bee a ls lee UR CU eee alee CL PETIA Tiel) eeu ucla ae) effect s and it as sata eda Variable Versus Absorption Costing Fixed Selling And Administrative Expenses Fixed Selling And Administrative Expenses Absorption Costing Variable Costing Direct Material Cost Product | Direct Material Cost Product Cost Cost Direct Labour Cost Direct Labour Cost Variable Manufacturing Overheads Variable Manufacturing Overheads Fixed Manufacturing Overheads Fixed Manufacturing Overheads Period Cost Variable Selling and Administrative Period | Variable Selling and Administrative Expenses Cost | ExpensesLearning Objective 1 Explain how variable costing differs from absorption costing and compute unit product costs under each method. De | Overview of Variable and Absorption Costing Variable Absorption Costing Costing [Direct Materials [Direct Labor arable Manuactring Overhead Fixed Manufacturing Ovemesd| Varable Satin and Adminsatve Expenses Foe Seting and Adminstaive ExpensesQuick Check ¥ ‘Which method will produce the highest values for work in process and finished goods inventories? ‘a. Absorption costing. . Variable costing. cc. They produce the same values for these inventories, di It depends. . Quick Check ¥ ‘Which method will produce the highest values {for work in process and finished goods inventories? sorption costing, . Variable costing. cc. They produce the same values for these inventories. di It depends. .Unit Cost Computations Harvey Company produces a single product with the following information available: Number of units produced annually 25,000 Variable costs per unit: Direct materials, direct labor, and variable mfg. overhead 10 Selling & administrative expenses $ 3 Fixed costs per year: Manufacturing overhead $150,000 Selling & administrative expenses $100,000 —— Unit Cost Computations Unit product cost is determined as follows: ‘Absorption Varia Costing _Costing Direct materials, direct labor, fandvariable mig. overhead $ «= 10 $10 Fixed mfg. overheat (150,000 + 26,000 units) Unit product cost La Faw 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.Learning Objective 2 Prepare income statements using both variable and absorption costing. Variable and Absorption Costing Income Statements Let's assume the following additional information for Harvey Company. © 20,000 units were sold during the year ata price (of $30 each, © There is no beginning inventory. Now, let's compute net operating income using both absorption and variable costing.Variable Costing Contribution Format. Income Statement. ‘Sels (20.000 30) ses vib xpeneee: ‘arabe cost of goo sold 20000 S10) 200.000 arabe sting &sinisatve ‘oponsos (20,000 3) 0.000 / 220000 ‘Totalvarabie expenses, ‘cntribution margin 40.000 oes fed expenses: ited manufacturing overhead 5 13004 Fixed soln & administrative expenses 100000 250,000_ Net operating income E2000. Absorption Costing Income Statement Sates (20,000 « $30) Less cost of goods Sola: (20,000 « $16) Gross margin Less seling & administrative expenses. Variable (20,000 » $3) $60,000 Net operating income 120,00Learning Objective 3 Reconcile variable costing] and absorption costing net operating incomes and explain why the two amounts differ. as Comparing the Two Methods $250,000 150,900 260,000 60000 $400,500Comparing the Two Methods We can reconcile the difference between absorption and variable income as follows: variable costing net operating income $90,000 |Add: Fixed mig. overhead costs deterred in inventory {6,000 units x $6 per unit) sscorpon couing ret operating income ET34000- Tatoo Fixed mfg. overhead _ $150,000 Units produced = 25,000 units = S®Perunit —— EEE Extended Comparisons of Income Data Harvey Company - Year Two. ‘Number of units produced 725,000 Number of units sold 120,000 Units in beginning Inventory 5,000 Unit sales price sw Variable costs per unit: Direct materials, rect labor, land variable mfg. overhead $ © 10. Selling & administrative pense soos Fixed costs per year: nufacturing overhead $160,000 ing & administrative ‘expenses. $100,000Unit Cost Computations ‘Absorption Varia Costing _Costing Direct materials, direct ‘and variable mfg. over sw 8 0 Fixed mfg. overhead ($180,000 + 28,000 units) Unit product cost [Since the variable costs per unit, total fixed costs, CI uu are Mute! unchanged, the unit cost computations also rien! Variable Costing Contribution Format Income Statement. Vara smanutactuting ‘conte only.Absorption Costing Income Statement ‘Uni product cout ‘Absorption Sales (0,000 $30) $800,000 Les cost of goods sod: (20,000 $16) 480,000 Gross margin| "420,000 Less soting & administrative expenses Variable (20,000 $3) $ 20.000 Fired 100,000 _ 180,000 Net operating income $230,000 Fixed manufacturing overhead released from inventory is 6,000 units x $6 = $30,000. Ss Comparing the Two Methods We can reconcile the difference between absorption and variable income as follows: Variable costing net operating income $260,000 Deduct: Fixed manufacturing overhead cost released from inventory (6,000 units x $8 per unit) 0,000 Absorption costing net operating income $290,000 Fixed mfg. overhead _ $150,000 Units produced = 25,000units = S@PerunitComparing the Two Methods Costing Method ‘stPeriod 2nd Period Total ‘Absorption. $ 120,000 § 230,000 $350,000 Variable 90,000 260,000 350,000 Summary of Key Insights Relation boawoen alation boavae production ettecton | variable and and sales inventory | absorption income This produced “Absorption = No change nits sois | in inventory This produced > Inventory nits sold Inoroases This proauend < Inventory nis sols | decreasesEnabling CVP Analysis Variable costing categorizes costs as fixed and variable so it is much easier to use this income statement format for CVP analysis. Because absorption costing assigns fixed manufacturing overhead costs to units produced ($6 Per unit for Harvey Company), a portion of fixed manufacturing overhead resides in inventory when Units remain unsold. The potential result is positive operating income when the number of units sold is less than the breakeven point. Explaining Changes in m (Operating Income Variable costing income is only affected by changes in unit sales. Itis 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.Supporting Decision Making Variable costing correctly identifies the additional variable costs incurred to make one more unit ($10 per unit for Harvey Company). It also emphasizes the impact of total fixed costs on profits. Because absorption costing assigns fixed manufacturing overhead costs to units produced (6 per unit for Harvey Company), it gives the impression that fixed manufacturing overhead is variable with respect fo the number of units produced, but itis not. The result can be inappropriate pricing decisions and product discontinuation decisions. Variable Costing and the Theory of Constraints (TOC) ‘Companies involved in TOC use a form of variable costing. However, one difference of the TOC approach is that it treats direct labor as a fixed cost for three reasons: (© Many companiLearning Objective 4 Prepare a segmented income statement that differentiates traceable fixed costs from common fixed costs and use it to make decisions. Decentralization and Segment Reporting a nc Store ‘A segment is any part Asale Teton or activity of an organization about which a manager seeks cost, revenue, or profit data Ase Center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. ‘Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin. Identifying Traceable Fixed Costs Traceable fixed costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. No computer No computer division means division manager. lonIdentifying Common Fixed Costs Common fixed costs arise because of the ‘overall operation of the company and would not disappear if any particular segment wer eliminated. No computer We still have a division but... company president. Traceable Costs Can Become Common Costs 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-ciass passengers.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. Profits Time Traceable and Common Costs (Ee) ont atlocate ‘common costs to ‘segments. loLevels of Segmented Statements Webber, Inc. has two divi: Webber, Inc. rt Computer Division | | Television Division Let's look more closely at the Television Division's income statement. as Levels of Segmented Statements Our approach to segment reporting uses the contribution format. Tacome Statement Cost of goods Contribution Margin Format sold consists of Television Division variable ‘Sales, ‘$300,000 ‘manufacturing jariable COGS: 120,000 costs. Oterverenc coats ‘a0 + B08 7 rretara fonicasniecoce | —istes Cenvowton margin tenor j/ [varaba costs mete tedcoee ‘noms “) | sve Sevoneag Eat aLevels of Segmented Statements Our approach to segment reporting uses the contribution format. Tacome Statement Contribution Margin Format ‘Television Division Contribution margin is computed by taking sales minus Sales $300,000 Variable COGS 120,000 eerie coe Other variable costs _30,000 Total variable costs 150,000. | [Segment margin Contribution margin 150,000" | | is Television's, Traceable fixed costs __ 90,000 ‘contribution Division margin “S_60,000 to profits. —— Levels of Segmented Statements income Statement ‘Company Television Computer Sales '$ 500,000" “$900,000 ~$ 200,000, Variable costs 1900. ___ 150,000 ___ 80,000. 270,000 150,000 720,000 470.000, __ 90,000 __60,000 Division margin 100,000" “$60,000. “8 40,000, ‘Common costs Net operating incomeLevels of Segmented Statements Tncome Statement ‘Company Television Computer Sales ‘$500,000 “$ 300,000" ~$ 200,000, Variable costs __230,000_ __ 150,000. __ 80,000, om '270,000 150,000. 120,000 Traceable FC __170,000 __90,000 __80,000 Division margin 100,000" “$60,000. “8 40,000 Common costs __25,000 Fommon costs should nat] Net operating income $75,000 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!Traceable Costs Can Become Common Costs Webber's Television Divi Television Division Regular Big Seren Product Lines —— Traceable Costs Can Become Common Costs Ineome Statement Televiaon Divison’ _ Regular Big Sereon 200,000 “$100,000, 25,000, ss000, 705,000 45,000 8000, __ 95,000, Zeno, S000" Product line margin ‘Common costs Divisional margin We obtained the following information from the Regular and Big Screen segments.Traceable Costs Can Become Common Costs Income Satement Tolovision| Division” _Regular__Big Screen Sales % 300,000" “$200,000 $100,000 Variable costs = 95,000, __ $5,000 cu 105.000" 45,000 ‘Traceable FC 35,000 Product line margin ales “00 ‘Common costs Divisional margin 7S 60,000 Fixed coats directly traced to the Television Division $80,000 + $10,000 = $90,000 Segmented Income Statements and Decision Making ana f Income Statement ‘Sales “$315,000 Fo 4 ‘Fraceable ‘0,000. __ "45,000, 000 Product ine margin 7.500” “S_65.2 aso] ‘Common costs 4 Disonel margin 562.500, [Division margin] [ Margin | [ Margin Increases by | |increases|| | increases $2,500 _| |by $5,250] | by $2,250Omission of Costs Costs assigned to a segment should include all costs attributable to that segment from the ‘company’s entire value chain. Business Functions Making Up The Value Chain Prodvet [Gustomer R&D| Design _| Mansfactuing| Marketing| Distbution | Service | eeveereereereerineeesmamessl Inappropriate Methods of Allocating Costs Among SegmentsCommon Costs and Segments. Common costs should not be arbitrarily allocated o segments "breed on the rationale that "someone has to cover the ‘common costs” for to reasons: 1. This practice may make a profitable business segment appear tobe unprofitable. 12. Allocating common fixed costs forces managers to be held accountable for costs they eannot contro. oood Quick Check v Tncome Swiament Hoagland's Lakeshore __Bar___Resta Sales ‘5 100,000 ~$ 700, Variable costs 60,000. __250,000 40,000" 450,000 26,000. __ 220,000. “S1s}000- “$230,000. Segment margin ‘Common costs Prott S_#4,000 ‘Assume that Hoagland’s Lakeshore prepared its ‘segmented income statement as shown.How much of the common fixed cost of {$200,000 can be avoided by eliminating the bar? c.Allof it. Quick Check v How much of the common fixed cost of {$200,000 can be avoided by eliminating the bar? None of it ‘Some of it. ©. Allof it ‘common fixed cost cannot be eliminated by dropping one of the segments.Quick Check v ‘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 fect? a. $20,000 , $30,000 ©. $40,000 4. $50,000 es Quick Check v ‘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 ifthe bar occupies 1,000 square feet and the sstaurant 9,000 square feet? 20,000, The bar would be peo allocated 1,9 of the cost . $40,000 ‘or $20,000. d. $50,000Quick Check v as oF Allocations of Common Costs nome Statement si Variable costs cm ‘Traceable FC ‘marginQuick Check v ‘Should the bar be eliminated? a. Yes b. No as Quick Check v ‘Should the bar be eliminated? ass 9 the bar. If we eliminate the bar, profit drops to $30,000! Hoagland's Lake shor Bar sales '$ 700,000 Variable costs 250,000 cm "450,000 ‘Traceable FC 220,000. Segment margin 230,000. Common cose 200,000! Prot 'S_ 30,000Companywide Income { - Statements ‘Since absorption costing is required for extemal reporting, most companies also use it for internal reports rather than incurring the additional cost of maintaining a separate variable cost system for internal reporting. Variable versus Absorption Costing manufacturing Peet rr ct ret Fixed manufacturing Cee ee ‘and willbe incurred eels Oa “CostingSegmented Financial Ss Information < Both U.S. GAAP and IFRS require publically traded companies to include segmented financial data in their annual reports. 11. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. 2. This requirement motivates managers to avold 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. es End of Chapter 6