Variable Costing and Segment

Reporting: Tools for Management

CHAPTER 6

Managerial Accounting
Seventeenth edition
 6-2

Learning Objective 1

Explain how variable costing

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

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 6-3

Three Simplifying Assumptions

1. This chapter uses actual costing rather than the
normal costing approach that was used in the job-
order costing chapters.
2. This chapter always uses the actual number of
units produced as the allocation base for assigning
actual fixed manufacturing overhead costs to
products.
3. This chapter always assumes that the variable
manufacturing costs per unit and the total fixed
manufacturing overhead cost per period remain
constant.

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 6-4

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

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 6-5

Quick Check 1

Which method will produce the highest values for

work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends…

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 6-6

Quick Check 1a

Which method will produce the highest values for

work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends. . .

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 6-7

Unit Cost Computations – Part 1

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

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 6-8

Unit Cost Computations– Part 2

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.
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 6-9

Learning Objective 2

Prepare income statements

using both variable and
absorption costing.

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 6-10

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.

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 6-11

Variable Costing Contribution Format

Income Statement All fixed
manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.

Variable Costing
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Variable cost of goods sold (20,000 × $10) $ 200,000
Variable selling & administrative
expenses (20,000 × $3) 60,000
Total variable expenses 260,000
Contribution margin 340,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 90,000

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 6-12

Absorption Costing Income Statement

Unit product
cost.
Absorption Costing

Sales (20,000 × $30) $ 600,000

Cost of goods sold (20,000 × $16) 320,000
Gross margin 280,000
Less selling & administrative expenses:
Variable (20,000 × $3) $ 60,000
Fixed 100,000 160,000
Net operating income $ 120,000

Fixed manufacturing overhead deferred in inventory is

5,000 units × $6 = $30,000.
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 6-13

Learning Objective 3

Reconcile variable costing and

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

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 6-14

Comparing the Two Methods – Part 1

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 6-15

Comparing the Two Methods – Part 2

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

Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 120,000

Fixed mfg. overhead $150,000

= = $6 per unit
Units produced 25,000 units
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 6-16

Extended Comparisons of Income Data

Harvey Company – Year Two

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 6-17

Unit Cost Computations

Since the variable costs per unit, total fixed costs, and
the number of units produced remained unchanged,
the unit cost computations also remain unchanged.

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 6-18

Variable Costing All fixed

manufacturing
Variable
overhead is
manufacturing
expensed.
costs only.

Variable Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Variable cost of goods sold (30,000 × $10) $ 300,000
Variable selling & administrative
expenses (30,000 × $3) 90,000
Total variable expenses 390,000
Contribution margin 900,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling & administrative expenses 100,000 250,000
Net operating income $ 650,000

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 6-19

Absorption Costing
Unit product
cost.
Absorption Costing

Sales (30,000 × $30) $ 900,000

Cost of goods sold (30,000 × $16) 480,000
Gross margin 420,000
Less selling & administrative expenses:
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
Net operating income $ 230,000

Fixed manufacturing overhead released from

inventory is 5,000 units × $6 = $30,000.
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 6-20

Reconciling the Difference – Part 1

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
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 6-21

Reconciling the Difference – Part 2

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 6-22

Summary of Key Insights

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 6-23

Enabling CVP Analysis

Variable costing categorizes costs as variable and fixed
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.
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 6-24

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.
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 6-25

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.
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 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.

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 6-27

Decentralization and Segment Reporting

A segment is any part or activity of an

organization about which a manager seeks
cost, revenue, or profit data.

An Individual Store A Service Center

A Sales Territory

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 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.
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 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.

Examples of traceable fixed costs include:

The salary of the Fritos The maintenance cost for the
product manager at PepsiCo building in which Boeing 747s
is a traceable fixed cost of the are assembled is a traceable
Fritos business segment of fixed cost of the 747 business
PepsiCo. segment of Boeing.

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 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.
Examples of common fixed costs include:
The salary of the CEO of The cost of heating a
General Motors is a Safeway or Kroger
common fixed cost of the grocery store is a
various divisions of common fixed cost of
General Motors. the various
departments.
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 6-31

Traceable Fixed 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.

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 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.

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 6-33

Traceable and Common Costs

Fixed
Costs
Don’t allocate
common costs to
segments.

Traceable Common

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 6-34

Levels of Segmented Statements – Part 1

Webber, Inc. has two divisions.

1.Computer Division
2.Television Division

Let’s look more closely at the

Television Division’s income statement.

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 6-35

Levels of Segmented Statements – Part 2

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

Levels of Segmented Statements – Part 3

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

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 6-37

Levels of Segmented Statements – Part 4

Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable expenses 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 expenses
Net operating
income

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 6-38

Levels of Segmented Statements – Part 5

Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable expenses 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 expenses 25,000 Common fixed expenses
Net operating
should not be allocated to
income $ 75,000
the divisions. These
expenses would remain
even if one of the divisions
were eliminated.

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 6-39

Traceable Fixed Costs Can Become

Common Fixed Costs – Part 1

As previously mentioned, fixed expenses that

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

Let’s see how this works using the

Webber, Inc. example.

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 6-40

Traceable Fixed Costs Can Become

Common Fixed Costs – Part 2
Webber’s Television Division has two
product lines:
1. Regular
2. Big Screen

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 6-41

Traceable Fixed Costs Can Become

Common Fixed Costs – Part 3
Income Statement
Television
Division Regular Big Screen
Sales $ 200,000 $ 100,000
Variable expenses 95,000 55,000
CM 105,000 45,000
Traceable FC 45,000 35,000
Product line margin $ 60,000 $ 10,000
Common expenses
Divisional margin

We obtained the following information from

the Regular and Big Screen segments.
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 6-42

Traceable Fixed Costs Can Become

Common Fixed Costs – Part 4
Income Statement
Television
Division Regular Big Screen
Sales $ 300,000 $ 200,000 $ 100,000
Variable expenses 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 expenses 10,000
Divisional margin $ 60,000

Fixed costs directly traced

to the Television Division
$80,000 + $10,000 = $90,000

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 6-43

Segmented Income Statements— Decision

Making and Break-even Analysis

Once a company prepares a

contribution format segmented
income statement, it can use
the statement to make decisions
and perform break-even analysis.

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 6-44

Segmented Income Statements— Decision

Making
5% increase in sales
Income Statement
Television
Division Regular Big Screen
Sales $ 315,000 $ 210,000 $ 105,000
Variable expenses 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 expenses 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
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 6-45

Learning Objective 5

Compute companywide and

segment break-even points
for a company with traceable
fixed costs.

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 6-46

Segmented Income Statements —

Break-even Analysis – Part 1

Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable expenses 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 expenses 25,000
Net operating
income $ 75,000

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 6-47

Segmented Income Statements —

Break-even Analysis – Part 2

Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable expenses 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 expenses 25,000
Net operating
income $ 75,000

Calculate the company-wide break-even point.

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 6-48

Segmented Income Statements —

Break-even Analysis – Part 3
The companywide break-even point is computed by
dividing the sum of the company’s traceable fixed
expenses and common fixed expenses by the company’s
overall contribution margin ratio.
Break-even $170,000 + $25,000
= = $361,111
Point 0.54

Contribution Margin $270,000

= = 0.54
Ratio $500,000

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 6-49

Segmented Income Statements —

Break-even Analysis – Part 4

Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable expenses 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 expenses 25,000
Net operating
income $ 75,000

Calculate break-even point for each business segment.

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 6-50

Segmented Income Statements —

Break-even Analysis – Part 5
A business segment’s break-even point is computed by dividing its
traceable fixed expenses by its contribution margin ratio.

Television Break-even $90,000

Point = 0.50 = $180,000

Contribution Margin = $150,000 = 0.50

Ratio $300,000

Computer Break-even $80,000

= = $133,333
Point 0.60

Contribution Margin = $120,000 = 0.60

Ratio $200,000
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 6-51

Segmented Income Statements —

Break-even Analysis – Part 6
Income Statement
Company Television Computer
Sales $ 500,000 $ 300,000 $ 200,000
Variable expenses 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 expenses 25,000
Net operating
income $ 75,000
Notice the $25,000 of companywide common fixed expenses are
excluded from the segment break-even calculations because the
common fixed expenses are not traceable to segments and are not
influenced by segment-level decisions.
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 6-52

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 Manufacturing Marketing Distribution
Design Service

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 6-53

Inappropriate Methods of Allocating

Costs Among Segments
Failure to trace costs directly
◦ Costs that can be traced directly to specific
segments of a company should not be allocated
to other segments.
Inappropriate allocation base
◦ Some companies allocate costs to segments
using arbitrary bases. Costs should be allocated
to segments only when the allocation base
actually drives the cost being allocated.

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 6-54

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.

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 6-55

Quick Check 2
Income Statement
Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable expenses 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 expenses 200,000
Net operating profit $ 44,000

Assume that Hoagland's Lakeshore prepared its

segmented income statement as shown.

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 6-56

Quick Check 2a
How much of the common fixed expense of
$200,000 can be avoided by eliminating the
bar?
a. None of it.
b. Some of it.
c. All of it.

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 6-57

Quick Check 2b
How much of the common fixed expense of
$200,000 can be avoided by eliminating the
bar?
a. None of it.
b. Some of it.
c. All of it.
Common fixed expenses
cannot be eliminated by
dropping one of the
segments.
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 6-58

Quick Check 2c
Suppose square feet is used as the basis for
allocating the common fixed expense 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

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 6-59

Quick Check 2d
Suppose square feet is used as the basis for
allocating the common fixed expense 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

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 6-60

Quick Check 2e

If Hoagland’s allocates its common

fixed expenses to the bar and the
restaurant, what would be the
reported profit of each segment?

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 6-61

Quick Check 2f
Income Statement
Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable expenses 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 expenses 200,000 20,000 180,000
Net operating profit (loss) $ 44,000 $ (6,000) $ 50,000

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Quick Check 2g
Income Statement
Hoagland's
Lakeshore Bar Restaurant
Sales $ 800,000 $ 100,000 $ 700,000
Variable expenses 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 expenses 200,000 20,000 180,000
Net operating profit (loss) $ 44,000 $ (6,000) $ 50,000

Do you think the Bar should be eliminated?

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 6-63

Quick Check 2h
Should the bar be eliminated?
a. Yes
b. No

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 6-64

Quick Check 2i
Should the bar be eliminated?
a. Yes The profit was $44,000 before
b. No eliminating the bar. If we eliminate the
bar, profit drops to $30,000!
Income Statement
Hoagland's
Lakeshore Bar Restaurant
Sales $ 700,000 $ 700,000
Variable expenses 250,000 250,000
CM 450,000 450,000
Traceable FC 220,000 220,000
Segment margin 230,000 $ 230,000
Common expenses 200,000 200,000
Net operating profit (loss) $ 30,000 $ 30,000
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 6-65

Company-wide Income Statements

Both U.S. GAAP and

IFRS require absorption costing
for external 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.
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Variable versus Absorption Costing

Absorption Costing
◦Fixed manufacturing costs must be
assigned to products to properly match
revenues and costs.

Variable Costing
◦Fixed manufacturing costs are capacity
costs and will be incurred even if nothing is
produced.
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Segmented Financial 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.

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 6-68

End of Chapter 6

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