Accounting Discussion #3 (part A)
jandreg
spptchap005.pptPowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 5
Variable Costing and Segment Reporting: Tools for Management
Chapter 5: Variable Costing and Segment Reporting: Tools for Management
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 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.
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Overview of Variable and Absorption Costing
Variable
Costing
Absorption
Costing
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Product
Costs
Period
Costs
Product
Costs
Period
Costs
Variable costing (also called direct costing or marginal 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 separating variable and fixed costs. The cost of a unit of product consists of direct materials, direct labor, and variable overhead. Fixed manufacturing overhead, and both variable and fixed selling and administrative expenses are treated as period costs and deducted from revenue as incurred.
Absorption costing (also called the full cost method) 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. Under absorption costing, the cost of a unit of product consists of direct materials, direct labor, and both variable and fixed overhead. Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenue as incurred.
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Harvey Company produces a single product with the following information available:
Unit Cost Computations
Harvey Company produces 25,000 units of a single product. Variable manufacturing costs total $10 per unit. Variable selling and administrative expenses are $3 per unit. Fixed manufacturing overhead for the year is $150,000 and fixed selling and administrative expenses for the year are $100,000.
Sheet1
| Number of units produced annually | 25,000 | ||
| Variable costs per unit: | |||
| Direct materials, direct labor, | |||
| and variable mfg. overhead | $ 10 | ||
| Selling & administrative expenses | $ 3 | ||
| Fixed costs per year: | |||
| Manufacturing overhead | $ 150,000 | ||
| Selling & administrative expenses | $ 100,000 |
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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.
Unit Cost Computations
The unit product costs under absorption and variable costing would be $16 and $10, respectively. 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.
Sheet1
| Absorption Costing | Variable Costing | |||
| Direct materials, direct labor, | ||||
| and variable mfg. overhead | $ 10 | $ 10 | ||
| Fixed mfg. overhead | ||||
| ($150,000 ÷ 25,000 units) | 6 | - 0 | ||
| Unit product cost | $ 16 | $ 10 |
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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.
We need some additional information to allow us to prepare income statements for Harvey Company:
- 20,000 units were sold during the year.
- The selling price per unit is $30.
- There is no beginning inventory.
Now let’s prepare income statements for Harvey Company. We will start with an absorption income statement.
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Variable Costing Contribution Format Income Statement
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.
Let’s examine a variable costing contribution format income statement. First, we subtract all variable expenses from sales to get contribution margin. At a product cost of $10 per unit, the variable cost of goods sold for 20,000 units is $200,000. The next variable expense is the variable selling and administrative expense. After computing contribution margin, we subtract fixed expenses to get the $90,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.
Sheet1
| 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 | 260,000 | ||
| Total variable expenses | ||||
| 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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Absorption Costing Income Statement
Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.
Unit product
cost.
Now, let’s examine an absorption costing income statement. Harvey sold only 20,000 of the 25,000 units produced, leaving 5,000 units in ending inventory. At a sales price of $30 per unit, sales revenue for the 20,000 units sold is $600,000. At a unit product cost of $16, cost of goods sold for the 20,000 units sold is $320,000. Subtracting cost of goods sold from sales, we find the gross margin of $280,000. After subtracting selling and administrative expenses from the gross margin, we see that net operating income is $120,000.
Fixed manufacturing overhead deferred in inventory, as a result of the 5,000 unsold units at $6 of fixed overhead per unit, is $30,000.
Sheet1
| Absorption | |||
| Sales (20,000 × $30) | $ 600,000 | ||
| Less 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 |
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Extended Comparisons of Income Data Harvey Company – Year Two
In the second year, Harvey Company sells 30,000 units. The selling price per unit, variable costs per unit, total fixed costs, and number of units produced remain unchanged. Five thousand units are in beginning inventory, left from last year.
Sheet1
| Number of units produced | 25,000 | ||
| Number of units sold | 30,000 | ||
| Units in beginning inventory | 5,000 | ||
| Unit sales price | $ 30 | ||
| Variable costs per unit: | |||
| Direct materials, direct labor, | |||
| and variable mfg. overhead | $ 10 | ||
| Selling & administrative | |||
| expenses | $ 3 | ||
| Fixed costs per year: | |||
| Manufacturing overhead | $ 150,000 | ||
| Selling & administrative | |||
| expenses | $ 100,000 |
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Variable Costing Contribution Format Income Statement
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.
First, let’s examine a variable costing contribution format income statement for the second year. At a product cost of $10 per unit, the variable cost of goods sold for 30,000 units is $300,000.
After computing contribution margin, we subtract fixed expenses to get the $260,000 net operating income. Note that all $150,000 of fixed manufacturing overhead is expensed in the current period.
Sheet1
| 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 | 390,000 | ||
| Total variable expenses | ||||
| Contribution margin | 510,000 | |||
| Less fixed expenses: | ||||
| Fixed manufacturing overhead | $ 150,000 | |||
| Fixed selling & administrative expenses | 100,000 | 250,000 | ||
| Net operating income | $ 260,000 |
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Absorption Costing Income Statement
Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.
Unit product
cost.
Of the 30,000 units sold in the second year, 25,000 units were produced in the second year and 5,000 units came from beginning inventory. The $30,000 of fixed manufacturing overhead deferred into inventory in the first year is released from inventory this year as part of the $16 unit product cost. Selling and administrative expenses are deducted from gross margin to obtain the net operating income of $230,000.
Fixed manufacturing overhead is released from inventory as a result of the 5,000 units sold in the second year that were produced in the first year. The amount released is $30,000 (5,000 units at $6 of fixed overhead per unit).
Sheet1
| Absorption | |||
| Sales (30,000 × $30) | $ 900,000 | ||
| Less 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 |
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Summary of Key Insights
On your screen is a summary of what we have observed from the Harvey Company’s two years:
- When units produced equal units sold, the two methods report the same net operating income.
- When units produced are greater units sold, as in year 1 for Harvey, absorption income is greater than variable costing income.
- When units produced are less than units sold, as in year 2 for Harvey, absorption costing income is less than variable costing income.
Sheet1
| 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 |
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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.
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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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.
There are two keys to building segmented income statements.
First, a contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. The contribution margin is especially useful in decisions involving temporary uses of capacity, such as special orders.
Second, traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.
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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
division means . . .
No computer
division manager.
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 the following:
- The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo.
- The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing.
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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
division but . . .
We still have a
company president.
A common fixed cost is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment. Examples of common fixed costs include the following:
- The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors.
- The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments – groceries, produce, and bakery.
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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.
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 a particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.
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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.
Time
Profits
A segment margin is computed by subtracting the traceable fixed costs of a segment from its contribution margin. The segment margin is a valuable tool for assessing the long-run profitability of a segment.
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Inappropriate Methods of Allocating Costs Among Segments
Segment
3
Segment
4
Segment
2
Segment
1
Inappropriate
allocation base
Failure to trace
costs directly
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, the rent for a branch office of an insurance company should be charged directly against the branch office rather than included in a companywide overhead pool and then spread throughout the company.
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, sales is frequently used to allocate selling and administrative expenses to segments. This should only be done if sales drive these expenses.
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Common Costs and Segments
Segment
3
Segment
4
Segment
2
Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons:
- This practice may make a profitable business segment appear to be unprofitable.
- Allocating common fixed costs forces managers to be held accountable for costs they cannot control.
Segment
1
Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons:
First, this practice may make a profitable business segment appear to be unprofitable. If the segment is eliminated the revenue lost may exceed the traceable costs that are avoided.
Second, allocating common fixed costs forces managers to be held accountable for costs that they cannot control.
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End of Chapter 5
End of chapter 5.
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Number of units produced annually25,000
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead10$
Selling & administrative expenses3$
Fixed costs per year:
Manufacturing overhead150,000$
Selling & administrative expenses100,000$
Absorption
Costing
Variable
Costing
Direct materials, direct labor,
and variable mfg. overhead10$ 10$
Fixed mfg. overhead
($150,000 ÷ 25,000 units)6 -
Unit product cost16$ 10$
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 × $3)60,000 260,000
Total variable expenses
Contribution margin340,000
Less fixed expenses:
Fixed manufacturing overhead150,000$
Fixed selling & administrative expenses100,000 250,000
Net operating income90,000$
Absorption
Sales (20,000 × $30)600,000$
Less cost of goods sold: (20,000 × $16)320,000
Gross margin280,000
Less selling & administrative expenses
Variable (20,000 × $3)60,000$
Fixed100,000 160,000
Net operating income120,000$
Number of units produced25,000
Number of units sold30,000
Units in beginning inventory5,000
Unit sales price30$
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead10$
Selling & administrative
expenses3$
Fixed costs per year:
Manufacturing overhead150,000$
Selling & administrative
expenses100,000$
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 × $3)90,000 390,000
Total variable expenses
Contribution margin510,000
Less fixed expenses:
Fixed manufacturing overhead150,000$
Fixed selling & administrative expenses100,000 250,000
Net operating income260,000$
Absorption
Sales (30,000 × $30)900,000$
Less cost of goods sold: (30,000 × $16)480,000
Gross margin420,000
Less selling & administrative expenses
Variable (30,000 × $3)90,000$
Fixed100,000 190,000
Net operating income230,000$
Relation betweenRelation between
productionEffect onvariable and
and salesinventoryabsorption income
Units produced Absorption
= No change =
Units soldin inventoryVariable
Units produced Absorption
>Inventory >
Units soldincreasesVariable
Units produced Absorption
<Inventory <
Units solddecreasesVariable
