Chapter 6 Variable Costing and Segment Reporting Tools for Management Overview of Variable and Absorption Costing Both income statements include product costs and period costs but they define these costs differently Variable costing income statements are grounded in the contribution format while absorption costing income statements ignore variable and fixed cost distinctions Net operating incomes often differ from one another bc they account for fixed manufacturing overhead differently Variable costing only those manufacturing costs that vary with output are treated as product costs product costs are direct materials direct labor variable portion of manufacturing overhead NOT the fixed portion of manufacturing overhead fixed manufacturing overhead is treated as a period cost like selling and administrative expenses aka direct costing or marginal costing method Absorption costing treats all manufacturing costs as product costs direct materials direct labor and both variable and fixed manufacturing overhead aka full cost method Selling and administrative expenses are always treated as period costs and expensed as incurred Variable and Absorption Costing An Example Variable costing contribution format income statement categorizes cost by function o Compute variable unit product cost direct materials direct labor variable manufacturing overhead o Variable costing COGS variable unit product cost from above number of units sold o Variable selling and administrative expenses whatever number units sold fixed selling and administrative expenses o Sales variable expenses variable COGS variable selling and administrative expense contribution margin fixed expenses fixed manufacturing overhead fixed selling and administrative expense net operating income Absorption costing income statement categorizes cost by how they behave o Determine unit product cost direct materials direct labor variable manufacturing overhead fixed manufacturing overhead units produced to get cost per unit Reconciliation of Variable Costing with Absorption Costing Income When the units produced exceed unit sales and hence inventories increase net operating income is higher under absorption costing than under variable costing bc some of the fixed manufacturing overhead of the period is deferred in inventories under absorption costing When the unit sales exceed the units produced and hence inventories decrease net operating income is lower under absorption costing some of the fixed manufacturing overhead from previous periods is released from inventories under absorption costing Fixed manufacturing overhead deferred in or released from inventories under absorption costing o Fixed manufacturing overhead in beginning inventories 0 o Fixed manufacturing overhead in ending inventories 35 000 o Fixed manufacturing overhead deferred in released from inventories 35 000 Reconciliation of variable costing and absorption costing net operating income o Variable costing net operating income o Add deduct fixed manufacturing overhead deferred in released from inventory under absorption costing o Absorption costing net operating income Changes in inventories affect absorption costing net operating income not variable costing net operating income When the units produced units sold absorption costing and variable costing net operating income are the same Advantages of Variable Costing and the Contribution Approach Enabling CVP analysis need fixed and variable costs separate so variable costing income statement is better to use Explaining changes in net operating income of units produced does not affect net operating income o Be aware of inventory levels under absorption costing if inventories increase fixed manufacturing overhead costs are deferred in inventories which in turn increased net operating income Supporting decision making variable costing method correctly identifies the additional variable costs that will be incurred to make one more unit and emphasizes the impact of fixed costs on profits Adapting to the theory of constraints TOC must carefully identify variable costs variable costing income statements have one adjustment to support TOC direct labor costs become fixed manufacturing for 3 reasons o Many companies have a commitment to guarantee workers a min o Direct labor is usually not the constraint therefore there is no reason o TOC emphasizes continuous improvement to maintain number of paid hours to increase it competitiveness Segmented Income Statements and the Contribution Approach Traceable fixed cost fixed cost of a segment that is incurred because of the existence of the segment if the segment had never existed the fixed cost would not have been incurred and if the segment were eliminated the fixed cost would disappear salary of Fritos product manager at Pepsi maintenance cost for the building in which Boeing 747s are assembled liability insurance at Disney 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 salary of CEO cost of heating a grocery store receptionist s salary at an office shared by a number of doctors Segment margin segment s contribution margin traceable fixed costs represents the margin available after a segment has covered all of its own costs best gauge of the long run profitability of a segment bc it includes only the costs caused by the segment Treat traceable costs as those costs that would disappear over time if the segment itself disappeared Fixed costs that are traceable to one segment may be a common cost of another segment Segmented Income Statements An Example Segments defined as divisions business product division consumer product division Segments defined as product lines within the divisions inside the consumer product division there is clip art and computer games consumer product division had 80 000 fixed expenses but only 70 000 of it can be traceable to the product lines the remaining 10 000 becomes a common fixed cost of the 2 product lines The 10 000 is a deprecation expense on a machine it is a traceable cost of the consumer products division as a whole but it is a common cost of the division s 2 product lines Can further segment the computer game product line into its sale channels online sales and retail sales Segmented Income Statements Common Mistakes Companies can omit some costs by accident inappropriately assign traceable fixed costs and arbitrarily allocate common fixed costs
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