Chapter 6- Variable Costing and Segment Reporting BMGT221

Product Costs

Costs incurred to acquire or make a product, including direct materials, direct labor, and the variable portion of overhead.Period Costs

Period Costs

Fixed overhead (entirety), selling, and administrative expenses.

Absorption Costing

Includes all manufacturing costs (fixed or variable) as product costs, while period costs include variable and fixed selling and administrative expenses.

Manufaturing Costing

Indirect costs, comprising variable overhead costs (vary with production level) and fixed overhead costs (remain constant despite production fluctuations).

Variable Costing

Considers fixed overhead costs as period costs, flowing through the income statement when incurred.

Period vs Product Costs

Product costs "attach" to a unit of product and are reflected in inventory until sold, while period costs are recognized on the income statement when incurred.

Overview of Variable and Absorption Costing

Both include direct materials, direct labor, and variable overhead; absorption costing also includes fixed overhead.

Net operating income: Absorbing income

Fluctuations can occur due to changes in inventories and unit sales because fixed overhead costs are deferred or released based on inventory changes.

Unit Cost Computations

• Unit product cost under absorption costing: This includes all production costs, both variable and fixed.

• Unit product cost under variable costing: Includes only the variable production costs.

Variable vs. Absorption Costing: Income Statements

Variable Costing:

• Only variable manufacturing costs are included.

• Fixed manufacturing overhead is expensed.

Absorption Costing:

• Both variable and fixed manufacturing costs are included.

Explaining Changes in Net Operating Income

• Variable costing income is only affected by changes in unit sales, not by the number of units produced.

• Absorption costing income is influenced by changes in both unit sales and units of production.

• Net operating income can increase simply by producing more units even if those units are not sold under absorption costing.

Supporting Decision Making

• Variable costing correctly identifies the additional variable costs incurred to make one more unit.

• It emphasizes the impact of total fixed costs on profits.

• Absorption costing assigns fixed manufacturing overhead costs to units produced, potentially leading to inappropriate pricing and product discontinuation decisions.

Enabling CVP Analysis

• Variable costing categorizes costs as variable and fixed, making it easier for CVP analysis.

• Absorption costing assigns fixed manufacturing overhead costs to units produced, potentially resulting in positive operating income when units sold are less than the breakeven point.

Contribution Margin (CM)

• Contribution Margin = Sales – Variable expenses

Segmented Income Statement

• It separates fixed from variable costs and 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.

• Examples include the salary of a product manager for a specific product line.

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.

• Examples include the salary of the CEO and heating costs for a store.

Traceable Fixed Costs

• Traceable fixed costs of one segment may be a common fixed cost of another segment.

• Example: Landing fees at an airport are traceable to a flight but not traceable to different passenger classes.

Traceable Costs

Costs directly attributable to a specific segment.

Common Costs

• Costs incurred for the overall operation of the company, not directly attributable to any specific segment.

• Don’t allocate common costs to segments.

Variable vs. Absorption costing

• Units produced=units sold; —>no change in inventory —>absorption=variable

• Units produced >Units sold—> inventories increases —> Absorption> variable (fixed overhead is deferred in inventory)

• Units produced< units sold —> inventories decrease —> Absorption < variable (fixed overhead is released from inventory)

Variable Costing Net Income with Absorption Costing Net Income

fixed overhead in ending inventories - fixed overhead in beginning inventories= overhead deferred (released from) inventories

Explaining Changes in Net Operating Income

• Variable costing income is only affected by changes in unit sales, not by the number of units produced. 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 increase simply by producing more units even if those units are not sold.

Supporting Decision Making

• Variable costing identifies the additional variable costs incurred to make one more unit and emphasizes the impact of total fixed costs on profits.

• Absorption costing assigns fixed manufacturing overhead costs to units produced, potentially leading to inappropriate pricing and product discontinuation decisions.

Enabling CVP Analysis

• Variable costing categorizes costs as variable and fixed, facilitating its use for CVP analysis.

• Absorption costing assigns fixed manufacturing overhead costs to units produced, potentially resulting in positive operating income when units sold are less than the breakeven point.

Contribution Margin (CM)

• Contribution Margin = Sales – Variable expenses

Segment

• Any part of an organization or activity about which a manager seeks cost, revenue, and/or profit data, e.g., individual store, service center, sales territory.

Keys to Segmented Income Statements

• Use of contribution format separates fixed from variable costs and enables calculation of contribution margin.

• Traceable fixed costs should be separated from common fixed costs to enable calculation of segment margin.

Segmented Income Statement

• Segment margin = Contribution margin – Traceable fixed costs.

• Best gauge of long-run profitability as it includes only costs caused by the segment.

Identifying Traceable Fixed Costs

• Fixed costs incurred because of the existence of a specific segment.

• Examples: Salary of product manager for a product line, maintenance cost for a segment-specific facility.

Identifying Common Fixed Costs

• Fixed costs supporting overall operation of the company, not specific to any segment.

• Examples: CEO salary, heating cost for a store.

Break-Even Analysis

• Sales for company to break even = Total fixed expenses + Common fixed expenses / Overall CM ratio

• Sales for a segment to break even = Segment traceable fixed expenses / Segment CM ratio

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

• Illustrates various business functions forming the company's value chain: R&D, Product Design, Manufacturing, Marketing, Distribution, Customer Service.

Inappropriate Methods of Allocating Costs Among Segments

• Failure to trace costs directly and inappropriate allocation bases are common pitfalls in cost allocation among segments.

Failure to Trace Costs Directly

• Costs that can be directly traced to specific segments should not be allocated to other segments.

Inappropriate Allocation Base

• Costs should be allocated to segments only when the allocation base actually drives the cost being allocated.

Common Costs and Segments

• Common costs should not be arbitrarily allocated to segments, as it can distort segment profitability and hold managers accountable for uncontrollable costs

Company-wide Income Statements

• Both U.S. GAAP and IFRS mandate absorption costing for external reports

Absorption Costing

• Requires fixed manufacturing costs to be assigned to products to match revenues and costs properly.

Variable Costing

• Considers fixed manufacturing costs as capacity costs and doesn't assign them to products if nothing is produced.

Segmented Financial Information

• U.S. GAAP and IFRS require publicly traded companies to disclose segmented financial data in their annual reports.

Reporting Methods

• Internal segmented reports should use the same methods as external reports to maintain consistency.