 10,000 square feet of warehousing space, which is leased at a price of $4 per square foot.
If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 square feet, respectively, then ABC can be used to trace the warehousing costs to the three products as shown.
Activity-based costing can help identify how costs shared by more than one segment are traceable to individual segments.
For example, assume that three products, a 9-inch, a 12-inch, and an 18-inch pipe, share 10,000 square feet of warehousing space, which is leased at a price of $4 per square foot.
If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 square feet, respectively, then activity-based costing can be used to trace the warehousing costs to the three products as shown.
When using activity-based costing to trace fixed costs to segments, managers must still ask themselves if the traceable costs that they have identified would disappear over time, if the segment disappeared. In this example, if the warehouse was owned rather than leased, perhaps the warehousing costs assigned to a given segment would not disappear if the segment was discontinued.

52. Levels of Segmented Statements
8-52
Levels of Segmented Statements
Webber, Inc. has two divisions.
Assume that Webber, Inc. has two divisions – the Computer Division and the Television Division.
Let’s look more closely at the Television Division’s income statement.

53. Levels of Segmented Statements
8-53
Levels of Segmented Statements
Our approach to segment reporting uses the contribution format.
Cost of goods
sold consists of
variable manufacturing
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.

54. Levels of Segmented Statements
8-54
Levels of Segmented Statements
Our approach to segment reporting uses the contribution format.
Contribution margin
is computed by taking sales minus variable costs.
Also notice that:
Contribution margin is computed by subtracting variable costs from sales; and
The divisional segment margin represents the Television Division’s contribution to overall company profits.
Segment margin
is Television’s
contribution
to profits.

55. Levels of Segmented Statements
8-55
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.

56. Levels of Segmented Statements
8-56
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.

57. Traceable Costs Can Become Common Costs
8-57
Traceable Costs Can Become Common Costs
As previously mentioned, fixed costs that are traceable to one segment can become common if the company is divided into smaller segments.
Let’s see how this works using the Webber, Inc. example!
The Television Division’s results can also be broken down into smaller segments. This enables us to see how traceable fixed costs of the Television Division can become common costs of smaller segments.

58. Traceable Costs Can Become Common Costs
8-58
Traceable Costs Can Become Common Costs
Webber’s Television Division
Regular
Big Screen
Television
Division
Assume that the Television Division can be broken down into two major product lines – Regular and Big Screen.
Product
Lines

59. Traceable Costs Can Become Common Costs
8-59
Traceable Costs Can Become Common Costs
Assume that the segment margins for these two product lines are as shown.
We obtained the following information from
the Regular and Big Screen segments.

60. Traceable Costs Can Become Common Costs
8-60
Traceable Costs Can Become Common Costs
Of the $90,000 of fixed costs that were previously traceable to the Television Division, only $80,000 is traceable to the two product lines and $10,000 is a common cost.
Fixed costs directly traced
to the Television Division
$80,000 + $10,000 = $90,000

61. 8-61
External Reports
The Accounting Standards Board now requires that companies in Canada include segmented financial data in their annual reports.
Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports.
Since the contribution approach to segment reporting does not comply with GAAP, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP.
The Accounting Standards Board (CICA Handbook section 1701) now requires that companies in Canada include segmented financial data in their annual reports. This ruling has implications for internal segment reporting because:
It mandates that companies report segmented results to shareholders using the same methods that are used for internal segmented reports.
Since the contribution approach to segment reporting does not comply with GAAP, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP. The absorption approach hinders internal decision making because it does not distinguish between fixed and variable costs or common and traceable costs.

62. Some Problems Hindrances to Proper Cost Assignment Omission of some
8-62
Hindrances to Proper Cost Assignment
Some Problems
Omission of some
costs in the
assignment process.
Assignment to segments
of costs that are
really common costs of
the entire organization.
Costs must be properly assigned to segments. All of the costs attributable to a segment—and only those costs—should be assigned to the segment. Unfortunately, companies often make mistakes when assigning costs to segments. They omit some costs, inappropriately assign traceable fixed costs, and arbitrarily allocate common fixed costs.
Use of inappropriate
methods for allocating
costs among segments.

63. 8-63
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 under-costing of products.
Product Customer
R&D Design Manufacturing Marketing Distribution Service

64. Inappropriate Methods of Allocating Costs Among Segments
8-64
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 company-wide 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 general and administrative expenses to segments. This should only be done if sales drive these period costs.
Segment 1
Segment 2
Segment 3
Segment 4

65. Common Costs and Segments
8-65
Common Costs and 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:
This practice 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 1
Segment 2
Segment 3
Segment 4

66. 8-66
Quick Check 
Assume that Hoagland's Lakeshore prepared the segmented income statement as shown.
Assume that Hoagland's Lakeshore prepared its segmented income statement as shown.

67. 8-67
Quick Check 
How much of the common fixed cost of $200,000 can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
How much of the common fixed cost of $200,000 can be avoided by eliminating the bar?

68. 8-68
Quick Check 
How much of the common fixed cost of $200,000 can be avoided by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
A common fixed cost cannot be eliminated by dropping one of the segments.
None of it. A common fixed cost cannot be eliminated by dropping one of the segments.

69. 8-69
Quick Check 
Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet?
a. $20,000
b. $30,000
c. $40,000
d. $50,000
Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet?

70. The bar would be allocated 1/10 of the cost or $20,000.
8-70
Quick Check 
Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet?
a. $20,000
b. $30,000
c. $40,000
d. $50,000
The bar would be allocated 1/10 of the cost or $20,000.
The bar would be allocated one tenth of the cost or $20,000.

71. 8-71
Quick Check 
If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment?
If Hoagland's allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment?

72. Allocations of Common Costs
8-72
Allocations of Common Costs
Take a minute and review this slide. Notice that the common costs of $200,000 are allocated to the bar and restaurant.
Hurray, now everything adds up!!!

73. Quick Check  Should the bar be eliminated? a. Yes b. No
8-73
Quick Check 
Should the bar be eliminated?
a. Yes
b. No
Should the bar be eliminated?

74. Quick Check  Should the bar be eliminated? a. Yes b. No
8-74
Quick Check 
Should the bar be eliminated?
a. Yes
b. No
The profit was $44,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000!
No. The profit was $40,000 before eliminating the bar. If we eliminate the bar, profit drops to $30,000!

75. 8-75
End of Chapter 8
End of Chapter 8.