Chapter 06 - Variable Costing and Segment Reporting: Tools for Management

Chapter 6
Lecture Notes

Chapter theme: Two general approaches are used for valuing

inventories and cost of goods sold. One approach, called
absorption costing, is generally used for external reporting
purposes. The other approach, called variable costing, is
1 preferred by some managers for internal decision making and
must be used when an income statement is prepared in the
contribution format. This chapter shows how these two
methods differ from each other. It also explains how to create
segmented contribution format income statements.

I. Overview of variable and absorption costing

Learning Objective 1: Explain how variable costing differs

2 from absorption costing and compute unit product costs
under each method.

A. Variable costing treats only those costs of production that

vary with output as product costs. This approach dovetails
with the contribution approach income statement and
supports CVP analysis because of its emphasis on
3 separating variable and fixed costs.

i. The cost of a unit of product consists of direct

materials, direct labor, and variable overhead.

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Helpful Hint: For simplicity, nearly all examples, exhibits,

problems, and exercises in this chapter treat direct labor as
a variable cost. However, students should be reminded that
labor is essentially a fixed cost in some companies. This is a
growing phenomenon as pointed out in earlier chapters.
Under variable costing, direct labor would not be included
in product costs when it is a fixed cost. This point is
reinforced in the discussion on theory of constraints at the
end of the chapter.

ii. Fixed manufacturing overhead, and both variable and

fixed selling and administrative expenses are treated as
period costs and deducted from revenue as incurred.

Helpful Hint: Emphasize that the only difference between

variable and absorption costing is in how the two methods
3
treat fixed manufacturing overhead costs. Also, emphasize
that under both methods, selling and administrative costs are
period costs and are not product costs.

B. Absorption costing treats all costs of production as product

costs, regardless of whether they are variable or fixed. Since
no distinction is made between variable and fixed costs,
absorption costing is not well suited for CVP computations.

i. The cost of a unit of product consists of direct

materials, direct labor, and both variable and fixed
overhead.

ii. Variable and fixed selling and administrative expenses

are treated as period costs and are deducted from
revenue as incurred.

4-5 Quick Check – absorption vs. variable costing

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II. Harvey Company—an example

A. Unit cost computations

i. Assume Harvey Company produces a single product

6 with available information as shown.

ii. The unit product costs under absorption and variable

costing would be $16 and $10, respectively.

1. Under absorption costing, all production costs,

7
variable and fixed, are included when determining
unit product cost.
2. Under variable costing, only the variable
production costs are included in product costs.

Helpful Hint: Before beginning the forthcoming income

comparisons, remind students of the relationship between
ending inventory and net operating income. Higher ending
inventory results in higher net operating income since costs
of goods available for sale less ending inventory equals cost
of goods sold. Therefore, a higher ending inventory results in
a lower expense (cost of goods sold) deducted to arrive at net
operating income.

Learning Objective 2: Prepare income statements using both

8 variable and absorption costing.

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B. Income comparison of variable and absorption costing

i. Harvey Company—additional assumptions.

9 1. 20,000 units were sold during the year.

2. The selling price per unit is $30.
3. There is no beginning inventory.

ii. Variable costing

1. The unit product cost is $10.

10 2. All $150,000 of fixed manufacturing cost is
expensed in the current period.
3. The net operating income is $90,000.

iii. Absorption costing

1. The unit product cost is $16.

11 2. The fixed manufacturing overhead cost
deferred in inventory is $30,000 (5,000 units ×
$6 per unit).
3. The net operating income is $120,000.

Helpful Hint: Explain that under absorption costing, the

recognition of fixed costs as an expense is really a timing
issue. When the items are sold, the fixed costs will be
reflected on the income statement as part of cost of goods
sold.

Learning objective 3: Reconcile variable costing and

12 absorption costing net operating incomes and explain why
the two amounts differ.

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Chapter 06 - Variable Costing and Segment Reporting: Tools for Management

iv. Comparing the two methods

1. Under absorption costing, $120,000 of fixed

manufacturing overhead is included in cost of
goods sold and $30,000 is deferred in ending
inventory as an asset on the balance sheet.
2. Under variable costing, the entire $150,000 of
13 fixed manufacturing overhead is treated as a
period expense.
a. The variable costing ending inventory is
$30,000 less than absorption costing,
thus explaining the difference in net
operating income between the two
methods.
3. The difference in net operating income between
the two methods ($30,000) can also be reconciled
by multiplying the number of units in ending
14 inventory (5,000 units) by the fixed
manufacturing overhead per unit ($6) that is
deferred in ending inventory under absorption
costing.

C. Extended comparisons of income data

i. Harvey Company—additional assumptions/facts

1. 30,000 units were sold in year 2.

15 2. The selling price per unit, variable costs per unit,
total fixed costs, and number of units produced
remain unchanged.
3. 5,000 units are in beginning inventory.

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ii. Unit cost computations

1. Since the variable costs per unit, total fixed costs,

16 and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.

iii. Variable costing

1. The unit product cost is $10.

17 2. All $150,000 of fixed manufacturing overhead
cost is expensed in the current period.
3. The net operating income is $260,000.

iv. Absorption costing

1. The unit product cost is $16.

18 2. The fixed manufacturing overhead cost
released from inventory is $30,000.
3. The net operating income is $230,000.

v. Comparing the two methods

1. The difference in net operating income between

the two methods ($30,000) can be reconciled by
multiplying the number of units in beginning
19 inventory (5,000 units) by the fixed
manufacturing overhead per unit ($6) that is
released from beginning inventory under
absorption costing.

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2. Across the two-year time frame, both methods

reported the same total net operating income
20 ($350,000). This is because over an extended
period of time sales cannot exceed production, nor
can production much exceed sales. The shorter the
20 time period, the more the net operating income
figures will tend to differ.

D. Summary of key insights

i. When units produced equals units sold, the two

methods report the same net operating income.

ii. When units produced are greater than units sold, as in

year 1 for Harvey, absorption income is greater than
21
variable costing income.

iii. When units produced are less than units sold, as in

year 2 for Harvey, absorption costing income is less
than variable costing income.

III. Advantages of variable costing and the contribution approach

A. Enabling CVP analysis

i. Variable costing categorizes costs as fixed and variable

so it is much easier to use this income statement format
for CVP analysis.

22 ii. Absorption costing assigns per unit fixed manufacturing

overhead costs to production. This can potentially
produce positive net operating income even when
the number of units sold is less than the breakeven
point.

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Chapter 06 - Variable Costing and Segment Reporting: Tools for Management

B. Explaining changes in net operating income

i. 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
23 operating income goes up and vice versa.

ii. 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.

C. Supporting decision making

i. Variable costing correctly identifies the additional

variable costs incurred to make one more unit. It
also emphasizes the impact of fixed costs on profits.
24
ii. Absorption costing gives the impression that fixed
manufacturing overhead is variable with respect to
the number of units produced, but it is not. This can
lead to inappropriate pricing decisions and product
discontinuation decisions.

D. Adapting to the Theory of Constraints

i. Companies involved in TOC use a form of variable

25 costing. However, one difference of the TOC
approach is that it treats direct labor as a fixed cost
for three reasons:

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Chapter 06 - Variable Costing and Segment Reporting: Tools for Management

1. Although direct laborers are paid an hourly wage,

many companies have a commitment, sometimes
enforced by labor contracts or by law, to
guarantee workers a minimum number of paid
hours.
25 2. Direct labor is not usually the constraint;
therefore, there is no reason to increase the
number of direct laborers.
3. TOC emphasizes the role direct laborers play in
driving continuous improvement. Since layoffs
often devastate morale, managers involved in
TOC are extremely reluctant to lay off employees.

IV. Segmented income statements and the contribution approach

A. Learning Objective 4: Prepare a segmented income

26 statement that differentiates traceable fixed costs from
common fixed costs and use it to make decisions.

A. Key concepts/definitions

i. A segment is a part or activity of an organization

about which managers would like cost, revenue, or
profit data.
27
1. Examples of segments include divisions of a
company, sales territories, individual stores,
service centers, manufacturing plants, marketing
departments, individual customers, and product
lines.

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Chapter 06 - Variable Costing and Segment Reporting: Tools for Management

ii. There are two keys to building segmented income

statements.

1. First, a contribution format should be used

because it separates fixed from variable costs
and it enables the calculation of a contribution
margin.
28 a. The contribution margin is especially useful
in decisions involving temporary uses of
capacity such as special orders.
2. Second, traceable fixed costs should be separated
from common fixed costs to enable the
calculation of a segment margin. Further
clarification of these terms is as follows:
a. A traceable fixed cost of a segment is a
fixed cost that is incurred because of the
existence of the segment. If the segment
were eliminated, the fixed cost would
disappear. Examples of traceable fixed costs
include:
(1). The salary of the Fritos product
29 manager at PepsiCo is a traceable
fixed cost of the Fritos business
segment of PepsiCo.
(2). The maintenance cost for the building
in which Boeing 747s are assembled
is a traceable fixed cost of the 747
business segment of Boeing.
b. A common fixed cost is a fixed cost that
supports the operations of more than one
30 segment, but is not traceable in whole or in
part to any one segment. Examples of
common fixed costs include:

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Chapter 06 - Variable Costing and Segment Reporting: Tools for Management

(1). The salary of the CEO of General

Motors is a common fixed cost of the
various divisions of General Motors.
30 (2). The cost of heating a Safeway or
Kroger grocery store is a common
fixed cost of the various departments
– groceries, produce, bakery, etc.
c. It is important to realize that the traceable
fixed costs of one segment may be a
common fixed cost of another segment.
For example:
31 (1). The landing fee paid to land an
airplane at an airport is traceable to a
particular flight, but it is not traceable
to first-class, business-class, and
economy-class passengers.

Helpful Hint: In practice, a great deal of disagreement exists

about what costs are traceable and what costs are common.
Some people claim that except for direct materials, virtually
all costs are common fixed costs that cannot be traced to
products. Others assert that all costs are traceable to
products; there are no common costs. The truth probably lies
somewhere in the middle – many costs can be traced to
products but not all costs.

d. A segment margin is computed by

subtracting the traceable fixed costs of a
segment from its contribution margin.
32 (1). The segment margin is a valuable tool
for assessing the long-run
profitability of a segment.

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Chapter 06 - Variable Costing and Segment Reporting: Tools for Management

33 (2). Allocating common costs to segments

reduces the value of the segment
margin as a guide to long-run
33 segment profitability.

Helpful Hint: Explain that a segment should not

automatically be eliminated if its segment margin is negative.
If a company that produces hair-styling products
discontinues its styling gel, sales on its shampoo and
conditioner might fall due to the unavailability of the
eliminated product.

B. Segmented income statements – an example

34
i. Assume that Webber, Inc. has two divisions – the
Computer Division and the Television Division.

1. The contribution format income statement for

the Television Division is as shown. Notice:
a. Cost of goods sold consists of variable
35 manufacturing costs.
b. Fixed and variable costs are listed in
separate sections.
c. Contribution margin is computed by
taking sales minus variable costs.
36 d. The divisional segment margin represents
the Television Division’s contribution to
overall company profits.

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2. The Television Division’s results can be rolled

into Webber, Inc.’s overall results as shown.
Notice:
37 a. The results of the Television and Computer
Divisions sum to the results shown for the
whole company.
b. The common costs for the company as a
38 whole ($25,000) are not allocated to the
divisions.
3. The Television Division’s results can also be
broken down into smaller segments. This enables
39 us to see how traceable fixed costs of the
Television Division can become common costs
of smaller segments.
a. Assume that the Television Division can be
40 broken down into two major product lines –
Regular and Big Screen.
b. Assume that the segment margins for these
41
two product lines are as shown.
c. Of the $90,000 of fixed costs that were
previously traceable to the Television
42 Division, $80,000 ($45,000 + $35,000) is
traceable to the two product lines and
$10,000 is a common cost.

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4. The Television Division’s results can also be used

for decision making. For example, assume
Webber believes that if the Television Division
spends $5,000 additional dollars on advertising it
will increase sales of Regular and Big Screen
televisions by 5%. Webber can compute the profit
43 impact of this course of action as follows:
a. The Regular contribution margin would
increase by $5,250.
b. The Big Screen contribution margin would
increase by $2,250.
c. The Television Division’s segment margin
would increase by $2,500.

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IV. Segmented income statements—common mistakes

A. Omission of costs

i. The costs assigned to a segment should include all

the costs attributable to that segment from the
company’s entire value chain as discussed in Chapter
1.
1. Since only manufacturing costs are included in
product costs under absorption costing, those
companies that choose to use absorption costing
for segment reporting purposes will omit from
their profitability analysis all “upstream” and
44 “downstream” costs.
a. “Upstream” costs include research and
development and product design costs.
b. “Downstream” costs include marketing,
distribution, and customer service costs.
c. Although these “upstream” and
“downstream” costs are nonmanufacturing
costs, they are just as essential to
determining product profitability as are
manufacturing costs. Omitting them from
profitability analysis will result in the
undercosting of products.

Helpful Hint: An example of a company with a very high

amount of upstream and downstream costs is a
pharmaceutical company such as Merck. A great deal of its
costs are comprised of research and development and
marketing.

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B. Inappropriate methods for assigning traceable costs to

segments

i. Failure to trace costs directly

1. Costs that can be traced directly to specific

segments of a company should not be allocated
to other segments. Rather, such costs should be
charged directly to the responsible segment. For
example:
a. The rent for a branch office of an insurance
company should be charged directly against
the branch office rather than included in a
45 companywide overhead pool and then
spread throughout the company.

ii. Inappropriate allocation base

1. Some companies allocate costs to segments using

arbitrary bases. Costs should be allocated to
segments for internal decision making purposes
only when the allocation base actually drives the
cost being allocated. For example:
a. Sales are frequently used to allocate selling
and administrative expenses to segments.
This should only be done if sales drive these
expenses.

C. Arbitrarily dividing common costs among segments

i. Common costs should not be arbitrarily allocated

46 to segments based on the rationale that “someone
has to cover the common costs” for two reasons:

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1. First, this practice may make a profitable business

segment appear to be unprofitable. If the segment
is eliminated the revenue lost may exceed the
46 traceable costs that are avoided.
2. Second, allocating common fixed costs forces
managers to be held accountable for costs that
they cannot control.

47-55 Quick Check – common costs

V. Income statements—an external reporting perspective

A. Companywide income statements

i. Practically speaking, absorption costing is

required for external reports in the United
States. IFRS also require absorption costing for
external reports.
56
ii. Probably because of the cost of maintaining two
separate costing systems, most companies use
absorption costing for their external and internal
reports.

iii. With all of the advantages of the contribution

approach, one may wonder why the absorption
approach is used at all. Perhaps the biggest reason
is because:
57 1. Advocates of absorption costing argue that it
better matches costs with revenues. They
contend that fixed manufacturing costs are just as
essential to manufacturing products as are the
variable costs.

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2. Advocates of variable costing view fixed

57 manufacturing costs as capacity costs. They
argue that fixed manufacturing costs would be
incurred even if no units were produced.

B. Segmented financial information

i. U.S. GAAP and IFRS require publicly-traded

companies to include segmented financial data in
their annual reports. These rulings have implications
for internal segment reporting because:

1. They mandate that companies must prepare

external segmented reports using the same
58 methods that they use for internal segmented
reports. 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.

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