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Chapter 06 Variable Costing and Segment Reporting: Tools for Management
Chapter 06
Variable Costing and Segment Reporting:Tools for Management
Solutions to Questions
 Absorption and variable costing differ in how they handle fixed manufacturing overhead. Underabsorption costing, fixed manufacturing overhead is treated as a product cost and hence is an asset untilproducts are sold. Under variable costing, fixed manufacturing overhead is treated as a period cost and isexpensed on the current period’s income statement.
Selling and administrative expenses are treated as period costs under both variable costing andabsorption costing.
Under absorption costing, fixed manufacturing overhead costs are included in product costs,along with direct materials, direct labor, and variable manufacturing overhead. If some of the units arenot sold by the end of the period, then they are carried into the next period as inventory. When the unitsare finally sold, the fixed manufacturing overhead cost that has been carried over with the units isincluded as part of that period’s cost of goods sold.
 Absorption costing advocates argue that absorption costing does a better job of matching costswith revenues than variable costing. They argue that all manufacturing costs must be assigned toproducts to properly match the costs of producing units of product with the revenues from the units whenthey are sold. They believe that no distinction should be made between variable and fixed manufacturingcosts for the purposes of matching costs and revenues.
 Advocates of variable costing argue that fixed manufacturing costs are not really the cost of anyparticular unit of product. If a unit is made or not, the total fixed manufacturing costs will be exactly thesame. Therefore, how can one say that these costs are part of the costs of the products? These costs areincurred to have the capacity to make products during a particular period and should be charged againstthat period as period costs according to the matching principle.
If production and sales are equal, net operating income should be the same under absorptionand variable costing. When production equals sales, inventories do not increase or decrease andtherefore under absorption costing fixed manufacturing overhead cost cannot be deferred in inventory orreleased from inventory.
Chapter 06 Variable Costing and Segment Reporting: Tools for Management
If production exceeds sales, absorption costing will usually show higher net operating incomethan variable costing. When production exceeds sales, inventories increase and under absorption costingpart of the fixed manufacturing overhead cost of the current period is deferred in inventory to the nextperiod. In contrast, all of the fixed manufacturing overhead cost of the current period is immediatelyexpensed under variable costing.
If fixed manufacturing overhead cost is released from inventory, then inventory levels must havedecreased and therefore production must have been less than sales.
Under absorption costing net operating income can be increased by simply increasing the level of production without any increase in sales. If production exceeds sales, units of product are added toinventory. These units carry a portion of the current period’s fixed manufacturing overhead costs into theinventory account, reducing the current period’s reportedexpenses and causing net operating income to increase.
Differences in reported net operating income between absorption and variable costing arisebecause of changing levels of inventory. In lean production, goods are produced strictly to customers’ orders. With production geared to sales, inventories are largely (or entirely) eliminated. If inventories arecompletely eliminated, they cannot change from one period to another and absorption costing andvariable costing will report the same net operating income.
 A segment is any part or activity of an organization about which a manager seeks cost, revenue,or profit data. Examples of segments include departments, operations, sales territories, divisions, andproduct lines.
Under the contribution approach, costs are assigned to a segment if and only if the costs aretraceable to the segment (i.e., could be avoided if the segment were eliminated). Common costs are notallocated to segments under the contribution approach.
 A traceable cost of a segment is a cost that arises specifically because of the existence of thatsegment. If the segment were eliminated, the cost would disappear. A common cost, by contrast, is acost that supports more than one segment, but is not traceable in whole or in part to any one of thesegments. If the departments of a company are treated as segments, then examples of the traceablecosts of a department would include the salary of the department’s supervisor, depreciation of machinesused exclusively by the department, and the costs of supplies used by the department. Examples of common costs would include the salary of the general counsel of the entire company, the lease cost of the headquarters building, corporate image advertising, and periodic depreciation of machines shared byseveral departments.
The contribution margin is the difference between sales revenue and variable expenses. Thesegment margin is the amount remaining after deducting traceable fixed expenses from the contributionmargin. The contribution margin is useful as a planning tool for many decisions, particularly those inwhich fixed costs don’t change. The segment margin is useful in assessing the overall profitability of asegment.
If common costs were allocated to segments, then the costs of segments would be overstatedand their margins would be understated. As a consequence, some segments may appear to beunprofitable and managers may be tempted to eliminate them. If a segment were eliminated because of the existence of arbitrarily allocated common costs, the overall profit of the company would decline andthe common cost that had been allocated to the segment would be reallocated to the remainingsegments—making them appear less profitable.
Chapter 06 Variable Costing and Segment Reporting: Tools for Management
There are often limits to how far down an organization a cost can be traced. Therefore, costs thatare traceable to a segment may become common as that segment is divided into smaller segment units.For example, the costs of national TV and print advertising might be traceable to a specific product line,but be a common cost of the geographic sales territories in which that product line is sold.
Exercise 6-1
(15 minutes)1.Under absorption costing, all manufacturing costs (variable and fixed)are included in product costs. (All currency values are in thousands of rupees, denoted by R.)Direct materials................................................................R120Direct labor......................................................................140 Variable manufacturing overhead.......................................50Fixed manufacturing overhead (R600,000 ÷ 10,000 units)... 60 Absorption costing unit product cost..................................R3702.Under variable costing, only the variable manufacturing costs areincluded in product costs. (All currency values are in thousands of rupees, denoted by R.)Direct materials..................................R120Direct labor........................................140 Variable manufacturing overhead........ 50 Variable costing unit product cost........R310Note that selling and administrative expenses are not treated as productcosts under either absorption or variable costing. These expenses arealways treated as period costs and are charged against the currentperiod’s revenue.

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