6-1
Variable Costing and Segment
Reporting: Tools for Management
Chapter 7
6-2
Learning Objective 1
Explain how variable
costing differs from
absorption costing and
compute unit product
costs under each
method.
6-3
Overview of Variable and
Absorption Costing
Variable Absorption
Costing Costing
Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs
Fixed Manufacturing Overhead
Period
Variable Selling and Administrative Expenses Period
Costs
Fixed Selling and Administrative Expenses Costs
6-4
Three Key Concepts
Variable vs Absorption Costing
1. Both formats include product and period costs,
but cost classifications are defined differently.
2. Variable costing income statements are
grounded in the contribution format and
categorize expenses based on cost behavior.
3. Both methods’ net operating incomes often differ
because of the fact that the methods account for
fixed manufacturing overhead differently.
6-5
Unit Cost Computations
Variable Absorption
Costing Total Per Unit Costing
Direct Materials
Product
Costs Direct Labor Product
Costs
Variable MOH
Fixed MOH
Period
Variable SG&A Period
Costs
Fixed SG&A Costs
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.
6-6
Concept Check 1
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…
6-7
Concept Check 1a
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. . .
6-8
Concept Check 2
Which of the following statements is false?
a. Under variable costing, only those manufacturing costs
that vary with output are treated as product costs.
b. Under variable costing, variable selling and
administrative expenses are treated as product costs.
c. Under absorption costing, fixed manufacturing
overhead is treated as a product cost.
d. Under absorption costing, fixed selling and
administrative expenses are treated as period costs.
6-9
Concept Check 2a
Which of the following statements is false?
a. Under variable costing, only those manufacturing costs
that vary with output are treated as product costs.
b. Under variable costing, variable selling and
administrative expenses are treated as product costs.
c. Under absorption costing, fixed manufacturing
overhead is treated as a product cost.
d. Under absorption costing, fixed selling and
administrative expenses are treated as period costs.
6-10
Learning Objective 2
Prepare income
statements using both
variable and absorption
costing.
6-11
Unit Cost Computations
Harvey Company produces a single
product with the following information:
available:
6-12
Unit Cost Computations
6-13
Variable and Absorption Costing
Income Statements
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 is no beginning inventory.
Now, let’s compute net operating income using both
absorption and variable costing.
6-14
Variable Costing Contribution Format
Income Statement All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only
Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Variable cost of goods sold (20,000 × $10) $ 200,000
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Total variable expenses
Contribution margin 340,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 90,000
6-15
Absorption Costing Income Statement
Unit product
cost
Fixed manufacturing overhead deferred in
inventory is 5,000 units × $6 = $30,000.
6-16
Learning Objective 3
Reconcile variable
costing and absorption
costing net operating
incomes and explain why
the two amounts differ.
6-17
Comparing the Two Methods –
Part 1
6-18
Comparing the Two Methods –
Part 1
6-19
Comparing the Two Methods –
Part 2
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income $ 90,000
Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 120,000
Fixed mfg. overhead $150,000
= = $6 per unit
Units produced 25,000 units
6-20
Extended Comparisons of Income
Data Harvey Company – Year Two
6-21
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.
6-22
Variable Costing All fixed
Variable manufacturing
manufacturing overhead is
costs only. expensed.
Variable Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Variable cost of goods sold (30,000 × $10) $ 300,000
Variable selling & administrative
expenses (30,000 × $3) 90,000
Total variable expenses 390,000
Contribution margin 510,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 260,000
6-23
Absorption Costing
Unit product
cost.
Fixed manufacturing overhead released from
inventory is 5,000 units × $6 = $30,000.
6-24
Reconciling the Difference
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income $ 260,000
Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000
Fixed mfg. overhead $150,000
= = $6 per unit
Units produced 25,000 units
6-25
Reconciling theDifference: 1 st and
2nd Periods
6-26
Comparative income Effects
6-27
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 break-even point.
6-28
Explaining Changes in Net Operating
Income
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.
6-29
Explaining Changes in Net Operating
Income
Variable
Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Variable COGS (20,000×$10) $ 200,000
Variable SG&A (20,000×$3) 60,000
Contribution margin 340,000
Less fixed expenses:
Fixed MOH $ 150,000
Fixed SG&A 100,000
Net operating income $ 90,000
Unit FMOH= FMOH / # of units produced
= 150,000 / 25,000
= $6 / unit
6-30
Absorption Costing and the Bankruptcy of U.S.
Automakers
• In the years leading up to the 2008 recession, General Motors, Ford,
and Chrysler were producing new vehicles in excess of market demand.
This led to large inventories on car dealer’s lots across the United
States. At the same time, profits were rising and executives at these
three companies were achieving their short-term incentive targets. How
is this possible? Absorption Costing may hold the answer.
• The big three had enormous fixed costs, from factories and machinery to
workers whose contracts protected them from layoffs when demand was
low. To “absorb” these costs, the automakers produced more cars while
using absorption costing. The more vehicles they made, the lower the
cost per vehicle, and the higher the profits on their income statements.
In effect, the automakers shifted costs from their income statements to
their balance sheets.
6-31
Concept Check 3
Smith Company produces and sells one product for $40
per unit. The company has no beginning inventories. Its
variable manufacturing cost per unit is $18 and the
variable selling and administrative expense per unit is
$4. The fixed manufacturing overhead and fixed selling
and administrative expense total $80,000 and $20,000,
respectively. If Smith Company produces 8,000 units
and sells 7,500 units during the year, then its net
operating income under variable costing would be
a. $65,000
b. $41,250
c. $40,000
d. $35,000
6-32
Concept Check 3a
Variable Costing
Sales (7,500 × $40) $ 300,000
Less variable expenses:
Variable cost of goods sold (7,500 × $18) $ 135,000
Variable selling & administrative
expenses (7,500 × $4) 30,000 165,000
Total variable expenses
Contribution margin 135,000
Less fixed expenses:
Fixed manufacturing overhead $ 80,000
Fixed selling & administrative expenses 20,000 100,000
Net operating income $ 35,000
6-33
Concept Check 3a
Smith Company produces and sells one product for $40
per unit. The company has no beginning inventories. Its
variable manufacturing cost per unit is $18 and the
variable selling and administrative expense per unit is
$4. The fixed manufacturing overhead and fixed selling
and administrative expense total $80,000 and $20,000,
respectively. If Smith Company produces 8,000 units
and sells 7,500 units during the year, then its net
operating income under variable costing would be
a. $65,000
b. $41,250
c. $40,000
d. $35,000
6-34
Concept Check 4
Smith Company produces and sells one product for $40
per unit. The company has no beginning inventories. Its
variable manufacturing cost per unit is $18 and the
variable selling and administrative expense per unit is
$4. The fixed manufacturing overhead and fixed selling
and administrative expense total $80,000 and $20,000,
respectively. If Smith Company produces 8,000 units
and sells 7,500 units during the year, then its net
operating income under absorption costing would be
a. $65,000
b. $41,250
c. $40,000
d. $35,000
6-35
Concept Check 4a
Unit product cost = DL+DM+VMOH+ Fixed MOH / # of units produced
= $18 + $80,000/8,000
= $28 / unit
6-36
Concept Check 4a
Smith Company produces and sells one product for $40
per unit. The company has no beginning inventories. Its
variable manufacturing cost per unit is $18 and the
variable selling and administrative expense per unit is
$4. The fixed manufacturing overhead and fixed selling
and administrative expense total $80,000 and $20,000,
respectively. If Smith Company produces 8,000 units
and sells 7,500 units during the year, then its net
operating income under variable costing would be
a. $65,000
b. $41,250
c. $40,000
d. $35,000
6-37
Learning Objective 4
Prepare a segmented income
statement that differentiates
traceable fixed costs from
common fixed costs and use
it to make decisions.
6-38
Decentralization and Segment
Reporting
An individual store
A segment is any part
or activity of an
organization about A Sales Territory
which a manager
seeks cost, revenue,
A Service Center
or profit data.
6-39
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.
6-40
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.
Example1) The salary of MTN Dew product manager at PepsiCo is a
traceable fixed cost of the MTN Dew business segment of PepsiCo.
Example2) The maintenance cost for the building in which Boeing
747s are assembled is a traceable fixed cost of the 747 business
segment of Boeing.
6-41
Identifying Common Fixed Costs
Common fixed costs arise because of the overall
operation of the company and would not disappear if
any particular segment were eliminated.
No computer We still have a
division but . . . company president.
Example1) The salary of the CEO of PepsiCo is a common fixed cost
of the various divisions of PepsiCo.
Example2) The cost of lightening LG Twin Towers is a common fixed
cost of the various departments.
6-42
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
6-43
Traceable and Common Costs
Fixed Don’t allocate
Costs common costs to
segments.
Traceable Common
6-44
Levels of Segmented Statements
Webber, Inc. has two divisions.
Webber, Inc.
Computer Division Television Division
Let’s look more closely at the Television
Division’s income statement.
6-45
Levels of Segmented Statements
Our approach to segment reporting uses the
contribution format.
Income Statement Cost of goods
Contribution Margin Format sold consists of
Television Division variable
Sales $ 300,000 manufacturing
Variable COGS 120,000 costs.
Other variable costs 30,000
Fixed and
Total variable costs 150,000
variable costs
Contribution margin 150,000
are listed in
Traceable fixed costs 90,000
separate
Division margin $ 60,000
sections.
6-46
Levels of Segmented Statements
Our approach to segment reporting uses the
contribution format.
Income Statement
Contribution margin
Contribution Margin Format
is computed by
Television Division
taking sales minus
Sales $ 300,000
variable costs.
Variable COGS 120,000
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 $ 60,000 to profits.
6-47
Levels of Segmented Statements
Segmented Income Statement
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable expenses 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common expenses
Net operating
income
6-48
Levels of Segmented Statements
Segmented Income Statement
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable expenses 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common expenses 25,000 Common fixed expenses
Net operating should not be allocated to
income $ 75,000 the divisions. These
expenses would remain
even if one of the
divisions were eliminated.
6-49
Traceable Fixed Costs Can Become
Common Fixed Costs
Fixed expenses that are traceable to one segment
can become common fixed expenses if the
company is divided into smaller segments.
Let’s see how this
works using the
Webber, Inc. example!
6-50
Traceable Fixed Costs Become
Common Costs
Webber’s Television Division
Television
Division
Regular Big Screen
Product
Lines
6-51
Traceable Fixed Costs Become
Common Costs
Income Statement
Television
Division Regular Big Screen
Sales $300,000 $ 200,000 $ 100,000
Variable expenses 150,000 95,000 55,000
CM 150,000 105,000 45,000
Traceable FC 90,000 45,000 35,000
Product line margin $ 60,000 $ 10,000
Common expenses
Fixed costs directly traced
Divisional margin 60,000 to the Television Division
Is $90,000
We obtained the following information from
the Regular and Big Screen segments.
6-52
Traceable Fixed Costs Become
Common Costs
Income Statement
Television
Division Regular Big Screen
Sales $ 300,000 $ 200,000 $ 100,000
Variable expenses 150,000 95,000 55,000
CM 150,000 105,000 45,000
Traceable FC 80,000 45,000 35,000
Product line margin 70,000 $ 60,000 $ 10,000
Common expenses 10,000
Divisional margin $ 60,000
Now, with refined segment, only
$80,000 is traceable to the two
product lines and $10,000 is a
common cost.
6-53
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:
1. This practice may make a profitable business segment appear
to be unprofitable.
2. Allocating common fixed costs forces managers to be held
accountable for costs they cannot control.
Segment Segment Segment Segment
1 2 3 4
6-54
Concept Check 5
Segmented Income Statement
Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable expenses 310,000 60,000 250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 $ 14,000 $ 230,000
Common expenses 200,000
Net operating profit $ 44,000
How much of the common fixed expense of $200,000 can be avoided
by eliminating the bar?
a. None of it.
b. Some of it.
c. All of it.
6-55
Concept Check 5a
How much of the common fixed expense of
$200,000 can be avoided by eliminating the
bar?
a. None of it.
b. Some of it.
c. All of it. Common fixed expenses
cannot be eliminated by
dropping one of the
segments.
Concept Check 6
6-56
Segmented Income Statement
Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable expenses 310,000 60,000 250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 $ 14,000 $ 230,000
Common expenses 200,000
Net operating profit $ 44,000
Suppose square feet is used as the basis for allocating the common
fixed expense 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
6-57
Concept Check 6a
Suppose square feet is used as the basis
for allocating the common fixed expense 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 The bar would be
c. $40,000 allocated 1/10 of the cost
or $20,000.
d. $50,000
Concept Check 7
6-58
Segmented Income Statement
Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable expenses 310,000 60,000 250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 $ 14,000 $ 230,000
Common expenses 200,000
Net operating profit $ 44,000
If Hoagland's allocates its common fixed expenses to the bar and the
restaurant, what would be the reported profit for bar and restaurant,
respectively?
a. $14,000 / $230,000
b. $14,000 / $30,000
c. ($11,000) / $45,000
d. ($6,000) / $50,000
6-59
Concept Check 7a
If Hoagland's allocates its common fixed
expenses to the bar and the restaurant, what
Income Statement
would be the reportedHoagland's
profit for bar and
Lakeshore Bar Restaurant
restaurant,
Sales
respectively?
$ 800,000 $ 100,000 $ 700,000
Variable expenses 310,000 60,000 250,000
a.
CM
$14,000 / $230,000 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
b. $14,000 / $30,000
Segment margin 244,000 14,000 230,000
Common expenses 200,000 20,000 180,000
c. ($11,000) / $45,000
Net operating profit (Loss) $ 44,000 $ (6,000) $ 50,000
d. ($6,000) / $50,000
6-60
Concept Check 8
Income Statement
Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable expenses 310,000 60,000 250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 14,000 230,000
Common expenses 200,000 20,000 180,000
Net operating profit (Loss) $ 44,000 $ (6,000) $ 50,000
Do you think the Bar should be eliminated?
a. Yes
b. No
6-61
Concept Check 8a
Should the bar be eliminated?
a. Yes
The profit was $44,000 before
b. No eliminating the bar. If we eliminate
the bar, profit drops to $30,000!
6-62
Companywide Income Statements
Both U.S. GAAP and
IFRS require absorption costing
for external reports.
Since absorption costing is required for
external 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.
6-63
Segmented Financial Information
Both U.S. GAAP and IFRS require publically traded
companies to include segmented financial data in their
annual reports.
1. Companies must report segmented results to
shareholders using the same methods that are used for
internal segmented reports.
2. 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.
6-64
End of Chapter 7