Managerial Accounting

Sixteenth Edition

Chapter 6
Variable Costing
and Segment
Reporting: Tools for
Management

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Learning Objective 1
Explain how variable costing differs from
absorption costing and compute unit product
costs under each method.

© McGraw-Hill Education. 6-2

 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.

© McGraw-Hill Education. 6-3

Overview of Variable and Absorption
Costing (1 of 2)
Variable Costing
• Product Costs
– Direct Materials
– Direct Labor
– Variable Manufacturing Overhead
• Period Costs
– Fixed Manufacturing Overhead
– Variable Selling and Administrative Expenses
– Fixed Selling and Administrative Expenses

© McGraw-Hill Education. 6-4

Overview of Variable and Absorption
Costing (2 of 2)
Absorption Costing
• Product Costs
– Direct Materials
– Direct Labor
– Variable Manufacturing Overhead
– Fixed Manufacturing Overhead
• Period Costs
– Variable Selling and Administrative Expenses
– Fixed Selling and Administrative Expenses

© McGraw-Hill Education. 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…

© McGraw-Hill Education. 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. . .
Answer: a

© McGraw-Hill Education. 6-7

 Unit Cost Computations – Part 1
Harvey Company produces a single product
with the following information available:
Number of units produced annually 25,000

Variable costs per unit:

Direct materials, direct labor, and variable mfg. $ 10
overhead
Selling & administrative expenses $3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative expenses $ 100,000

© McGraw-Hill Education. 6-8

 Unit Cost Computations – Part 2
Unit product cost is determined as follows:
Absorption Variable
Costing Costing
Direct materials, direct labor, and variable
$ 10 $ 10
mfg. overhead
Fixed mfg. overhead ($150,000 ÷ 25,000
6 -
units)
Unit product cost $ 16 $ 10

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.

© McGraw-Hill Education. 6-9

 Learning Objective 2
Prepare income statements using both
variable and absorption costing.

© McGraw-Hill Education. 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.

© McGraw-Hill Education. 6-11

Variable Costing Contribution Format
Income Statement
• Variable cost of goods sold (20,000 × $ 10)
$200,00: Variable manufacturing costs only.
• Fixed manufacturing overhead $150,000: All fixed
manufacturing overhead is expensed.
Variable Costing Variable Costing
Sales (20,000 x $30) $ 600,000
Less variable expenses:
Variable cost of goods sold (30,000 x $10) $ 200,000
Variable selling and administrative expenses (30,000 x $3) 60,000
Total variable expenses 260,000
Contribution margin 340,000
Less fixed expenses:
Fixed manufacturing overhead $ 150,000
Fixed selling and administrative expenses 100,000 250,000
Net Operating Income $ 90,000

© McGraw-Hill Education. 6-12

 Absorption Costing Income
Statement
Cost of goods sold (20,000 × $16): Unit product cost.

Fixed manufacturing overhead deferred in inventory is

5,000 units × $6 = $30,000.

© McGraw-Hill Education. 6-13

 Learning Objective 3
Reconcile variable costing and absorption costing
net operating incomes and explain why the two
amounts differ.

© McGraw-Hill Education. 6-14

Comparing the Two Methods – Part 1
Cost of Goods Ending Period
Total
Sold Inventory Expense
Absorption
costing
Variable mfg.
$ 200,00 $ 50,000 $- $ 250,000
expenses
Fixed mfg.
120,000 30,000 - 150,000
expenses
$ 320,000 $ 80,000 $- $ 400,000
Variable
costing
Variable mfg.
$ 200,000 $ 50,000 $- $ 250,000
expenses
Fixed mfg.
- - 150,000 150,000
expenses
$ 200,000 $ 50,000 $ 150,000 $ 400,000

© McGraw-Hill Education. 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
30,000
(5,000 units × $6 per unit)
Absorption costing net operating income $ 120,000

Fixed mfg.overhead $150,000

  $6 per unit
Units produced 25,000 units

© McGraw-Hill Education. 6-16

Extended Comparisons of Income
Data Harvey Company – Year Two
Number of units produced 25,000
Number of units sold 30,000
Units in beginning inventory 5,000
Units sales price $ 30
Variable costs per unit:
Direct materials, direct labor, and variable $ 10
mfg. overhead
Selling & administrative expenses $3
Fixed costs per year:
Manufacturing overhead $ 150,000
Selling & administrative expenses $ 100,000

© McGraw-Hill Education. 6-17

 Unit Cost Computations
Absorption on Variable
Costing Costing
Direct materials, direct labor, and variable
$ 10 $ 10
mfg. overhead
Fixed mfg. overhead ($150,000 ÷ 25,000
6 -
units)
Unit product cost $ 16 $ 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.

© McGraw-Hill Education. 6-18

 Variable Costing (1 of 2)
• Variable cost of goods sold (30,000 × $10):
Variable manufacturing costs only.
• Fixed manufacturing overhead $ 150,000:
All fixed manufacturing overhead is
expensed.

© McGraw-Hill Education. 6-19

 Variable Costing (2 of 2)
Variable Variable
Costing Costing
Sales (30,000 × $30) $ 900,000
Less variable expenses:
Variable cost of goods sold (30,000 × $10) $ 300,000
Variable selling & administrative expenses
90,000
(30,000 × $3)
Total variable expenses 390,000
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

© McGraw-Hill Education. 6-20

 Absorption Costing
Cost of goods sold (30,000 ×$16): 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 × $16) $ 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.
© McGraw-Hill Education. 6-21
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 30,000
released from inventory (5,000 units × $6 per unit)
Absorption costing net operating income $230,000

Fixed mfg.overhead $150,000

  $6 per unit
Units produced 25,000 units

© McGraw-Hill Education. 6-22

Reconciling the Difference – Part 2

Costing Method 1st Period 2nd Period Total

Absorption $ 120,000 $ 230,000 $ 350,000
Variable 90,000 260,000 350,000

© McGraw-Hill Education. 6-23

 Summary of Key Insights

Relation between production Effect on inventory Relation between variable

and sales and absorption incomes
Units produced = Units sold No change in Absorption = Variable
inventory
Units produced > Units sold Inventory increases Absorption > Variable

Units produced < Units sold Inventory decreases Absorption < Variable

© McGraw-Hill Education. 6-24

 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.

© McGraw-Hill Education. 6-25

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.

© McGraw-Hill Education. 6-26

 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.
© McGraw-Hill Education. 6-27
 Learning Objective 4
Prepare a segmented income statement that
differentiates traceable fixed costs from common
fixed costs and use it to make decisions.

© McGraw-Hill Education. 6-28

 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

© McGraw-Hill Education. 6-29

 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.

© McGraw-Hill Education. 6-30

 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 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.

© McGraw-Hill Education. 6-31

 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 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.

© McGraw-Hill Education. 6-32

 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.

© McGraw-Hill Education. 6-33

 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.

© McGraw-Hill Education. 6-34

 Traceable and Common Costs
• Fixed Costs
• Traceable
• Common
– Don’t allocate common costs to segments.

© McGraw-Hill Education. 6-35

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.

© McGraw-Hill Education. 6-36

Levels of Segmented Statements –
Part 2 (1 of 2)
Our approach to segment reporting uses the
contribution format.

© McGraw-Hill Education. 6-37

Levels of Segmented Statements –
Part 2 (2 of 2)
• Cost of goods sold consists of variable
manufacturing costs.
• Fixed and variable costs are listed in separate
sections.

© McGraw-Hill Education. 6-38

Levels of Segmented Statements –
Part 3 (1 of 2)
Our approach to segment reporting uses the
contribution format.

© McGraw-Hill Education. 6-39

Levels of Segmented Statements –
Part 3 (2 of 2)
• Contribution margin is computed by taking sales
minus variable costs.
• Segment margin is Television’s contribution to
profits.

© McGraw-Hill Education. 6-40

Levels of Segmented Statements –
Part 4

© McGraw-Hill Education. 6-41

Levels of Segmented Statements –
Part 5

Common fixed expenses should not be allocated

to the divisions. These expenses would remain
even if one of the divisions were eliminated.
© McGraw-Hill Education. 6-42
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.

© McGraw-Hill Education. 6-43

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

© McGraw-Hill Education. 6-44

Traceable Fixed Costs Can Become
Common Fixed Costs – Part 3

We obtained the following information from the

Regular and Big Screen segments.
© McGraw-Hill Education. 6-45
 Traceable Fixed Costs Can Become
Common Fixed Costs – Part 4
Fixed costs directly traced to the Television
Division $80,000 + $10,000 = $90,000

© McGraw-Hill Education. 6-46

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.

© McGraw-Hill Education. 6-47

Segmented Income Statements—
Decision Making (1 of 2)

© McGraw-Hill Education. 6-48

Segmented Income Statements—
Decision Making (2 of 2)
• 5% increase in sales: Sales Television Division
$210,000
• $5,000 additional advertising: Common expenses
Television division 15,000
• Division margin increases by $2,500: Divisional
margin: Television Division $ 62,500
• Margin increases by $5,250 CM: Regular
110,250, product line margin $ 65,250
• Margin increases by $2,250 CM: Regular 47,250
product line margin $ 12,250

© McGraw-Hill Education. 6-49

 Learning Objective 5
Compute companywide and segment break-
even points for a company with traceable fixed
costs.

© McGraw-Hill Education. 6-50

Segmented Income Statements —
Break-even Analysis – Part 1

© McGraw-Hill Education. 6-51

Segmented Income Statements —
Break-even Analysis – Part 2

Calculate the company-wide break-even point.

© McGraw-Hill Education. 6-52

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.
$170,000  $25,000
Break - even point   $361,111
0.54
$270,000
Contributi on Margin Ratio   0.54
$500,000

© McGraw-Hill Education. 6-53

Segmented Income Statements —
Break-even Analysis – Part 4

Calculate break-even point for each business

segment.
© McGraw-Hill Education. 6-54
 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
$90,000
Break - even Point = = $180,000
0.50
$150,000
Contribution Margin Ratio = = 0.50
$300,000
Computer
$80,000
Break - even Point = = $133,333
0.60
$120,000
Contribution Margin Ratio = = 0.60
$200,000

© McGraw-Hill Education. 6-55

 Segmented Income Statements —
Break-even Analysis – Part 6

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.

© McGraw-Hill Education. 6-56

 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

© McGraw-Hill Education. 6-57

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.

© McGraw-Hill Education. 6-58

 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.

© McGraw-Hill Education. 6-59

 Quick Check 2

Assume that Hoagland's Lakeshore prepared its

segmented income statement as shown.

© McGraw-Hill Education. 6-60

 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.

© McGraw-Hill Education. 6-61

 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.
Answer: a
Common fixed expenses cannot be eliminated by
dropping one of the segments.

© McGraw-Hill Education. 6-62

 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

© McGraw-Hill Education. 6-63

 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
b. $30,000
c. $40,000
d. $50,000
Answer: a
The bar would be allocated 1/10 of the cost or
$20,000.

© McGraw-Hill Education. 6-64

 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?

© McGraw-Hill Education. 6-65

Quick Check 2f

© McGraw-Hill Education. 6-66

 Quick Check 2g

Do you think the Bar should be eliminated?

© McGraw-Hill Education. 6-67

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

© McGraw-Hill Education. 6-68

 Quick Check 2i (1 of 2)
Should the bar be eliminated?
a. Yes
b. No
Answer: b

© McGraw-Hill Education. 6-69

 Quick Check 2i (2 of 2)
The profit was $44,000 before eliminating the
bar. If we eliminate the bar, profit drops to
$30,000!

© McGraw-Hill Education. 6-70

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.

© McGraw-Hill Education. 6-71

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.

© McGraw-Hill Education. 6-72

 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.

© McGraw-Hill Education. 6-73

 End of Presentation

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
6-74
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.