Chapter 7: Variable Costing and Segment Reporting: Tools for Management

Objective 1: Explain differences between variable costing and absorption costing; compute unit product costs for each method.
Objective 2: Prepare income statements using both costing methods.
Objective 3: Reconcile net operating income from both methods and clarify their differences.
Objective 4: Create segmented income statements separating traceable fixed costs from common fixed costs for decision-making.
Objective 5: Compute company-wide and segment break-even points considering traceable fixed costs.

Actual Costing: Uses actual direct materials (DM), direct labor (DL), and overhead (OH) costs; relevant only for producing costs, as discussed in Chapter 2.
Constant Variable Costs: Assumes a constant amount of variable manufacturing costs per unit and total fixed manufacturing costs per period throughout the analysis.

Product costs include:
- Direct Materials (DM)
- Direct Labor (DL)
- Variable Overhead (VOH)
Period costs include:
- Fixed Overhead (FOH) - treated as a period expense rather than a product cost.
- Variable Selling Administration (VSA) Expenses
- Fixed Selling Administration (FSA) Expenses
Usage: Primarily for internal decision-making processes.

Definition: Also known as the traditional costing method.
Product costs include:
- Direct Materials (DM)
- Direct Labor (DL)
- Variable Overhead (VOH)
- Fixed Overhead (FOH) - absorbed into the product cost.
Period costs include:
- Variable Selling Administration (VSA) Expenses
- Fixed Selling Administration (FSA) Expenses
Usage: Used for external reporting; helps determine values for ending inventory and cost of goods sold (COGS).

Key Distinction: Absorption costing includes FOH as part of the product costs, which results in higher inventory values compared to variable costing, impacting decision-making on product pricing and discontinuation.

Production Information:
- Number of units produced annually: 25,000
- Variable costs:
- Direct materials, direct labor, and variable manufacturing overhead: $10/unit
- Selling & administrative expenses: $3/unit
- Fixed costs:
- Manufacturing overhead: $150,000/year
- Selling & administrative expenses: $100,000/year
Calculating Per Unit Costs:
- Fixed OH per unit: rac{150,000}{25,000} = 6
- Unit product cost under Variable Costing: 10 (DM, DL, VOH) = $10
- Unit product cost under Absorption Costing: 10 + 6 (FOH) = $16
- Conclusion: Absorption costing results in a higher unit product cost.

Absorption Costing Income Statement includes all traditional product costs as part of COGS, with all other costs accounted as period expenses.
Variable Costing Income Statement consists of variable expenses including:
- Variable COGS (variable product costs)
- Variable selling/admin expenses (variable period expenses)
- Fixed expenses treated as period expenses; fixed overhead is accounted in the period produced.

Data: 500 computers produced and sold.
Absorption Costing Calculation:
- Cost per computer: 100 + 50 + 25 + 75 = 250
- Income Statement Performance:
- Sales: 750\cdot500=375,000
- COGS: 500\cdot500=250,000 (for Absorption costing)
- Net operating income: 232,500

Units Made < Units Sold:
- Results in lower absorption costing income due to previously absorbed fixed costs being considered as current period expenses.
Units Made > Units Sold:
- Results in higher absorption costing income due to costs being absorbed by unsold inventory.

Definition of Segment: Any part of an organization for which managers require cost and revenue data (e.g., Sales Territories, Individual Stores).
Contribution Format: A necessary approach in segmented income statements to distinguish fixed from variable costs, facilitating the calculation of contribution margins.
Traceable Fixed Costs: Costs directly associated with a segment that would cease if the segment were discontinued.
- Example: Salary of a product manager for a specific product.
Common Fixed Costs: Costs related to overall operations that do not disappear with the elimination of a segment.
- Example: Salary of a company-wide CEO.

Contribution Margin: Calculated as sales minus variable costs.
**Income Statement Example for Television Division: **
- Sales: $300,000
- Variable costs: $120,000
- Contribution margin: $180,000
- Traceable fixed expenses: $90,000
- Division margin: $60,000

Company Breakdown: Sales of both Television and Computer Divisions alongside contribution margins and traceable fixed expenses.
- Example Total Sales: $500,000
- Common expenses deducted for net operating income calculation.

Company-wide Break-even Sales Formula: Break-even = Total Fixed Costs / Contribution Margin Ratio
Segment Break-even Sales: Assessing traceable fixed costs against contribution margins to determine segment efficiency.
- Example: CM Ratio = rac{ ext{Contribution Margin}}{ ext{Sales}}

Present segmented statements including percentages and calculations for east and west divisions for Paisley Corporation, summarizing break-even points efficiently.