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CHAPTER 6 Variable Costing and Segment Reporting: Tools for Management Misguided Incentives in the Auto Industry BUSIN ESS FO CUS LEARNING OBJECTIVES After studying Chapter 6, you should be able to: When the economy tanks, automakers, such as General Motors and Chrysler, often “flood the market” with a supply of vehicles that far exceeds customer demand. They pursue this course of action even though it tarnishes their brand image and increases their auto storage costs, tire replacement costs, customer rebate costs, and advertising costs. This begs the question why would managers knowingly produce more vehicles than are demanded by customers? In the auto industry, a manager’s bonus is often influenced by her company’s reported profits; thus, there is a strong incentive to boost profits by producing more units. How can this be done you ask? It would seem logical that producing more units would have no impact on profits unless the units were sold, right? Wrong! As we will discover in this chapter, absorption costing—the most widely used method of determining product costs—can artificially increase profits when managers choose to increase the quantity of units produced. ■ Source: Marielle Segarra, “Lots of Trouble,” CFO, March 2012, pp. 29–30. LO6–1 Explain how variable costing differs from absorption costing and compute unit product costs under each method. LO6–2 Prepare income statements using both variable and absorption costing. LO6–3 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. LO6–4 Prepare a segmented income statement that differentiates traceable fixed costs from common fixed costs and use it to make decisions. LO6–5 Compute companywide and segment break-even points for a company with traceable fixed costs. LO6–6 (Appendix 6A) Prepare an income statement using super-variable costing and reconcile this approach with variable costing. 233 234 Chapter 6 his chapter describes two applications of the contribution for- T mat income statements that were introduced in earlier chapters. First, it explains how manufacturing companies can prepare variable costing income statements, which rely on the contribution format, for internal decision making purposes. The variable costing approach will be contrasted with absorption costing income statements, which were discussed in Chapter 3 and are generally used for external reports. Ordinarily, variable costing and absorption costing produce different net operating income figures, and the difference can be quite large. In addition to showing how these two methods differ, we will describe the advantages of variable costing for internal reporting purposes and we will show how management decisions can be affected by the costing method chosen. Second, the chapter explains how the contribution format can be used to prepare segmented income statements. In addition to companywide income statements, managers need to measure the profitability of individual segments of their organizations. A segment is a part or activity of an organization about which managers would like cost, revenue, or profit data. This chapter explains how to create contribution format income statements that report profit data for business segments, such as divisions, individual stores, geographic regions, customers, and product lines. Overview of Variable and Absorption Costing LO6–1 Explain how variable costing differs from absorption costing and compute unit product costs under each method. As you begin to read about variable and absorption costing income statements in the coming pages, focus your attention on three key concepts. First, both income statement formats include product costs and period costs, although they define these cost classifications differently. Second, variable costing income statements are grounded in the contribution format. They categorize expenses based on cost behavior—variable expenses are reported separately from fixed expenses. Absorption costing income statements ignore variable and fixed cost distinctions. Third, as mentioned in the paragraph above, variable and absorption costing net operating income figures often differ from one another. The reason for these differences always relates to the fact the variable costing and absorption costing income statements account for fixed manufacturing overhead differently. Pay very close attention to the two different ways that variable costing and absorption costing account for fixed manufacturing overhead. Variable Costing Under variable costing, only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and, like selling and administrative expenses, it is expensed in its entirety each period. Consequently, the cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost. Variable costing is sometimes referred to as direct costing or marginal costing. Absorption Costing As discussed in Chapter 3, absorption costing treats all manufacturing costs as product costs, regardless of whether they are variable or fixed. The cost of a unit of product under the absorption costing method consists of direct materials, direct labor, and both variable and fixed manufacturing overhead. Thus, absorption costing allocates a portion of fixed Variable Costing and Segment Reporting: Tools for Management 235 manufacturing overhead cost to each unit of product, along with the variable manufacturing costs. Because absorption costing includes all manufacturing costs in product costs, it is frequently referred to as the full cost method. Selling and Administrative Expenses Selling and administrative expenses are never treated as product costs, regardless of the costing method. Thus, under absorption and variable costing, variable and fixed selling and administrative expenses are always treated as period costs and are expensed as incurred. Summary of Differences The essential difference between variable costing and absorption costing, as illustrated in Exhibit 6–1, is how each method accounts for fixed manufacturing overhead costs—all other costs are treated the same under the two methods. In absorption costing, fixed manufacturing overhead costs are included as part of the costs of work in process inventories. When units are completed, these costs are transferred to finished goods and only when the units are sold do these costs flow through to the income statement as part of cost of goods sold. In variable costing, fixed manufacturing overhead costs are considered to be period costs—just like selling and administrative costs—and are taken immediately to the income statement as period expenses. EXHIBIT 6–1 Variable Costing versus Absorption Costing Costs Manufacturing costs Balance Sheet Raw materials purchases Raw Materials inventory Direct materials used in production Direct labor Variable manufacturing overhead Ab so co rptio sti ng n Work in Process inventory Goods completed (cost of goods manufactured) Income Statement Cost of Goods Sold Finished Goods inventory Fixed manufacturing overhead Goods sold Variab le costin g Nonmanufacturing costs Selling and administrative Period Expenses 236 Chapter 6 Variable and Absorption Costing—An Example To illustrate the difference between variable costing and absorption costing, consider Weber Light Aircraft, a company that produces light recreational aircraft. Data concerning the company’s operations appear below: Per Aircraft Selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . . . . . Fixed manufacturing overhead . . . . . . . . . . . . . . . . . . . Variable selling and administrative expenses . . . . . . . . Fixed selling and administrative expenses . . . . . . . . . Beginning inventory . . . . . . . . . . . . . . . . . . . . . . . . . . Units produced . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Units sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ending inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . Per Month $100,000 $19,000 $5,000 $1,000 $70,000 $10,000 $20,000 January February March 0 1 1 0 0 2 1 1 1 4 5 0 As you review the data above, it is important to realize that for the months of January, February, and March, the selling price per aircraft, variable cost per aircraft, and total monthly fixed expenses never change. The only variables that change in this example are the number of units produced (January 5 1 unit produced; February 5 2 units produced; March 5 4 units produced) and the number of units sold (January 5 1 unit sold; February 5 1 unit sold; March 5 5 units sold). We will first construct the company’s variable costing income statements for January, February, and March. Then we will show how the company’s net operating income would be determined for the same months using absorption costing. Variable Costing Contribution Format Income Statement LO6–2 Prepare income statements using both variable and absorption costing. To prepare the company’s variable costing income statements for January, February, and March we begin by computing the unit product cost. Under variable costing, product costs consist solely of variable production costs. At Weber Light Aircraft, the variable production cost per unit is $25,000, determined as follows: Variable Costing Unit Product Cost Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . . . . . . . . Variable costing unit product cost . . . . . . . . . . . . . . . . . . . $19,000 5,000 1,000 $25,000 Since each month’s variable production cost is $25,000 per aircraft, the variable costing cost of goods sold for all three months can be easily computed as follows: Variable Costing Cost of Goods Sold January Variable production cost (a) . . . . . . . . . . . . . . . . . Units sold (b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable cost of goods sold (a) 3 (b) . . . . . . . . . . $25,000 1 $25,000 February March $25,000 1 $25,000 $25,000 5 $125,000 Variable Costing and Segment Reporting: Tools for Management 237 And the company’s total selling and administrative expense would be derived as follows: Selling and Administrative Expenses January Variable selling and administrative expense (@ $10,000 per unit sold) . . . . . . . . . . . . . . . . . . Fixed selling and administrative expense . . . . . . . Total selling and administrative expense . . . . . . . . $10,000 20,000 $30,000 February March $10,000 20,000 $30,000 $50,000 20,000 $70,000 Putting it all together, the variable costing income statements would appear as shown in Exhibit 6–2. Notice, the contribution format has been used in these income statements. Also, the monthly fixed manufacturing overhead costs ($70,000) have been recorded as a period expense in the month incurred. Variable Costing Contribution Format Income Statements January February Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable expenses: Variable cost of goods sold . . . . . . . . . . . . Variable selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . . . Total variable expenses . . . . . . . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . . . . . . . . Fixed expenses: Fixed manufacturing overhead . . . . . . . . . . Fixed selling and administrative expense . . . Total fixed expenses . . . . . . . . . . . . . . . . . . . Net operating income (loss) . . . . . . . . . . . . . . March $100,000 $100,000 $500,000 25,000 25,000 125,000 10,000 35,000 65,000 10,000 35,000 65,000 50,000 175,000 325,000 70,000 20,000 90,000 $ (25,000) 70,000 20,000 90,000 $ (25,000) 70,000 20,000 90,000 $235,000 A simple method for understanding how Weber Light Aircraft computed its variable costing net operating income figures is to focus on the contribution margin per aircraft sold, which is computed as follows: Contribution Margin per Aircraft Sold Selling price per aircraft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable production cost per aircraft . . . . . . . . . . . . . . . . . . . . Variable selling and administrative expense per aircraft . . . . . Contribution margin per aircraft . . . . . . . . . . . . . . . . . . . . . . . $100,000 $25,000 10,000 35,000 $ 65,000 The variable costing net operating income for each period can always be computed by multiplying the number of units sold by the contribution margin per unit and then subtracting total fixed costs. For Weber Light Aircraft these computations would appear as follows: Number of aircraft sold . . . . . . . . . . . . . . . Contribution margin per aircraft . . . . . . . . . Total contribution margin . . . . . . . . . . . . . . Total fixed expenses . . . . . . . . . . . . . . . . . . Net operating income (loss) . . . . . . . . . . . . January February March 1 3 $65,000 $65,000 90,000 $(25,000) 1 3 $65,000 $65,000 90,000 $(25,000) 5 3 $65,000 $325,000 90,000 $235,000 Notice, January and February have the same net operating loss. This occurs because one aircraft was sold in each month and, as previously mentioned, the selling price per aircraft, variable cost per aircraft, and total monthly fixed expenses remain constant. EXHIBIT 6–2 Variable Costing Income Statements 238 Chapter 6 Absorption Costing Income Statement As we begin the absorption costing portion of the example, remember that the only reason absorption costing income differs from variable costing is that the methods account for fixed manufacturing overhead differently. Under absorption costing, fixed manufacturing overhead is included in product costs. In variable costing, fixed manufacturing overhead is not included in product costs and instead is treated as a period expense just like selling and administrative expenses. The first step in preparing Weber’s absorption costing income statements for January, February, and March is to determine the company’s unit product costs for each month as follows1: Absorption Costing Unit Product Cost January Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable manufacturing overhead . . . . . . . . . . . . . . . Fixed manufacturing overhead ($70,000 4 1 unit produced in January; $70,000 4 2 units produced in February; $70,000 4 4 units produced in March) . . . Absorption costing unit product cost . . . . . . . . . . . . February March $19,000 5,000 1,000 $19,000 5,000 1,000 $19,000 5,000 1,000 70,000 $95,000 35,000 $60,000 17,500 $42,500 Notice that in each month, Weber’s fixed manufacturing overhead cost of $70,000 is divided by the number of units produced to determine the fixed manufacturing overhead cost per unit. Given these unit product costs, the company’s absorption costing net operating income in each month would be determined as shown in Exhibit 6–3. The sales for all three months in Exhibit 6–3 are the same as the sales shown in the variable costing income statements. The January cost of goods sold consists of one unit produced during January at a cost of $95,000 according to the absorption costing system. The February cost of goods sold consists of one unit produced during February at a cost of $60,000 according to the absorption costing system. The March cost of goods sold ($230,000) consists of one unit produced during February at an absorption cost of $60,000 plus four units produced in March with a total absorption cost of $170,000 (5 4 units produced 3 $42,500 per unit). The selling and administrative expenses equal the amounts reported in the variable costing income statements; however they are reported as one amount rather than being separated into variable and fixed components. EXHIBIT 6–3 Absorption Costing Income Statements Absorption Costing Income Statements January February Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold ($95,000 3 1 unit; $60,000 3 1 unit; $60,000 3 1 unit 1 $42,500 3 4 units) . . . Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . Net operating income (loss) . . . . . . . . . . . . . . 1 March $100,000 $100,000 $500,000 95,000 5,000 30,000 $ (25,000) 60,000 40,000 30,000 $ 10,000 230,000 270,000 70,000 $200,000 For simplicity, we assume in this section that an actual costing system is used in which actual costs are spread over the units produced during the period. If a predetermined overhead rate were used, the analysis would be similar, but more complex. Variable Costing and Segment Reporting: Tools for Management 239 Note that even though sales were exactly the same in January and February and the cost structure did not change, net operating income was $35,000 higher in February than in January under absorption costing. This occurs because one aircraft produced in February is not sold until March. This aircraft has $35,000 of fixed manufacturing overhead attached to it that was incurred in February, but will not be recorded as part of cost of goods sold until March. Contrasting the variable costing and absorption costing income statements in Exhibits 6–2 and 6–3, note that net operating income is the same in January under variable costing and absorption costing, but differs in the other two months. We will discuss this in some depth shortly. Also note that the format of the variable costing income statement differs from the absorption costing income statement. An absorption costing income statement categorizes costs by function—manufacturing versus selling and administrative. All of the manufacturing costs flow through the absorption costing cost of goods sold and all of the selling and administrative expenses are listed separately as period expenses. In contrast, in the contribution approach, costs are categorized according to how they behave. All of the variable expenses are listed together and all of the fixed expenses are listed together. The variable expenses category includes manufacturing costs (i.e., variable cost of goods sold) as well as selling and administrative expenses. The fixed expenses category also includes both manufacturing costs and selling and administrative expenses. THE BEHAVIORAL SIDE OF CALCULATING UNIT PRODUCT COSTS IN BUSINESS Andreas STIHL, a manufacturer of chain saws and other landscaping products, asked its U.S. subsidiary, STIHL Inc., to replace its absorption costing income statements with the variable costing approach. From a computer systems standpoint, the change was not disruptive because STIHL used an enterprise system called SAP that accommodates both absorption and variable costing. However, from a behavioral standpoint, STIHL felt the change could be very disruptive. For example, STIHL’s senior managers were keenly aware that the variable costing approach reported lower unit product costs than the absorption costing approach. Given this reality, the sales force might be inclined to erroneously conclude that each product had magically become more profitable, thereby justifying ill-advised price reductions. Because of behavioral concerns such as this, STIHL worked hard to teach its employees how to interpret a variable costing income statement. Source: Carl S. Smith, “Going for GPK: STIHL Moves Toward This Costing System in the United States,” Strategic Finance, April 2005, pp. 36–39. Reconciliation of Variable Costing with Absorption Costing Income As noted earlier, variable costing and absorption costing net operating incomes may not be the same. In the case of Weber Light Aircraft, the net operating incomes are the same in January, but differ in the other two months. These differences occur because under absorption costing some fixed manufacturing overhead is capitalized in inventories (i.e., included in product costs) rather than being immediately expensed on the income statement. If inventories increase during a period, under absorption costing some of the fixed manufacturing overhead of the current period will be deferred in ending inventories. For example, in February two aircraft were produced and each carried with it $35,000 (5 $70,000 4 2 aircraft produced) in fixed manufacturing overhead. Since only one aircraft was sold, $35,000 of this fixed manufacturing overhead was on February’s absorption costing income statement as part of cost of goods sold, but $35,000 would have been on the balance sheet as part of finished goods inventories. In contrast, under variable costing all of the $70,000 of fixed manufacturing overhead appeared on the February income LO6–3 Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ. 240 Chapter 6 statement as a period expense. Consequently, net operating income was higher under absorption costing than under variable costing by $35,000 in February. This was reversed in March when four units were produced, but five were sold. In March, under absorption costing $105,000 of fixed manufacturing overhead was included in cost of goods sold ($35,000 for the unit produced in February and sold in March plus $17,500 for each of the four units produced and sold in March), but only $70,000 was recognized as a period expense under variable costing. Hence, the net operating income in March was $35,000 lower under absorption costing than under variable costing. In general, when the units produced exceed unit sales and hence inventories increase, net operating income is higher under absorption costing than under variable costing. This occurs because some of the fixed manufacturing overhead of the period is deferred in inventories under absorption costing. In contrast, when unit sales exceed the units produced and hence inventories decrease, net operating income is lower under absorption costing than under variable costing. This occurs because some of the fixed manufacturing overhead of previous periods is released from inventories under absorption costing. When the units produced and unit sales are equal, no change in inventories occurs and absorption costing and variable costing net operating incomes are the same.2 Variable costing and absorption costing net operating incomes can be reconciled by determining how much fixed manufacturing overhead was deferred in, or released from, inventories during the period: Fixed Manufacturing Overhead Deferred in, or Released from, Inventories under Absorption Costing January February Fixed manufacturing overhead in ending inventories . . . . . . . . . . . . . . . . . . . . . . . Fixed manufacturing overhead in beginning inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed manufacturing overhead deferred in (released from) inventories . . . . . . . . . . . . . . . . March $0 $35,000 $ 0 0 0 35,000 $0 $35,000 $(35,000) In equation form, the fixed manufacturing overhead that is deferred in or released from inventories can be determined as follows: Manufacturing overhead Fixed manufacturing Fixed manufacturing deferred in overhead in overhead in 5 2 (released from) inventory ending inventories beginning inventories The reconciliation would then be reported as shown in Exhibit 6–4: EXHIBIT 6–4 Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes January February March Variable costing net operating income (loss) . . . . . $(25,000) $(25,000) $235,000 Add (deduct) fixed manufacturing overhead deferred in (released from) inventory under 0 35,000 (35,000) absorption costing . . . . . . . . . . . . . . . . . . . . . . . . Absorption costing net operating income (loss) . . . $(25,000) $ 10,000 $200,000 2 These general statements about the relation between variable costing and absorption costing net operating income assume LIFO is used to value inventories. Even when LIFO is not used, the general statements tend to be correct. Although U.S. GAAP allows LIFO and FIFO inventory flow assumptions, International Financial Reporting Standards do not allow a LIFO inventory flow assumption. Variable Costing and Segment Reporting: Tools for Management Relation between Production and Sales for the Period Effect on Inventories Relation between Absorption and Variable Costing Net Operating Incomes Units produced 5 Units sold No change in inventories Absorption costing net operating income 5 Variable costing net operating income Units produced . Units sold Inventories increase Absorption costing net operating income . Variable costing net operating income* Units produced , Units sold Inventories decrease Absorption costing net operating income , Variable costing net operating income† *Net operating income is higher under absorption costing because fixed manufacturing overhead cost is deferred in inventory under absorption costing as inventories increase. † Net operating income is lower under absorption costing because fixed manufacturing overhead cost is released from inventory under absorption costing as inventories decrease. Again note that the difference between variable costing net operating income and absorption costing net operating income is entirely due to the amount of fixed manufacturing overhead that is deferred in, or released from, inventories during the period under absorption costing. Changes in inventories affect absorption costing net operating income—they do not affect variable costing net operating income, providing that variable manufacturing costs per unit are stable. The reasons for differences between variable and absorption costing net operating incomes are summarized in Exhibit 6–5. When the units produced equal the units sold, as in January for Weber Light Aircraft, absorption costing net operating income will equal variable costing net operating income. This occurs because when production equals sales, all of the fixed manufacturing overhead incurred in the current period flows through to the income statement under both methods. For companies that use Lean Production, the number of units produced tends to equal the number of units sold. This occurs because goods are produced in response to customer orders, thereby eliminating finished goods inventories and reducing work in process inventory to almost nothing. So, when a company uses Lean Production differences in variable costing and absorption costing net operating income will largely disappear. When the units produced exceed the units sold, absorption costing net operating income will exceed variable costing net operating income. This occurs because inventories have increased; therefore, under absorption costing some of the fixed manufacturing overhead incurred in the current period is deferred in ending inventories on the balance sheet, whereas under variable costing all of the fixed manufacturing overhead incurred in the current period flows through to the income statement. In contrast, when the units produced are less than the units sold, absorption costing net operating income will be less than variable costing net operating income. This occurs because inventories have decreased; therefore, under absorption costing fixed manufacturing overhead that had been deferred in inventories during a prior period flows through to the current period’s income statement together with all of the fixed manufacturing overhead incurred during the current period. Under variable costing, just the fixed manufacturing overhead of the current period flows through to the income statement. 241 EXHIBIT 6–5 Comparative Income Effects— Absorption and Variable Costing 242 Chapter 6 IN BUSINESS LEAN MANUFACTURING SHRINKS INVENTORIES Conmed, a surgical device maker in Utica, New York, switched to lean manufacturing by replacing its assembly lines with U-shaped production cells. It also started producing only enough units to satisfy customer demand rather than producing as many units as possible and storing them in warehouses. The company calculated that its customers use one of its disposable surgical devices every 90 seconds, so that is precisely how often it produces a new unit. Its assembly area for fluid-injection devices used to occupy 3,300 square feet of space and contained $93,000 worth of parts. Now the company produces its fluid-injection devices in 660 square feet of space while maintaining only $6,000 of parts inventory. When Conmed adopted lean manufacturing, it substantially reduced its finished goods inventories. What impact do you think this initial reduction in inventories may have had on net operating income? Why? Source: Pete Engardio, “Lean and Mean Gets Extreme,” BusinessWeek, March 23 and 30, 2009, pp. 60–62. Advantages of Variable Costing and the Contribution Approach Variable costing, together with the contribution approach, offers appealing advantages for internal reports. This section discusses three of those advantages. Enabling CVP Analysis CVP analysis requires that we break costs down into their fixed and variable components. Because variable costing income statements categorize costs as fixed and variable, it is much easier to use this income statement format to perform CVP analysis than attempting to use the absorption costing format, which mixes together fixed and variable costs. Moreover, absorption costing net operating income may or may not agree with the results of CVP analysis. For example, let’s suppose that you are interested in computing the sales that would be necessary to generate a target profit of $235,000 at Weber Light Aircraft. A CVP analysis based on the January variable costing income statement from Exhibit 6–2 would proceed as follows: Sales (a) . . . . . . . . . . . . . . . . . . . . . . . . . . . Contribution margin (b) . . . . . . . . . . . . . . . Contribution margin ratio (b) 4 (a) . . . . . . . Total fixed expenses . . . . . . . . . . . . . . . . . $100,000 $65,000 65% $90,000 Target profit 1 Fixed expenses Dollar sales to attain target profit 5 _________________________ CM ratio $235,000 1 $90,000 5 _________________ 5 $500,000 0.65 Thus, a CVP analysis based on the January variable costing income statement predicts that the net operating income would be $235,000 when sales are $500,000. And indeed, the net operating income under variable costing is $235,000 when the sales are $500,000