Variable Costing & Segmented Reporting

November 18, 2015 Variable Costing & Segmented Reporting

Agenda • Variable vs Absorption (or Full) Costing • Cost classifications under each • Income statement comparison and income effects • Advantages of variable costing • Segmented reporting • Traceable and common fixed costs • Cautions on allocating fixed costs

ProductCosts Direct Materials ProductCosts Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead PeriodCosts PeriodCosts Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Overview of Variable and Absorption Costing VariableCosting AbsorptionCosting

Unit Cost Computations Hy Company produces a single product with the following information available:

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.

Variable and Absorption Costing Income Statements Assume the following additional information for Hy Company. • 20,000 units were sold during the year at a priceof $30 each. • There is no beginning inventory. Compute net operating income using both absorption and variable costing.

All fixedmanufacturingoverhead isexpensed. Variablemanufacturing costs only. Variable Costing Contribution Format Income Statement

Unit product cost. Absorption Costing Income Statement Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000.

Extended Comparisons of Income Data Hy Company – Year Two

All fixedmanufacturingoverhead isexpensed. Variablemanufacturing costs only. Variable Costing Contribution Format Income Statement

Unit product cost. Absorption Costing Income Statement Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000.

Summary of Key Insights

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.

Inventory as a lever to Net Income • Net Income can be increased by increasing production • The more produced, and unsold, inventory is built • As inventory is built, product costs are held on the balance sheet, in inventory • Not expensed in COGS • Variable product costs of excess production will have no impact • Incremental costs all transfer into inventory • Fixed product costs, however, get defrayed into inventory • Unit fixed costs will have decreased • The unit costs in COGS will decrease • Net income increases

Inventory as a lever to Net Income • Financial Accounting vs Managerial Accounting • Financial Accounting requires certain inventory valuation methods which leads towards absorption costing • Managerial Accounting gives latitude to use variable costing to aid in CVP analysis and business decisions • Given the reporting benefits of increasing production on Net Income, why wouldn’t a company endlessly increase production?

Inventory as a lever to Net Income • Given the reporting benefits of increasing production on Net Income, why wouldn’t a company endlessly increase production? • Impact on cash? • Cost of borrowing? • Potential obsolescence? • Incremental step function fixed costs? • Ethics?

Inventory as a lever to Net Income • Given the reporting benefits of increasing production on Net Income, why wouldn’t a company endlessly increase production? • Impact on cash? • Cost of borrowing? • Potential obsolescence? • Incremental step function fixed costs? • Ethics? • Inventory is a “use” of cash • Interest costs reduce NI • Inventory write-down • New fixed costs, backfire • Do what’s best for the business, not what drives a performance measure

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.

Identifying Traceable Fixed Costs Traceable fixed costsarise 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. Identifying Traceable Fixed Costs Traceable fixed costsarise because of the existence of a particular segment and would disappear over time if the segment itself disappeared.

Identifying Common Fixed Costs Common fixed costsarise 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. Identifying Common Fixed Costs Common fixed costsarise because of the overall operation of the company and would not disappear if any particular segment were eliminated.

Common vs Traceable Costs • Cost • Tax on only factory building • Tax on bike factory building of conglomerate • EVP Marketing • Supply Chain Management Dept. • Quality control department • Research & Development • Delivery truck • Raw materials • Bicycle assembler

Common vs Traceable Costs Traceable or Common? Common Traceable to Bike Segment Common, most likely Dependent on dept. Structure Is QC testing one or all products? Should be traceable by time spent Should be traceable by # of deliveries Not a fixed cost Not a fixed cost • Cost • Tax on only factory building • Tax on bike factory building of conglomerate • EVP Marketing • Supply Chain Management Dept. • Quality control department • Research & Development • Delivery truck • Raw materials • Bicycle assembler

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, or sub-segment.

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, or sub-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.

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

Segment 1 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: • 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 2 Segment 3 Segment 4

Segment 1 Common Costs and Segments • There is no perfect solution for common cost allocation • Just as there was no perfect solution for allocating the overhead portion of product costs • Remember POHR and ABC? • Each company will conduct a full analysis, negotiate with its managers and arrive at a reasonable and motivating allocation method Segment 2 Segment 3 Segment 4

Review • Variable versus Absorption Costing (or Full Costing) • Cost classifications under each • Income statement comparison and income effects • Advantages of variable costing • Segmented reporting • Traceable and common fixed costs • Cautions on allocating fixed costs

Variable Costing & Segmented Reporting