Variable Costing and

Segment Reporting: Tools for

Management
Chapter 6
 6-2

Learning Objective 1

Explain how variable

costing differs from
absorption costing
and compute unit
product costs under
each method.
 6-3

Overview of Variable and

Absorption Costing
Variable Absorption
Costing Costing
Direct Materials
Product
Direct Labor Product
Costs
Variable Manufacturing Overhead Costs
Fixed Manufacturing Overhead
Period
Variable Selling and Administrative Expenses Period
Costs
Fixed Selling and Administrative Expenses Costs
 6-4

Quick Check 
Which
Which method
method will
will produce
produce thethe highest
highest values
values
for
for work
work in
in process
process and
and finished
finished goods
goods
inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..
 6-5

Quick Check 
Which
Which method
method will
will produce
produce thethe highest
highest values
values
for
for work
work in
in process
process and
and finished
finished goods
goods
inventories?
inventories?
a.
a. Absorption
Absorption costing.
costing.
b.
b. Variable
Variable costing.
costing.
c.
c. They
They produce
produce the the same
same values
values for
for these
these
inventories.
inventories.
d.
d. ItIt depends.
depends. .. ..
 6-6

Unit Cost Computations

Harvey Company produces a single product
with the following information available:
 6-7

Unit Cost Computations

Unit product cost is determined as follows:

Under absorption costing, all production costs, variable

and fixed, are included when determining unit product
cost. Under variable costing, only the variable
production costs are included in product costs.
 6-8

Learning Objective 2

Prepare income
statements using
both variable and
absorption costing.
 6-9

Variable and Absorption

Costing Income Statements
Let’s assume the following additional information
for Harvey Company.
▫ 20,000 units were sold during the year at a price
of $30 each.
▫ There is no beginning inventory.

Now, let’s compute net operating

income using both absorption
and variable costing.
 6-10

Variable Costing Contribution Format

Income Statement All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.
Variable
VariableCosting
Costing
Sales
Sales(20,000
(20,000××$30)
$30) $$600,000
600,000
Less
Lessvariable
variableexpenses:
expenses:
Variable
Variablecost
costofofgoods
goodssold
sold(20,000
(20,000××$10)
$10) $$200,000
200,000
Variable
Variableselling
selling&&administrative
administrative
expenses
expenses(20,000
(20,000××$3)
$3) 60,000
60,000 260,000
260,000
Total
Totalvariable
variableexpenses
expenses
Contribution
Contributionmargin
margin 340,000
340,000
Less
Lessfixed
fixedexpenses:
expenses:
Fixed
Fixedmanufacturing
manufacturingoverhead
overhead $$150,000
150,000
Fixed
Fixedselling
selling&&administrative
administrativeexpenses
expenses 100,000
100,000 250,000
250,000
Net
Netoperating
operatingincome
income $$ 90,000
90,000
 6-11

Absorption Costing Income Statement

Unit product

cost.

Fixed manufacturing overhead deferred in

inventory is 5,000 units × $6 = $30,000.
 6-12

Learning Objective 3

Reconcile variable
costing and
absorption costing
net operating
incomes and explain
why the two amounts
differ.
 6-13

Comparing the Two Methods

 6-14

Comparing the Two Methods

We can reconcile the difference between
absorption and variable income as follows:

Variable
Variable costing
costingnet
netoperating
operatingincome
income $$ 90,000
90,000
Add:
Add:Fixed
Fixedmfg.
mfg. overhead
overheadcosts
costs
deferred
deferredinininventory
inventory
(5,000
(5,000units
units×× $6
$6per
perunit)
unit) 30,000
30,000
Absorption
Absorptioncosting
costingnet
netoperating
operatingincome
income $$ 120,000
120,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
 6-15

Extended Comparisons of
Income Data Harvey Company
– Year Two
 6-16

Unit Cost Computations

Absorption
Absorption Variable
Variable
Costing
Costing Costing
Costing
Direct
Directmaterials,
materials, direct
directlabor,
labor,
and
and variable
variable mfg.
mfg. overhead
overhead $$ 10
10 $$ 10
10
Fixed
Fixed mfg.
mfg. overhead
overhead
($150,000
($150,000÷÷25,000
25,000units)
units) 66 --
Unit
Unitproduct
productcost
cost $$ 16
16 $$ 10
10

Since the variable costs per unit, total fixed costs,

and the number of units produced remained
unchanged, the unit cost computations also
remain unchanged.
 6-17

Variable Costing Contribution Format

Income Statement All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.
Variable
VariableCosting
Costing
Sales
Sales(30,000
(30,000××$30)
$30) $$900,000
900,000
Less
Lessvariable
variableexpenses:
expenses:
Variable
Variablecost
costofofgoods
goodssold
sold(30,000
(30,000××$10)
$10) $$300,000
300,000
Variable
Variableselling
selling&&administrative
administrative
expenses
expenses(30,000
(30,000××$3)
$3) 90,000
90,000 390,000
390,000
Total
Totalvariable
variableexpenses
expenses
Contribution
Contributionmargin
margin 510,000
510,000
Less
Lessfixed
fixedexpenses:
expenses:
Fixed
Fixedmanufacturing
manufacturingoverhead
overhead $$150,000
150,000
Fixed
Fixedselling
selling&&administrative
administrativeexpenses
expenses 100,000
100,000 250,000
250,000
Net
Netoperating
operatingincome
income $$260,000
260,000
 6-18

Absorption Costing Income Statement

Unit product

cost.

Fixed manufacturing overhead released from

inventory is 5,000 units × $6 = $30,000.
 6-19

Comparing the Two Methods

We can reconcile the difference between
absorption and variable income as follows:

Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
 6-20

Comparing the Two Methods

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000
 6-21

Summary of Key Insights

Relation between Relation between
production Effect on variable and
and sales inventory absorption income
Units produced Absorption
= No change =
Units sold in inventory Variable
Units produced Absorption
> Inventory >
Units sold increases Variable
Units produced Absorption
< Inventory <
Units sold decreases Variable
 6-22

Enabling CVP Analysis

Variable costing categorizes costs as fixed and
variable so it is much easier to use this income
statement format for CVP analysis.

Because absorption costing assigns fixed

manufacturing overhead costs to units produced ($6
per unit for Harvey Company), a portion of fixed
manufacturing overhead resides in inventory when
units remain unsold. The potential result is positive
operating income when the number of units sold is
less than the breakeven point.
 6-23

Explaining Changes in Net Operating

Income
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 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 be
increased simply by producing more units
even if those units are not sold.
 6-24

Supporting Decision Making

Variable costing correctly identifies the additional
variable costs incurred to make one more unit ($10
per unit for Harvey Company). It also emphasizes
the impact of total fixed costs on profits.

Because absorption costing assigns fixed

manufacturing overhead costs to units produced ($6
per unit for Harvey Company), it gives the impression
that fixed manufacturing overhead is variable with
respect to the number of units produced, but it is not.
The result can be inappropriate pricing decisions and
product discontinuation decisions.
 6-25

Variable Costing and the

Theory of Constraints (TOC)
Companies involved in TOC use a form of variable
costing. However, one difference of the TOC
approach is that it treats direct labor as a fixed cost
for three reasons:
 Many companies have a commitment to guarantee
workers a minimum number of paid hours.
 Direct labor is usually not the constraint.
 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.
 6-26

Learning Objective 4

Prepare a
segmented income
statement that
differentiates
traceable fixed costs
from common fixed
costs and use it to
make decisions.
 6-27

Decentralization and Segment

Reporting An Individual Store

Quick
Quick Mart
Mart

A segment is any part A Sales Territory

or activity of an
organization about
which a manager
seeks cost, revenue,
or profit data. A Service Center
 6-28

Keys to Segmented Income

Statements
There are two keys to building
segmented income statements:
A contribution format should be used
because it separates fixed from variable costs
and it 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.
 6-29

Identifying Traceable Fixed

Costs
Traceable fixed costs arise because of the
existence of a particular segment and would
disappear over time if the segment itself
disappeared.

No computer No computer
division means . . . division manager.
 6-30

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.

No computer We still have a

division but . . . company president.
 6-31

Traceable Costs Can Become

Common Costs
It is important to realize that the traceable
fixed costs of one segment may be a
common fixed cost of another segment.

For example, the landing fee

paid to land an airplane at an
airport is traceable to the
particular flight, but it is not
traceable to first-class,
business-class, and
economy-class passengers.
 6-32

Segment Margin
The segment margin, which is computed by
subtracting the traceable fixed costs of a segment
from its contribution margin, is the best gauge of
the long-run profitability of a segment.
Profits

Time
 6-33

Traceable and Common Costs

Fixed Don’t allocate

Costs common costs to
segments.

Traceable Common
 6-34

Levels of Segmented
Statements
Webber, Inc. has two divisions.

W ebber, Inc.

Com puter Division Television Division

Let’s
Let’s look
look more
more closely
closely at
at the
the Television
Television
Division’s
Division’s income
income statement.
statement.
 6-35

Levels of Segmented
Statements
Our approach to segment reporting uses the
contribution format.
Income Statement Cost
Cost of
of goods
goods
Contribution Margin Format sold
sold consists
consists of
of
Television Division variable
variable
Sales $ 300,000 manufacturing
manufacturing
Variable COGS 120,000 costs.
costs.
Other variable costs 30,000
Fixed
Fixed and
and
Total variable costs 150,000
variable
variable costs
costs
Contribution margin 150,000
are
are listed
listed in
in
Traceable fixed costs 90,000
separate
separate
Division margin $ 60,000
sections.
sections.
 6-36

Levels of Segmented
Statements
Our approach to segment reporting uses the
contribution format.
Income Statement
Contribution Margin Format
Contribution
Contribution margin
margin
is
is computed
computed byby
Television Division
taking
taking sales
sales minus
minus
Sales $ 300,000
variable
variable costs.
costs.
Variable COGS 120,000
Other variable costs 30,000
Total variable costs 150,000 Segment
Segment margin
margin
Contribution margin 150,000 is
is Television’s
Television’s
Traceable fixed costs 90,000 contribution
contribution
Division margin $ 60,000 to
to profits.
profits.
 6-37

Levels of Segmented
Statements
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs
Net operating
income
 6-38

Levels of Segmented
Statements
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable costs 230,000 150,000 80,000
CM 270,000 150,000 120,000
Traceable FC 170,000 90,000 80,000
Division margin 100,000 $ 60,000 $ 40,000
Common costs 25,000
Common
Common costs
costs should
should notnot
Net operating
be
be allocated
allocated to
to the
the
income $ 75,000 divisions.
divisions. These
These costs
costs
would
would remain
remain even
even ifif one
one
of
of the
the divisions
divisions were
were
eliminated.
eliminated.
 6-39

Traceable Costs Can Become

Common Costs

As previously mentioned, fixed costs that

are traceable to one segment can become
common if the company is divided into
smaller segments.

Let’s see how this works

using the Webber, Inc.
example!
 6-40

Traceable Costs Can Become

Common Costs
Webber’s Television Division
Television
Division

Regular Big Screen

Product
Lines
 6-41

Traceable Costs Can Become

Common Costs
Income Statement
Television
Division Regular Big Screen
Sales $ 200,000 $ 100,000
Variable costs 95,000 55,000
CM 105,000 45,000
Traceable FC 45,000 35,000
Product line margin $ 60,000 $ 10,000
Common costs
Divisional margin

We obtained the following information from

the Regular and Big Screen segments.
 6-42

Traceable Costs Can Become

Common Costs
Income Statement
Television
Division Regular Big Screen
Sales $ 300,000 $ 200,000 $ 100,000
Variable costs 150,000 95,000 55,000
CM 150,000 105,000 45,000
Traceable FC 80,000 45,000 35,000
Product line margin 70,000 $ 60,000 $ 10,000
Common costs 10,000
Divisional margin $ 60,000

Fixed
Fixed costs
costs directly
directly traced
traced
to
to the
the Television
Television Division
Division
$80,000
$80,000 ++ $10,000
$10,000 == $90,000
$90,000
 6-43

Segmented Income Statements and

Decision Making 5% increase in sales
Income Statement
Television
Division Regular Big Screen
Sales $ 315,000 $ 210,000 $ 105,000
Variable costs 157,500 99,750 57,750
CM 157,500 110,250 47,250
Traceable FC 80,000 45,000 35,000
Product line margin 77,500 $ 65,250 $ 12,250
Common costs 15,000
Divisional margin $ 62,500

$5,000 additional Division margin Margin Margin

advertising increases by increases increases
$2,500 by $5,250 by $2,250
 6-44

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

Product Customer
R&D Design Manufacturing Marketing Distribution Service
 6-45

Inappropriate Methods of Allocating

Costs Among Segments

Failure to trace
costs directly Inappropriate
allocation base

Segment Segment Segment Segment

1 2 3 4
 6-46

Common Costs and Segments

Common costs should not be arbitrarily allocated to segments
based on the rationale that “someone has to cover the
common costs” for two reasons:
1. This practice may make a profitable business segment appear
to be unprofitable.

2. Allocating common fixed costs forces managers to be held

accountable for costs they cannot control.

Segment Segment Segment Segment

1 2 3 4
 6-47

Quick Check 
Income Statement

Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable costs 310,000 60,000 250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 $ 14,000 $ 230,000
Common costs 200,000
Profit $ 44,000

Assume that Hoagland's Lakeshore prepared its

segmented income statement as shown.
 6-48

Quick Check 

How much of the common fixed cost of

$200,000 can be avoided by eliminating the
bar?
a. None of it.
b. Some of it.
c. All of it.
 6-49

Quick Check 

How much of the common fixed cost of

$200,000 can be avoided by eliminating the
bar?
a. None of it.
b. Some of it.
c. All of it.
A common fixed cost
cannot be eliminated by
dropping one of the
segments.
 6-50

Quick Check 

Suppose square feet is used as the basis for

allocating the common fixed cost of $200,000.
How much would be allocated to the bar if the
bar occupies 1,000 square feet and the
restaurant 9,000 square feet?
a. $20,000
b. $30,000
c. $40,000
d. $50,000
 6-51

Quick Check 

Suppose square feet is used as the basis for

allocating the common fixed cost of $200,000.
How much would be allocated to the bar if the
bar occupies 1,000 square feet and the
restaurant 9,000 square feet?
a. $20,000 The bar would be
b. $30,000 allocated 1/10 of the cost
c. $40,000
or $20,000.
d. $50,000
 6-52

Quick Check 
If Hoagland's allocates its common
costs to the bar and the restaurant,
what would be the reported profit of
each segment?
 6-53

Allocations of Common Costs

Income Statement

Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable costs 310,000 60,000 250,000
CM 490,000 40,000 450,000
Traceable FC 246,000 26,000 220,000
Segment margin 244,000 14,000 230,000
Common costs 200,000 20,000 180,000
Profit $ 44,000 $ (6,000) $ 50,000

Hurray, now everything adds up!!!

 6-54

Quick Check 
Should the bar be eliminated?
a. Yes
b. No
 6-55

Quick Check 
Should the bar be eliminated?
a. Yes
b. No The profit was $44,000 before
eliminating the bar. If we eliminate
the bar,
Income profit drops to $30,000!
Statement

Hoagland's
Lakeshore Bar Restaurant
Sales $ 700,000 $ 700,000
Variable costs 250,000 250,000
CM 450,000 450,000
Traceable FC 220,000 220,000
Segment margin 230,000 230,000
Common costs 200,000 200,000
Profit $ 30,000 $ 30,000
 6-56

Companywide Income Global View

Statements

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

Since absorption costing is required for

external reporting, most companies also use
it for internal reports rather than incurring the
additional cost of maintaining a separate
variable cost system for internal reporting.
 6-57

Variable versus Absorption

Costing
Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.

Absorption Variable
Costing Costing
 6-58

Segmented Financial Global View

Information
Both U.S. GAAP and IFRS require publically
traded companies to include segmented
financial data in their annual reports.
1. Companies must report segmented results to
shareholders using the same methods that are used
for internal segmented reports.
2. 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.
 6-59

End of Chapter 6