Chapter 6: Variable Costing and Segment Reporting

Chapter 6: Variable Costing and Segment Reporting

6-1 Overview of Accounting and Reporting

• Traditional Accounting Focus:
  • Historically focused on double-entry bookkeeping, financial statement preparation, and providing information to external users like creditors, banks, and investors.
  • Emphasis on rules, disclosure, and attestation (assurance).
  • Measurement was cruder compared to today's standards.
• Modern Management Accounting:
  • Concentrates on providing information to managers for decision-making, resource allocation, and performance evaluation.
  • Also serves analysts and employees.
  • Involves more detailed measurement and control, without the need for external attestation.
• Evolution of Accounting:
  • Shifted from primarily serving external users to also assisting internal management.
  • From focusing on bookkeeping to providing economic information for decision-making.

6-2 Learning Objectives

• Explain the difference between Variable Costing and Absorption Costing.
• Prepare income statements using both Variable and Absorption Costing.
• Reconcile the Net Operating Incomes of Variable and Absorption Costing.
• Prepare a segmented income statement, differentiating between Traceable Fixed Costs and Common Fixed Costs.
• Compute company-wide and segment break-even points.

6-1: Variable Costing vs. Absorption Costing

• Absorption Costing:
  • Product Costs: Raw Materials, Direct Labor, Manufacturing Overhead (Variable and Fixed).
  • Period Costs: Selling and Administrative Expenses (Variable and Fixed).
  • Fixed manufacturing overhead is treated as a product cost and is included in inventory until the products are sold.
• Variable Costing:
  • Product Costs: Direct Materials, Direct Labor, Variable Manufacturing Overhead.
  • Period Costs: Fixed Manufacturing Overhead, Variable Selling and Administrative Expenses, Fixed Selling and Administrative Expenses.
  • Fixed manufacturing overhead is treated as a period cost and is expensed in the period incurred.

6-2: Variable Costing vs. Absorption Costing - Example

• Car Manufacturing Costs:
  • Main frame: 8,000
  • 4 wheels: 3,000
  • 4 doors: 5,000
  • Battery: 6,000
  • Labor: 2,000
  • Applied MOH (Manufacturing Overhead): 4,000
  • Total Cost: 28,000

6-3: Cost Flows under Absorption Costing

• Raw materials purchases flow into Raw Materials Inventory.
• Direct materials used, direct labor, and manufacturing overhead (both variable and fixed) flow into Work in Process Inventory.
• Goods completed flow into Finished Goods Inventory.
• Goods sold flow into Cost of Goods Sold (an expense on the Income Statement).
• Selling and administrative expenses are also recognized on the Income Statement as period costs.

6-4: Cost Flows under Variable Costing

• Similar to absorption costing, raw materials, direct labor, and variable manufacturing overhead flow through inventory accounts.
• However, fixed manufacturing overhead is treated as a period expense and is expensed directly to the income statement.
• Selling and administrative costs are also treated as period expenses.

6-5: In-Class Exercise

• If fixed manufacturing overhead is incurred in January for making two vehicles, and one is sold in February and the other in March:
  • Under variable costing, the fixed manufacturing overhead cost should be recognized as an expense in January, as it is a period cost.

6-6: Preparing Income Statements

• Learning Objective 6-2: Preparing income statements using Variable and Absorption Costing.

6-7: Variable Costing Income Statement - Example

• Weber Light Aircraft:
  • Selling price per aircraft: 100,000
  • Direct materials: 19,000
  • Direct labor: 5,000
  • Variable manufacturing overhead: 1,000
  • Fixed manufacturing overhead: 70,000
  • Variable selling and administrative expense: 10,000
  • Fixed selling and administrative expense: 20,000
• Unit Product Cost (Variable Costing): Direct Materials + Direct Labor + Variable Manufacturing Overhead = 19,000 + 5,000 + 1,000 = $25,000

6-8: Variable Costing - Cost of Goods Sold Computation

• Beginning inventory, units produced, units sold, and ending inventory are tracked.
• Cost of Goods Sold = Unit Product Cost × Units Sold

6-9: Variable Costing Contribution Format Income Statement

• Format:
  • Sales
  • Variable Expenses:
    • Variable Cost of Goods Sold
    • Variable Selling and Administrative Expense
  • Total Variable Expenses
  • Contribution Margin (= Sales - Total Variable Expenses)
  • Fixed Expenses:
    • Fixed Manufacturing Overhead
    • Fixed Selling and Administrative Expense
  • Total Fixed Expenses
  • Net Operating Income (Loss) (= Contribution Margin - Total Fixed Expenses)

6-10: SZ Inc. In-Class Exercise

• Prepare a Contribution Format Income Statement using Variable Costing.
  • Selling price: 1,800
  • Units sold: 50
  • Variable costs per unit:
    • Direct materials: 950
    • Direct labor: 100
    • Variable manufacturing overhead: 150
    • Variable S&A expense: 100
  • Fixed costs per month:
    • Fixed manufacturing overhead: 12,000
    • Fixed S&A expense: 8,000

6-11: Absorption Costing Income Statement

• Unit Product Cost: Includes Direct Materials, Direct Labor, Variable Manufacturing Overhead and Fixed Manufacturing Overhead.

6-12: Absorption Costing - Unit Cost Calculation

• Unit Fixed Manufacturing Overhead = Fixed Manufacturing Overhead / Number of Units Produced
• Unit Product Cost = Direct Materials + Direct Labor + Variable Manufacturing Overhead + Fixed Manufacturing Overhead

6-13: Absorption Costing Income Statement

• Format:
  • Sales
  • Cost of Goods Sold
  • Gross Margin (= Sales - Cost of Goods Sold)
  • Selling and Administrative Expenses
  • Net Operating Income (Loss) (= Gross Margin - Selling and Administrative Expenses)

6-14: Absorption Costing - Cost of Goods Sold

• Cost of Goods Sold = Number of Units Sold × Unit Product Cost
• The unit product cost includes fixed manufacturing overhead, so changes in production levels can affect the unit cost and, therefore, the cost of goods sold and net operating income.

6-15: Reconciling Variable and Absorption Costing

• Goal (Learning Objective 6-3): Reconcile variable costing and absorption costing net operating incomes and explain differences.

6-16: Comparing the Two Methods

• Fixed manufacturing overhead is treated as a period cost under variable costing and as a product cost under absorption costing.
• This difference affects the timing of when the fixed manufacturing overhead is expensed, which can lead to differences in net operating income between the two methods.

6-17: Key Insights Summary

• Production vs. Sales:
  • If Units Produced = Units Sold: Absorption Costing Net Operating Income = Variable Costing Net Operating Income
  • If Units Produced > Units Sold: Absorption Costing Net Operating Income > Variable Costing Net Operating Income (due to fixed manufacturing overhead deferred in inventory).
  • If Units Produced < Units Sold: Absorption Costing Net Operating Income < Variable Costing Net Operating Income (due to fixed manufacturing overhead released from inventory).

6-18: In-Class Exercise

• The net operating income under variable costing is greater than under absorption costing when units produced are fewer than units sold.

6-19: SZ Inc. In-Class Exercise

• SZ Inc.'s yearly fixed manufacturing overhead is 12,000. Units produced: 1,000. Units sold: 800. Ending inventory: 200.
  • Amount of fixed manufacturing overhead cost included in ending inventory under absorption costing:
  • Fixed manufacturing overhead per unit: 12,000 / 1,000 = $12
  • Fixed manufacturing overhead in ending inventory: 12 × 200 = $2,400

6-20: Advantages of Variable Costing

• Enables CVP Analysis: Easier to categorize costs as variable and fixed.
• Explaining Changes in Net Operating Income: Income is only affected by changes in unit sales under variable costing.
• Supporting Decision Making: Highlights additional variable costs and the total amount of fixed manufacturing costs that must be covered.

6-21: Segmented Reporting

• Learning Objective 6-4: Prepare a segmented income statement that differentiates traceable fixed costs from common fixed costs and use it to make decisions.

6-22: Business Segments

• Segment: Any part or activity of an organization about which a manager seeks cost, revenue, or profit data (e.g., individual store, sales territory, product line).

6-23: Segmented Statements

• Webber, Inc. Example: PC Division and TV Division.

6-24: Traceable and Common Costs

• Traceable Fixed Costs: Arise because of the existence of a particular segment and would disappear over time if the segment disappeared.
• Common Fixed Costs: Arise because of the overall operation of the company and would NOT disappear if any particular segment were eliminated.
• Key Point: Don't allocate common costs to segments.

6-25: Identifying Traceable Fixed Costs

• Example: The salary of the Jersey City store manager at Walmart is a traceable fixed cost of the Jersey City business segment of Walmart.

6-26: Identifying Common Fixed Costs

• Example: The salary of the CEO of Walmart is a common fixed cost of the various stores of Walmart.

6-27: Segment Margin

• Calculated by subtracting the traceable fixed costs of a segment from its contribution margin.
• Best gauge of the long-run profitability of a segment.

6-28: Segmented Statements Format

• Sales
• Variable Expenses
• Contribution Margin
• Traceable Fixed Expenses
• Segment Margin
• Common Fixed Expenses
• Net Operating Income

6-29: Corbel Corporation In-Class Exercise

• US Division: Sales 580,000, Variable Expenses 319,000, Traceable Fixed Expenses 186,000
• Asia Division: Sales 510,000, Variable Expenses 178,000, Traceable Fixed Expenses 222,000
• Total Common Fixed Expenses: 235,000
• Calculate the Segmented Statement.

6-30: Break-Even Analysis

• Learning Objective 6-5: Compute company-wide and segment break-even points for a company with traceable fixed costs.

6-31: Company-Wide Break-Even Point

• Calculate the company-wide break-even point using the formula:
• Profit = (CM ratio × Sales) – Fixed expenses
• Set target profit to zero to find the break-even point.
  • 0 = (CM ratio × Sales) – Fixed expenses

6-32: Break-Even Point for Segments

• Calculate the break-even point for each segment using the same formula, but only include traceable fixed expenses in the calculation.
• Remember: Common fixed expenses are excluded from the segment break-even calculations because they are not traceable to segments.

6-33: Corbel Corporation In-Class Exercise

• Based on the segmented statement, calculate the break-even sales for Division A.
• Use the formula: Sales = Fixed Expenses / CM Ratio.

6-34: Chapter 6 Summary

• Explain how variable costing differs from absorption costing and compute unit product costs under each method.
• Prepare income statements using both variable and absorption costing.
• Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ.
• Prepare a segmented income statement that differentiates traceable fixed costs from common fixed costs.
• Compute companywide and segment break-even points.