Diego Company

unit_4_homework_template1.xlsacct_ch06

The problem for Foundational 15 is on page 264-265, Diego Company while Ethics Challenge is on page 278-279.

>The Foundational

.00

00,000.00

expenses

6,000.00

Variable manufacturing overhead
Fixed manufacturing overhead

-4

Variable selling and administrative

Fixed manufacturing overhead

Fixed selling and administrative

Sales

per unit

Sales

Variable expenses:
Variable cost of goods sold
Variable selling and administrative
Contribution margin
Fixed expenses:
Fixed manufacturing overhead
Fixed selling and administrative
Net operating gain (loss)

Sales

Variable expenses

Contribution margin

Net operating gain (loss)

Variable costs

per unit

Manufacturing:

Direct Materials

$ 24.00

Direct Labor

Variable manufacturing overhead

$ 2.00

Variable selling and administrative

$ 4.00

Fixed costs per year

Fixed manufacturing overhead

Fixed selling and administrative

$ 4

Variable costing

Absorption costing

1 – 2

Direct materials

Direct labor

Unit product cost

Sales

Variable expenses

Variable cost of goods sold

Contribution margin

Fixed expenses:

Net operating gain (loss)

5-6

Cost of goods sold

Gross margin

Selling and administrative expenses

Net operating income

Variable costing net operating income

Add: fixed manufacturing overhead

deferred in inventory under absorption costing

units

Absorption costing net operating income

Profit

Unit CM X Q – Fixed expenses

10-11

Total

East

West

Traceable fixed expenses

Region segment margin

Common fixed expenses

not traceable to regions

Foregone segment margin in the West region

Additional contribution margin in the East region

Increase (decrease) in profits if the West region is dropped

15.

Additional advertising

Additional contribution margin in the West region

Increase in profits

Ethics Challenge

units

2 Desired Inventory, December 31 units

Expected sales, last quarter units
Total needs units
Less inventory, September 30 units
Required production units

	Desired Inventory, December 31
	Expected sales, last quarter
	Total needs
	Less inventory, September 30
	Required production

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CHAPTER OUTLINE

Overview of Variable and Absorption Costing

• Variable Costing

• Absorption Costing

• Selling and Administrative Expenses

Variable and Absorption Costing—An Example

• Variable Costing Contribution Format Income Statement

• Absorption Costing Income Statement

Reconciliation of Variable Costing with Absorption
Costing Income

Advantages of Variable Costing and
the Contribution Approach

• Enabling CVP Analysis

• Explaining Changes in Net Operating Income

• Supporting Decision Making

• Adapting to the Theory of Constraints

Segmented Income Statements and the Contribution
Approach

• Traceable and Common Fixed Costs and the Segment Margin

• Identifying Traceable Fixed Costs

• Traceable Costs Can Become Common Costs

Segmented Income Statements—An Example

• Levels of Segmented Income Statements

• Segmented Income Statements and Decision Making

Segmented Income Statements—Common Mistakes

• Omission of Costs

• Inappropriate Methods for Assigning Traceable Costs among
Segments

• Arbitrarily Dividing Common Costs among Segments

Income Statements—An External Reporting Perspective

• Companywide Income Statements

• Segmented Financial Information

Variable Costing and
Segment Reporting:
Tools for Management 6

A LOOK AT THIS CHAPTER
This chapter explains how to use
the contribution format to create
variable costing income statements
for manufacturers and segmented
income statements. It also contrasts
variable costing income statements and
absorption income statements.

A LOOK AHEAD
Chapter 7 describes the budgeting
process.

A LOOK BACK
Chapter 5 explained how to compute
a break-even point and how to
determine the sales needed to achieve
a desired profit. We also described
how to compute and use the margin of
safety and operating leverage.

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237

DECISION FEATURE LEARNING
OBJECTIVES

After studying Chapter 6,
you should be able to:

LO1 Explain how variable
costing differs from absorp-
tion costing and compute
unit product costs under
each method.

LO2 Prepare income
statements using both vari-
able and absorption costing.

LO3 Reconcile variable
costing and absorption
costing net operating
incomes and explain why
the two amounts differ.

LO4 Prepare a segmented
income statement that
differentiates traceable
fixed costs from common
fixed costs and use it to
make decisions.

IBM’s $2.5 Billion Investment in Technology
When it comes to state-of-the-art in automation, IBM’s $2.5 billion semiconductor manufacturing
facility in East Fishkill, New York, is tough to beat. The plant uses wireless networks, 600 miles of cable,
and more than 420 servers to equip itself with what IBM claims is more computing power than NASA
uses to launch a space shuttle.

Each batch of 25 wafers (one wafer can be processed into 1,000 computer chips) travels through
the East Fishkill plant’s manufacturing process without ever being touched by human hands. A
computer system “looks at orders and schedules production runs . . . adjusts schedules to allow for
planned maintenance and . . . feeds vast reams of production data into enterprise-wide management
and financial-reporting systems.” The plant can literally run itself as was the case a few years ago when
a snowstorm hit and everyone went home while the automated system continued to manufacture
computer chips until it ran out of work.

In a manufacturing environment such as this, labor costs are insignificant and fixed overhead costs
are huge. There is a strong temptation to build inventories and increase profits without increasing sales.
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
by increasing the quantity of units produced.

Source: Ghostwriter, “Big Blue’s $2.5 Billion Sales Tool,” Fortune, September 19, 2005, pp. 316F–316J.

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238 Chapter 6

T his chapter describes two applications of the contribution format income statements that were introduced in Chapters 1 and 5. 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 state-
ments, which were discussed in Chapter 2 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, man-
agers 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
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 classifica-
tions differently. Second, variable costing income statements are grounded in the con-
tribution format. They categorize expenses based on cost behavior—variable costs are
reported separately from fixed costs. Absorption costing income statements ignore vari-
able 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 manu-
facturing overhead cost. Variable costing is sometimes referred to as direct costing or
marginal costing.

Absorption Costing
As discussed in Chapter 2, 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

LEARNING OBJECTIVE 1

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

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239Variable Costing and Segment Reporting: Tools for Management

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 cost-
ing, 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.

E X H I B I T 6–1 Variable Costing versus Absorption Costing

Manufacturing costs

Finished Goods inventory

Goods completed
(cost of goods
manufactured)

Period Expenses

Income Statement

Balance Sheet

Costs

Cost of Goods Sold
Goods
sold

Variable costin

Ab
so

rp
tio

n
co

st
in

g
Ab
so
rp
tio
n
co
st
in
g

Direct materials
used in production

Work in Process inventory

Raw Materials inventory

Variable
manufacturing

overhead

Fixed
manufacturing

overhead

Raw materials
purchases

Direct labor

Nonmanufacturing costs

Selling and
administrative

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240 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 concern-
ing the company’s operations appear below:

Per Aircraft Per Month

Selling price ……………………………………………………………. $100,000
Direct materials ………………………………………………………. $19,000
Direct labor …………………………………………………………….. $5,000
Variable manufacturing overhead ……………………………… $1,000
Fixed manufacturing overhead ………………………………….. $70,000
Variable selling and administrative expenses ………………. $10,000
Fixed selling and administrative expenses ………………….. $20,000

January February March

Beginning inventory ……………………………………………. 0 0 1
Units produced …………………………………………………… 1 2 4
Units sold ………………………………………………………….. 1 1 5
Ending inventory ………………………………………………… 0 1 0

As you review the data above, it is important to realize that for the months of January, Feb-
ruary, 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
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

LEARNING OBJECTIVE 2

Prepare income statements
using both variable and
absorption costing.

In this chapter all differences in net operating income between variable costing and absorption cost-
ing will be caused by the accounting for fixed manufacturing overhead. Variable costing treats fixed
manufacturing overhead as a period cost. This means that the entire amount of fixed manufactur-
ing overhead incurred each period is recorded as an expense on the income statement within that
period. Fixed manufacturing overhead is not attached to units of production. Absorption costing
treats fixed manufacturing overhead as a product cost. This means that the entire amount of fixed
manufacturing overhead incurred each period is attached to the units produced during that period.
The fixed manufacturing overhead attached to units of production is recorded as an expense on the
income statement only when the units are sold.

HELPFUL HINT

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241Variable Costing and Segment Reporting: Tools for Management

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 ………………………………………………………………….. $19,000
Direct labor ………………………………………………………………………… 5,000
Variable manufacturing overhead ………………………………………….. 1,000
Variable costing unit product cost………………………………………….. $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 February March

Variable production cost (a) ………………………………. $25,000 $25,000 $25,000
Units sold (b) ………………………………………………….. 1 1 5
Variable cost of goods sold (a) 3 (b) …………………. $25,000 $25,000 $125,000

And the company’s total selling and administrative expense would be derived as follows:

Selling and Administrative Expenses
January February March

Variable selling and administrative expense
(@ $10,000 per unit sold) ………………………………. $10,000 $10,000 $50,000
Fixed selling and administrative expense …………. 20,000 20,000 20,000
Total selling and administrative expense ………….. $30,000 $30,000 $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 March

Sales ………………………………………………………….. $100,000 $100,000 $500,000

Variable expenses:
Variable cost of goods sold …………………………. 25,000 25,000 125,000
Variable selling and administrative
expense ……………………………………………….. 10,000 10,000 50,000
Total variable expenses …………………………………. 35,000 35,000 175,000
Contribution margin ………………………………………. 65,000 65,000 325,000
Fixed expenses:
Fixed manufacturing overhead ……………………. 70,000 70,000 70,000
Fixed selling and administrative expense ……… 20,000 20,000 20,000
Total fi xed expenses ……………………………………… 90,000 90,000 90,000
Net operating income (loss) …………………………… $ (25,000) $ (25,000) $235,000

E X H I B I T 6–2
Variable Costing Income
Statements

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242 Chapter 6

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 ……………………………………………………….. $100,000
Variable production cost per aircraft ………………………………………. $25,000
Variable selling and administrative expense per aircraft ……………. 10,000 35,000
Contribution margin per aircraft …………………………………………….. $ 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 sub-
tracting total fixed costs. For Weber Light Aircraft these computations would appear
as follows:

January February March

Number of aircraft sold …………………….. 1 1 5
Contribution margin per aircraft …………. × $65,000 × $65,000 × $65,000
Total contribution margin…………………… $65,000 $65,000 $325,000
Total fi xed expenses ………………………… 90,000 90,000 90,000
Net operating income (loss) ………………. $(25,000) $(25,000) $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 air-
craft, variable cost per aircraft, and total monthly fixed expenses remain constant.

When students prepare variable costing income statements they often mistakenly assume that vari-
able selling and administrative expense is a product cost. The confusion arises because variable
selling and administrative expense is included in the calculation of contribution margin; however, it
is not a product cost. Variable selling and administrative expense is always a period cost and the
total amount of this expense included in the income statement is always derived by multiplying the
variable selling and administrative expense per unit by the number of units sold—not the number of
units produced.

HELPFUL HINT

Absorption Costing Income Statement
As we begin the absorption costing portion of the example, remember that the only rea-
son absorption costing income differs from variable costing is that the methods account
for fixed manufacturing overhead differently. Under absorption costing, fixed manufac-
turing 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 follows 1 :

1 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.

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243Variable Costing and Segment Reporting: Tools for Management

Absorption Costing Unit Product Cost
January February March

Direct materials …………………………………………………… $19,000 $19,000 $19,000
Direct labor …………………………………………………………. 5,000 5,000 5,000
Variable manufacturing overhead …………………………… 1,000 1,000 1,000
Fixed manufacturing overhead ($70,000 ÷ 1 unit
produced in January; $70,000 ÷ 2 units produced in
February; $70,000 ÷ 4 units produced in March) ….. 70,000 35,000 17,500
Absorption costing unit product cost ………………………. $95,000 $60,000 $42,500

Compute the unit product cost for each period mentioned in a problem before attempting to create
the income statements. To compute absorption costing unit product costs, always take the fixed
manufacturing overhead incurred in each period and divide it by the number of units produced
during that period. Do not use the number of units sold to calculate unit product costs. The number
of units sold is used to calculate the cost of goods sold for an income statement; however, the
number of units produced is used to compute unit product costs.

HELPFUL HINT

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 vari-
able 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 accord-
ing 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.

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

Absorption Costing Income Statements

January February March
Sales ………………………………………………………….. $100,000 $100,000 $500,000

Cost of goods sold ($95,000 × 1 unit;
$60,000 × 1 unit; $60,000 × 1 unit +
$42,500 × 4 units) ……………………………………. 95,000 60,000 230,000
Gross margin ………………………………………………. 5,000 40,000 270,000
Selling and administrative expenses ………………. 30,000 30,000 70,000
Net operating income (loss) …………………………… $ (25,000) $ 10,000 $200,000

E X H I B I T 6–3
Absorption Costing Income
Statements

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244 Chapter 6

February is not sold until March. This aircraft has $35,000 of fixed manufacturing over-
head 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 Exhib-
its 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 dif-
fers from the absorption costing income statement. An absorption costing income state-
ment 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 costs are listed separately as period expenses. In con-
trast, 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 cat-
egory also includes both manufacturing costs and selling and administrative expenses.

Be careful computing the cost of goods sold under absorption costing when the units that have
been sold were produced in more than one period. For example, if a company produces 8,000 units
and sells 10,000 units in year 2, it is wrong to compute the cost of goods sold for year 2 by
multiplying 10,000 units by the unit product cost for units produced in year 2. Logically speaking,
it is impossible for this solution to be correct because only 8,000 units were produced in year 2.
Assuming there is no ending inventory at the end of year 2, the correct cost of goods sold figure
would include 8,000 units multiplied by the unit product cost for units produced in year 2 plus 2,000
units multiplied by the unit product cost for units produced in year 1.

HELPFUL HINT

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 absorp-
tion costing some fixed manufacturing overhead is capitalized in inventories (i.e., included
in product costs) rather than currently 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 manufactur-
ing overhead appeared on the February income 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

LEARNING OBJECTIVE 3

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

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245Variable Costing and Segment Reporting: Tools for Management

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 pro-
duced and hence inventories decrease, net operating income is lower under absorption
costing than under variable costing. This occurs because some of the fixed manufactur-
ing 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 March

Fixed manufacturing overhead in
beginning inventories ………………………………………… $0 $ 0 $ 35,000
Fixed manufacturing overhead in ending
inventories ………………………………………………………. 0 35,000 0

Fixed manufacturing overhead deferred in
(released from) inventories ………………………………… $0 $35,000 $(35,000)

The reconciliation would then be reported as shown in Exhibit 6–4 :

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.

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) fi xed manufacturing overhead
deferred in (released from) inventory
under absorption costing ………………………………….. 0 35,000 (35,000)
Absorption costing net operating income (loss) ………. $(25,000) $ 10,000 $200,000

E X H I B I T 6–4
Reconciliation of Variable Costing
and Absorption Costing Net
Operating Incomes

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 manu-
facturing 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 cost-
ing 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 pro-
cess 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;

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246 Chapter 6

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.

Effect on Relation between
Absorption and Variable

Costing Net
Operating Incomes

Relation between Inventories
Production and Sales
for the Period

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.

E X H I B I T 6–5 Comparative Income Effects—Absorption and Variable Costing

Conmed, a surgical device maker in Utica, New York, switched to lean manufacturing by replac-
ing 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 inven-
tories. 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.

IN BUSINESS Lean Manufacturing Shrinks Inventories

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247Variable Costing and Segment Reporting: Tools for Management

ADVANTAGES OF VARIABLE COSTING AND
THE CONTRIBUTION APPROACH

Variable costing, together with the contribution approach, offers appealing advantages
for internal reports. This section discusses four 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 attempt-
ing 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) ……………………………………………….. $100,000
Contribution margin (b) ……………………………. $65,000
Contribution margin ratio (b) ÷ (a) …………….. 65%
Total fi xed expenses ……………………………….. $90,000

Dollar sales to attain target profit =
Target profit + Fixed expenses

_________________________
CM ratio

= $235,000 + $90,000 _________________
0.65

= $500,000

CONCEPT
CHECK

✓

In its first year of operations, Kelley Company produced 10,000 units and sold 7,000 units.
Its direct materials, direct labor, variable manufacturing overhead, and variable selling
and administrative unit costs were $12, $8, $2, and $1, respectively. Its total fixed manu-
facturing overhead for the year was $50,000.
1. What is the amount of cost of goods sold under variable costing?
a. $220,000.
b. $161,000.
c. $154,000.
d. $230,000.

2. What is the amount of cost of goods sold under absorption costing?
a. $189,000.
b. $196,000.
c. $179,000.
d. $186,000.

3. When comparing Kelley’s absorption costing net operating income to its variable

costing net operating income, which of the following will be true?
a. Its absorption costing net operating income will be $35,000 lower than its variable

costing net operating income.
b. Its absorption costing net operating income will be $35,000 higher than its variable

costing net operating income.
c. Its absorption costing net operating income will be $15,000 lower than its variable

costing net operating income.
d. Its absorption costing net operating income will be $15,000 higher than its variable

costing net operating income.

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248 Chapter 6

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
in March. However, the net operating income under absorption costing is not $235,000
in March, even though the sales are $500,000. Why is this? The reason is that under
absorption costing, net operating income can be distorted by changes in inventories. In
March, inventories decreased, so some of the fixed manufacturing overhead that had been
deferred in February’s ending inventories was released to the March income statement,
resulting in a net operating income that is $35,000 lower than the $235,000 predicted by
CVP analysis. If inventories had increased in March, the opposite would have occurred—
the absorption costing net operating income would have been higher than the $235,000
predicted by CVP analysis.

Explaining Changes in Net Operating Income
The variable costing income statements in Exhibit 6–2 are clear and easy to understand.
All other things the same, when sales go up, net operating income goes up. When sales go
down, net operating income goes down. When sales are constant, net operating income is
constant. The number of units produced does not affect net operating income.

Absorption costing income statements can be confusing and are easily misinterpreted.
Look again at the absorption costing income statements in Exhibit 6–3 ; a manager might
wonder why net operating income went up from January to February even though sales
were exactly the same. Was it a result of lower selling costs, more efficient operations,
or was it some other factor? In fact, it was simply because the number of units produced
exceeded the number of units sold in February and so some of the fixed manufacturing
overhead costs were deferred in inventories in that month. These costs have not gone
away—they will eventually flow through to the income statement in a later period when
inventories go down. There is no way to tell this from the absorption costing income
statements.

To avoid mistakes when absorption costing is used, readers of financial statements
should be alert to changes in inventory levels. Under absorption costing, if inventories
increase, fixed manufacturing overhead costs are deferred in inventories, which in turn
increases net operating income. If inventories decrease, fixed manufacturing overhead
costs are released from inventories, which in turn decreases net operating income. Thus,
when absorption costing is used, fluctuations in net operating income can be due to changes
in inventories rather than to changes in sales.

Supporting Decision Making
The variable costing method correctly identifies the additional variable costs that will be
incurred to make one more unit. It also emphasizes the impact of fixed costs on profits.
The total amount of fixed manufacturing costs appears explicitly on the income state-
ment, highlighting that the whole amount of fixed manufacturing costs must be covered
for the company to be truly profitable. In the Weber Light Aircraft example, the vari-
able costing income statements correctly report that the cost of producing another unit is
$25,000 and they explicitly recognize that $70,000 of fixed manufactured overhead must
be covered to earn a profit.

Under absorption costing, fixed manufacturing overhead costs appear to be variable
with respect to the number of units sold, but they are not. For example, in January, the
absorption unit product cost at Weber Light Aircraft is $95,000, but the variable portion
of this cost is only $25,000. The fixed overhead costs of $70,000 are commingled with
variable production costs, thereby obscuring the impact of fixed overhead costs on prof-
its. Because absorption unit product costs are stated on a per unit basis, managers may
mistakenly believe that if another unit is produced, it will cost the company $95,000.
But of course it would not. The cost of producing another unit would be only $25,000.

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249Variable Costing and Segment Reporting: Tools for Management

Misinterpreting absorption unit product costs as variable can lead to many problems,
including inappropriate pricing decisions and decisions to drop products that are in fact
profitable.

Adapting to the Theory of Constraints
The Theory of Constraints (TOC), which was introduced in the Prologue, suggests that
the key to improving a company’s profits is managing its constraints. For reasons that
will be discussed in a later chapter, this requires careful identification of each product’s
variable costs. Consequently, companies involved in TOC use a form of variable costing.

Variable costing income statements require one adjustment to support the TOC approach.
Direct labor costs need to be removed from variable production costs and reported as part
of the fixed manufacturing costs that are entirely expensed in the period incurred. The TOC
treats direct labor costs as a fixed cost for three reasons. First, even though direct labor
workers may be paid on an hourly basis, many companies have a commitment—sometimes
enforced by labor contracts or by law—to guarantee workers a minimum number of paid
hours. Second, direct labor is not usually the constraint; therefore, there is no reason to
increase it. Hiring more direct labor workers would increase costs without increasing the
output of saleable products and services. Third, TOC emphasizes continuous improvement
to maintain competitiveness. Without committed and enthusiastic employees, sustained con-
tinuous improvement is virtually impossible. Because layoffs often have devastating effects
on employee morale, managers involved in TOC are extremely reluctant to lay off employees.

For these reasons, most managers in TOC companies regard direct labor as a committed-
fixed cost rather than a variable cost. Hence, in the modified form of variable costing
used in TOC companies, direct labor is not usually classified as a product cost.

Each year Webb Company produces and sells 20,000 units of its only product. The selling price
for this product is $100 per unit and its direct materials, direct labor, and variable manufacturing
overhead costs per unit are $25, $15, and $10, respectively. Webb’s annual fixed manufacturing
overhead expenses and fixed selling and administrative expenses are $400,000 and $150,000,
respectively. It does not have any variable selling and administrative expenses.

The company’s marketing manager believes a 10% price increase would lead to a 20% decline
in the number of units sold. He claims that if the level of production stays at 20,000 units his price
hike will increase gross margins and net operating income by $40,000. Would you support the price
increase? Do you think it will increase profits?

DECISION POINT The Pricing Decision

SEGMENTED INCOME STATEMENTS AND
THE CONTRIBUTION APPROACH

In the remainder of the chapter, we’ll learn how to use the contribution approach to con-
struct income statements for business segments. These segmented income statements are
useful for analyzing the profitability of segments, making decisions, and measuring the
performance of segment managers.

Traceable and Common Fixed Costs and the
Segment Margin
You need to understand three new terms to prepare segmented income statements using
the contribution approach— traceable fixed cost, common fixed cost, and segment margin.

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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A traceable fixed cost of a segment is a fixed cost that is incurred because of the
existence of the segment—if the segment had never existed, the fixed cost would not
have been incurred; and 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.

• The liability insurance at Disney World is a traceable fixed cost of the Disney World
business segment of the Disney Corporation.

A common fixed cost is a fixed cost that supports the operations of more than one seg-
ment, but is not traceable in whole or in part to any one segment. Even if a segment were
entirely eliminated, there would be no change in a true common fixed cost. For example:

• 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
store’s various departments—groceries, produce, bakery, meat, etc.

• The cost of the receptionist’s salary at an office shared by a number of doctors is a
common fixed cost of the doctors. The cost is traceable to the office, but not to indi-
vidual doctors.

To prepare a segmented income statement, variable expenses are deducted from sales
to yield the contribution margin for the segment. The contribution margin tells us what
happens to profits as volume changes—holding a segment’s capacity and fixed costs con-
stant. The contribution margin is especially useful in decisions involving temporary uses
of capacity such as special orders. These types of decisions often involve only variable
costs and revenues—the two components of contribution margin.

The segment margin is obtained by deducting the traceable fixed costs of a segment from
the segment’s contribution margin. It represents the margin available after a segment has
covered all of its own costs. The segment margin is the best gauge of the long-run profitability
of a segment because it includes only those costs that are caused by the segment. If a segment
can’t cover its own costs, then that segment probably should be dropped (unless it has impor-
tant side effects on other segments). Notice, common fixed costs are not allocated to segments.

From a decision-making point of view, the segment margin is most useful in major
decisions that affect capacity such as dropping a segment. By contrast, as we noted ear-
lier, the contribution margin is most useful in decisions involving short-run changes in
volume, such as pricing special orders that involve temporary use of existing capacity.

Smith & Hawken, an outdoor-accessories retailer, has experienced growing Internet sales and
declining catalog sales. These trends seem consistent with conventional wisdom, which suggests
that the Internet will make catalogs obsolete. Yet, Smith & Hawken, like many retailers with growing
Internet sales, has no plans to discontinue its catalogs. In fact, the total number of catalogs mailed in
the United States by all companies has jumped from 16.6 billion in 2002 to 19.2 billion in 2005. Why?

Catalog shoppers and Internet shoppers are not independent customer segments. Catalog
shoppers frequently choose to complete their sales transactions online rather than placing tele-
phone orders. This explains why catalogs remain a compelling marketing medium even though
catalog sales are declining for many companies. If retailers separately analyze catalog sales and
Internet sales, they may discontinue the catalogs segment while overlooking the adverse impact of
this decision on Internet segment margins.

Source: Louise Lee, “Catalogs, Catalogs, Everywhere,” BusinessWeek, December 4, 2006, pp. 32–34.

IN BUSINESS Has The Internet Killed Catalogs?

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251Variable Costing and Segment Reporting: Tools for Management

Identifying Traceable Fixed Costs
The distinction between traceable and common fixed costs is crucial in segment reporting
because traceable fixed costs are charged to segments and common fixed costs are not. In
an actual situation, it is sometimes hard to determine whether a cost should be classified
as traceable or common.

The general guideline is to treat as traceable costs only those costs that would disappear
over time if the segment itself disappeared. For example, if one division within a company
were sold or discontinued, it would no longer be necessary to pay that division manager’s
salary. Therefore the division manager’s salary would be classified as a traceable fixed
cost of the division. On the other hand, the president of the company undoubtedly would
continue to be paid even if one of many divisions was dropped. In fact, he or she might
even be paid more if dropping the division was a good idea. Therefore, the president’s sal-
ary is common to the company’s divisions and should not be charged to them.

When assigning costs to segments, the key point is to resist the temptation to allocate
costs (such as depreciation of corporate facilities) that are clearly common and that will
continue regardless of whether the segment exists or not. Any allocation of common costs
to segments reduces the value of the segment margin as a measure of long-run segment
profitability and segment performance.

Traceable Costs Can Become Common Costs
Fixed costs that are traceable to one segment may be a common cost of another segment.
For example, United Airlines might want a segmented income statement that shows the
segment margin for a particular flight from Chicago to Paris further broken down into
first-class, business-class, and economy-class segment margins. The airline must pay a
substantial landing fee at Charles DeGaulle airport in Paris. This fixed landing fee is a
traceable cost of the flight, but it is a common cost of the first-class, business-class, and
economy-class segments. Even if the first-class cabin is empty, the entire landing fee
must be paid. So the landing fee is not a traceable cost of the first-class cabin. But on the
other hand, paying the fee is necessary in order to have any first-class, business-class, or
economy-class passengers. So the landing fee is a common cost of these three classes.

SEGMENTED INCOME STATEMENTS—AN EXAMPLE
ProphetMax, Inc., is a rapidly growing computer software company. Exhibit 6–6 shows
its variable costing income statement for the most recent month. As the company has
grown, its senior managers have asked for segmented income statements that could be
used to make decisions and evaluate managerial performance. ProphetMax’s controller
responded by creating examples of contribution format income statements segmented by
the company’s divisions, product lines, and sales channels. She created Exhibit 6–7 to
explain that ProphetMax’s profits can be segmented into its two divisions—the Business
Products Division and the Consumer Products Division. The Consumer Products Divi-
sion’s profits can be further segmented into the Clip Art and Computer Games product
lines. Finally, the Computer Games product line’s profits (within the Consumer Products
Division) can be segmented into the Online and Retail Stores sales channels.

IN BUSINESS

In 2001, Victoria Pappas Collection, a small company specializing in women’s sportswear, reported
a net loss of $280,000 on sales of $1 million. When the company’s founder, Vickie Giannukos, seg-
mented her company’s income statement into the six markets that she was serving, the results were
revealing. The Dallas and Atlanta markets generated $825,000 of sales and incurred $90,000 of

IN BUSINESS Computing Segment Margins Helps An Entrepreneur

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252

(continued)

IN BUSINESS

traceable fixed costs. The other four markets combined produced $175,000 of sales and also
incurred $90,000 of traceable fixed costs. Given the average contribution margin ratio of 38%, the
Dallas and Atlanta markets earned a segment margin of $223,500 [($825,000 3 38%) 2 $90,000]
while the other four markets combined incurred a loss of $23,500 [($175,000 3 38%) 2 $90,000].

Vicky had made a common mistake—she chased every possible dollar of sales without knowing if
her efforts were profitable. Based on her segmented income statements, she discontinued operations
in three cities and hired a new sales representative in Los Angeles. She decided to focus on growing
sales in Dallas and Atlanta while deferring expansion into new markets until it could be done profitably.

Source: Norm Brodsky, “The Thin Red Line,” Inc. Magazine, January 2004, pp. 49–52.

ProphetMax, Inc.
Variable Costing Income Statement

Sales ……………………………………………………………. $500,000
Variable expenses:
Variable cost of goods sold ………………………….. 180,000
Other variable expenses ……………………………… 50,000
Total variable expenses ………………………………….. 230,000

Contribution margin ……………………………………….. 270,000
Fixed expenses ……………………………………………… 255,000
Net operating income …………………………………….. $ 15,000

E X H I B I T 6–6
ProphetMax, Inc. Variable Costing
Income Statement

E X H I B I T 6–7
ProphetMax, Inc.: Examples of
Business Segments

Business
Products
Division

Computer
Games

Clip Art

Retail StoresOnline Sales

Product

Lines

Divisions

Sales
Channels

ProphetMax,
Inc.

Consumer
Products
Division

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253Variable Costing and Segment Reporting: Tools for Management

Levels of Segmented Income Statements
Exhibit 6–8 , on the next page, contains the controller’s segmented income statements for
the segments depicted in Exhibit 6–7 . The contribution format income statement for the
entire company appears at the very top of the exhibit under the column labeled Total Com-
pany. Notice, the net operating income shown in this column ($15,000) is the same as the
net operating income shown in Exhibit 6–6 . Immediately to the right of the Total Company
column are two columns—one for each of the two divisions. We can see that the Busi-
ness Products Division’s traceable fixed expenses are $90,000 and the Consumer Products
Division’s are $80,000. These $170,000 of traceable fixed expenses (as shown in the Total
Company column) plus the $85,000 of common fixed expenses not traceable to individual
divisions equals ProphetMax’s total fixed expenses ( $255,000 ) as shown in Exhibit 6–6 . We
can also see that the Business Products Division’s segment margin is $60,000 and the Con-
sumer Products Division’s is $40,000. These segment margins show the company’s divi-
sional managers how much each of their divisions is contributing to the company’s profits.

The middle portion of Exhibit 6–8 further segments the Consumer Products Division
into its two product lines, Clip Art and Computer Games. The dual nature of some fixed
costs can be seen in this portion of the exhibit. Notice, in the top portion of Exhibit 6–8
when segments are defined as divisions, the Consumer Products Division has $80,000
in traceable fixed expenses. However, when we drill down to the product lines (in the
middle portion of the exhibit), only $70,000 of the $80,000 cost that was traceable to the
Consumer Products Division is traceable to the product lines. The other $10,000 becomes
a common fixed cost of the two product lines of the Consumer Products Division.

Why would $10,000 of traceable fixed costs become a common fixed cost when the divi-
sion is divided into product lines? The $10,000 is the monthly depreciation expense on a
machine that is used to encase products in tamper-proof packages for the consumer market.
The depreciation expense is a traceable cost of the Consumer Products Division as a whole,
but it is a common cost of the division’s two product lines. Even if one of the product lines
were discontinued entirely, the machine would still be used to wrap the remaining products.
Therefore, none of the depreciation expense can really be traced to individual products.

The $70,000 traceable fixed cost of the product lines consists of the costs of product
specific advertising. A total of $30,000 was spent on advertising clip art and $40,000 was
spent on advertising computer games. Clearly, these costs can be traced to the individual
product lines.

Segmented Income Statements
and Decision Making
The bottom portion of Exhibit 6–8 can be used to illustrate how segmented income state-
ments support decision making. It further segments the Computer Games product line into
its two sales channels, Online Sales and Retail Stores. The Online Sales segment has a seg-
ment margin of $48,000 and the Retail Stores segment has a segment margin of $(3,000).
Let’s assume that ProphetMax wants to know the profit impact of discontinuing the sale of
computer games through its Retail Stores sales channel. The company believes that online
sales of its computer games will increase 10% if it discontinues the Retail Stores sales
channel. It also believes that the Business Products Division and Clip Art product line will
be unaffected by this decision. How would you compute the profit impact of this decision?

The first step is to calculate the profit impact of the Retail Stores sales channel disappear-
ing. If this sales channel disappears, we assume its sales, variable expenses, and traceable
fixed expenses would all disappear. The quickest way to summarize these financial impacts
is to focus on the Retail Stores’ segment margin. In other words, if the Retail Stores sales
channel disappears, then its segment margin of a loss of $3,000 would also disappear. This
would increase ProphetMax’s net operating income by $3,000. The second step is to calcu-
late the profit impact of increasing online sales of computer games by 10%. To perform this
calculation, we assume that the Online Sales total traceable fixed expenses ($15,000) remain
constant and its contribution margin ratio remains constant at 63% ( 5 $63,000 4 $100,000).
If online sales increase $10,000 ( 5 $100,000 3 10%), then the Online Sales segment’s

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E X H I B I T 6–8
ProphetMax, Inc.—Segmented
Income Statements in the
Contribution Format

Segments Defi ned as Divisions
Divisions

Business Consumer
Total Products Products
Company Division Division

Sales …………………………………………………… $500,000 $300,000 $200,000

Variable expenses:
Variable cost of goods sold ………………….. 180,000 120,000 60,000
Other variable expenses ……………………… 50,000 30,000 20,000

Total variable expenses ………………………….. 230,000 150,000 80,000

Contribution margin ……………………………….. 270,000 150,000 120,000
Traceable fi xed expenses ……………………….. 170,000 90,000 80,000

Divisional segment margin ……………………… 100,000 $ 60,000 $ 40,000
Common fi xed expenses not
traceable to individual divisions ……………. 85,000

Net operating income …………………………. $ 15,000

Segments Defi ned as Product Lines
of the Consumer Products Division

Consumer
Products Computer
Division Clip Art Games

Sales …………………………………………………… $200,000 $75,000 $125,000

Variable expenses:
Variable cost of goods sold ………………….. 60,000 20,000 40,000
Other variable expenses ……………………… 20,000 5,000 15,000

Total variable expenses ………………………….. 80,000 25,000 55,000

Contribution margin ……………………………….. 120,000 50,000 70,000
Traceable fi xed expenses ……………………….. 70,000 30,000 40,000

Product-line segment margin…………………… 50,000 $20,000 $ 30,000
Common fi xed expenses not
traceable to individual product lines ………. 10,000

Divisional segment margin ………………….. $ 40,000

Segments Defi ned as Sales Channels for One Product Line,
Computer Games, of the Consumer Products Division
Sales Channels

Computer Online Retail
Games Sales Stores

Sales …………………………………………………… $125,000 $100,000 $25,000

Variable expenses:
Variable cost of goods sold ………………….. 40,000 32,000 8,000
Other variable expenses ……………………… 15,000 5,000 10,000

Total variable expenses ………………………….. 55,000 37,000 18,000

Contribution margin ……………………………….. 70,000 63,000 7,000
Traceable fi xed expenses ……………………….. 25,000 15,000 10,000

Sales-channel segment margin ……………….. 45,000 $ 48,000 $ (3,000)
Common fi xed expenses not
traceable to individual sales channels …… 15,000

Product-line segment margin ………………. $ 30,000

Product Line

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255Variable Costing and Segment Reporting: Tools for Management

contribution margin will increase by $6,300 ( 5 $10,000 3 63%). The overall profit impact
of discontinuing the Retail Stores sales channel can be summarized as follows:

Avoidance of the retail segment’s loss ………………………… $3,000
Online Sales additional contribution margin ………………… 6,300
Increase in ProphetMax’s net operating income …………… $9,300

SEGMENTED INCOME STATEMENTS—COMMON MISTAKES
All of the costs attributable to a segment—and only those costs—should be assigned to
the segment. Unfortunately, companies often make mistakes when assigning costs to seg-
ments. They omit some costs, inappropriately assign traceable fixed costs, and arbitrarily
allocate common fixed costs.

Omission of Costs
The costs assigned to a segment should include all costs attributable to that segment
from the company’s entire value chain. All of these functions, from research and devel-
opment, through product design, manufacturing, marketing, distribution, and customer
service, are required to bring a product or service to the customer and generate revenues.

However, only manufacturing costs are included in product costs under absorption
costing, which is widely regarded as required for external financial reporting. To avoid
having to maintain two costing systems and to provide consistency between internal and
external reports, many companies also use absorption costing for their internal reports
such as segmented income statements. As a result, such companies omit from their prof-
itability analysis part or all of the “upstream” costs in the value chain, which consist of
research and development and product design, and the “downstream” costs, which consist
of marketing, distribution, and customer service. Yet these nonmanufacturing costs are
just as essential in determining product profitability as are the manufacturing costs. These
upstream and downstream costs, which are usually included in selling and administra-
tive expenses on absorption costing income statements, can represent half or more of the
total costs of an organization. If either the upstream or downstream costs are omitted in
profitability analysis, then the product is undercosted and management may unwittingly
develop and maintain products that in the long run result in losses.

Inappropriate Methods for Assigning
Traceable Costs among Segments
In addition to omitting costs, many companies do not correctly handle traceable fixed
expenses on segmented income statements. First, they do not trace fixed expenses to seg-
ments even when it is feasible to do so. Second, they use inappropriate allocation bases to
allocate traceable fixed expenses to segments.

Failure to Trace Costs Directly Costs that can be traced directly to a specific
segment should be charged directly to that segment and should not be allocated to other
segments. For example, the rent for a branch office of an insurance company should be
charged directly to the branch office rather than included in a companywide overhead
pool and then spread throughout the company.

Inappropriate Allocation Base Some companies use arbitrary allocation bases
to allocate costs to segments. For example, some companies allocate selling and adminis-
trative expenses on the basis of sales revenues. Thus, if a segment generates 20% of total
company sales, it would be allocated 20% of the company’s selling and administrative
expenses as its “fair share.” This same basic procedure is followed if cost of goods sold or
some other measure is used as the allocation base.

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Costs should be allocated to segments for internal decision-making purposes only when
the allocation base actually drives the cost being allocated (or is very highly correlated with
the real cost driver). For example, sales should be used to allocate selling and administrative
expenses only if a 10% increase in sales will result in a 10% increase in selling and adminis-
trative expenses. To the extent that selling and administrative expenses are not driven by sales
volume, these expenses will be improperly allocated—with a disproportionately high percent-
age of the selling and administrative expenses assigned to the segments with the largest sales.

Arbitrarily Dividing Common Costs
among Segments
The third business practice that leads to distorted segment costs is the practice of assign-
ing nontraceable costs to segments. For example, some companies allocate the common
costs of the corporate headquarters building to products on segment reports. However, in
a multiproduct company, no single product is likely to be responsible for any significant
amount of this cost. Even if a product were eliminated entirely, there would usually be
no significant effect on any of the costs of the corporate headquarters building. In short,
there is no cause-and-effect relation between the cost of the corporate headquarters build-
ing and the existence of any one product. As a consequence, any allocation of the cost of
the corporate headquarters building to the products must be arbitrary.

Common costs like the costs of the corporate headquarters building are necessary, of
course, to have a functioning organization. The practice of arbitrarily allocating common
costs to segments is often justified on the grounds that “someone” has to “cover the com-
mon costs.” While it is undeniably true that a company must cover its common costs to
earn a profit, arbitrarily allocating common costs to segments does not ensure that this will
happen. In fact, adding a share of common costs to the real costs of a segment may make
an otherwise profitable segment appear to be unprofitable. If a manager eliminates the
apparently unprofitable segment, the real traceable costs of the segment will be saved, but
its revenues will be lost. And what happens to the common fixed costs that were allocated
to the segment? They don’t disappear; they are reallocated to the remaining segments of
the company. That makes all of the remaining segments appear to be less profitable—
possibly resulting in dropping other segments. The net effect will be to reduce the overall
profits of the company and make it even more difficult to “cover the common costs.”

Additionally, common fixed costs are not manageable by the manager to whom they
are arbitrarily allocated; they are the responsibility of higher-level managers. When com-
mon fixed costs are allocated to managers, they are held responsible for those costs even
though they cannot control them.

INCOME STATEMENTS—AN EXTERNAL REPORTING PERSPECTIVE

Companywide Income Statements
Practically speaking, absorption costing is required for external reports according to U.S.
generally accepted accounting principles (GAAP). 3 Furthermore, International Financial
Reporting Standards (IFRS) explicitly require companies to use absorption costing. Prob-
ably because of the cost and possible confusion of maintaining two separate costing

3 The Financial Accounting Standards Board (FASB) has created a single source of authoritative
nongovernmental U.S. generally accepted accounting principles (GAAP) called the FASB Accounting
Standards Codification (FASB codification). Although the FASB codification does not explicitly
disallow variable costing, it does explicitly prohibit companies from excluding all manufacturing
overhead costs from product costs. It also provides an in-depth discussion of fixed overhead allocation
to products, thereby implying that absorption costing is required for external reports. Although
some companies expense significant elements of fixed manufacturing costs on their external reports,
practically speaking, U.S. GAAP requires absorption costing for external reports.

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systems—one for external reporting and one for internal reporting—most companies use
absorption costing for their external and internal reports.

With all of the advantages of the contribution approach, you may wonder why the
absorption approach is used at all. While the answer is partly due to adhering to tradi-
tion, absorption costing is also attractive to many accountants and managers because they
believe it better matches costs with revenues. Advocates of absorption costing argue that
all manufacturing costs must be assigned to products in order to properly match the costs
of producing units of product with their revenues when they are sold. The fixed costs
of depreciation, taxes, insurance, supervisory salaries, and so on, are just as essential to
manufacturing products as are the variable costs.

Advocates of variable costing argue that fixed manufacturing costs are not really the
costs of any particular unit of product. These costs are incurred to have the capacity to
make products during a particular period and will be incurred even if nothing is made dur-
ing the period. Moreover, whether a unit is made or not, the fixed manufacturing costs will
be exactly the same. Therefore, variable costing advocates argue that fixed manufacturing
costs are not part of the costs of producing a particular unit of product, and thus, the match-
ing principle dictates that fixed manufacturing costs should be charged to the current period.

Segmented Financial Information
U.S. GAAP and IFRS require that publicly traded companies include segmented financial
and other data in their annual reports and that the segmented reports prepared for external
users must use the same methods and definitions that the companies use in internal seg-
mented reports that are prepared to aid in making operating decisions. This is a very unusual
stipulation because companies are not ordinarily required to report the same data to external
users that are used for internal decision-making purposes. This requirement creates incen-
tives for publicly traded companies to avoid using the contribution format for internal seg-
mented reports. Segmented contribution format income statements contain vital information
that companies are often very reluctant to release to the public (and hence competitors). In
addition, this requirement creates problems in reconciling internal and external reports.

IN BUSINESS
In 2009, 3M Company reported segmented profitability to its shareholders by product lines and
geographic areas. A portion of the company’s segmented information is summarized below (all
numbers are in millions):

Net Sales
Net Operating

Income

Product Lines:
Industrial and transportation ………………………….. $7,116 $1,238
Health care …………………………………………………. $4,294 $1,350
Consumer and office …………………………………….. $3,471 $748
Safety, security, and protection services ………….. $3,180 $745
Display and graphics ……………………………………. $3,132 $590
Electro and communications …………………………. $2,276 $322

Geographic Areas:
United States ………………………………………………. $8,509 $1,640
Asia Pacifi c …………………………………………………. $6,120 $1,528
Europe, Middle East and Africa ……………………… $5,972 $1,003
Latin America and Canada ……………………………. $2,516 $631

3M’s annual report does not report the gross margins or contribution margins for its business
segments. Why do you think this is the case?

Source: 3M Company, 2009 Annual Report.

3M Reports Segmented Profitability to Shareholders IN BUSINESS

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SUMMARY

LO1 Explain how variable costing differs from absorption costing and compute
unit product costs under each method.
Variable and absorption costing are alternative methods of determining unit product costs. Under
variable costing, only variable manufacturing costs (direct materials, direct labor, and variable
manufacturing overhead) are treated as product costs. Fixed manufacturing overhead is treated
as a period cost and it is expensed on the income statement as incurred. By contrast, absorption
costing treats fixed manufacturing overhead as a product cost, along with direct materials, direct
labor, and variable overhead.

LO2 Prepare income statements using both variable and absorption costing.
The unit product costs under the two methods are different and so the cost of goods sold are dif-
ferent on the income statement. Additionally, fixed manufacturing overhead is expensed on the
income statement under variable costing, but is included in unit product costs under absorption
costing. Under both costing methods, selling and administrative expenses are treated as period
costs and are expensed on the income statement as incurred.

LO3 Reconcile variable costing and absorption costing net operating incomes and
explain why the two amounts differ.
Because absorption costing treats fixed manufacturing overhead as a product cost, a portion
of fixed manufacturing overhead is assigned to each unit as it is produced. If units of product
are unsold at the end of a period, then the fixed manufacturing overhead cost attached to those
units is carried with them into the inventory account and deferred to a future period. When these
units are later sold, the fixed manufacturing overhead cost attached to them is released from the
inventory account and charged against income as part of cost of goods sold. Thus, under absorp-
tion costing, it is possible to defer a portion of the fixed manufacturing overhead cost from one
period to a future period through the inventory account.

LO4 Prepare a segmented income statement that differentiates traceable fixed
costs from common fixed costs and use it to make decisions.
Segmented income statements provide information for evaluating the profitability and perfor-
mance of divisions, product lines, sales territories, and other segments of a company. Under the
contribution approach covered in this chapter, variable costs and fixed costs are clearly distin-
guished from each other and only those costs that are traceable to a segment are assigned to the
segment. A cost is considered traceable to a segment only if the cost is caused by the segment
and could be avoided by eliminating the segment. Fixed common costs are not allocated to
segments. The segment margin consists of revenues, less variable expenses, less traceable fixed
expenses of the segment.

GUIDANCE ANSWER TO DECISION POINT
The Pricing Decision (p. 249)
Under absorption costing, the fixed manufacturing overhead cost per unit is $20 ($400,000 4 20,000 units).
The absorption costing unit product cost is $70 ($25 1 $15 1 $10 1 $20) and the gross margin per unit
is $30 ($100 2 $70). The variable costing unit product cost is $50 ($25 1 $15 1 $10) and the contribu-
tion margin per unit is $50 ($100 2 $50). When the company produces and sells 20,000 units at a price
of $100, it earns a total gross margin of $600,000 (20,000 units 3 $30) and a total contribution margin of
$1,000,000 (20,000 units 3 $50).

A 10% price increase would raise the selling price to $110 per unit, whereas a 20% decline in unit
sales would drop the sales volume to 16,000 units. In this scenario, the total gross margin earned is
$640,000 (16,000 units 3 $40), which is $40,000 higher than the gross margin from the original scenario.
This explains why the marketing manager thinks the price increase is a good idea. However, if the price
increase is implemented the total contribution margin earned would become $960,000 (16,000 units 3
$60), which is $40,000 lower than the contribution margin from the original scenario. The price increase
will lower profits by $40,000.

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259Variable Costing and Segment Reporting: Tools for Management

GUIDANCE ANSWERS TO CONCEPT CHECKS
1. Choice c. The variable costing unit product cost is $22 ($12 1 $8 1 $2). The cost of goods

sold is $154,000 (7,000 units sold 3 $22 per unit). The variable selling and administrative
expense is a period cost, not a product cost.

2. Choice a. The absorption costing fixed manufacturing overhead cost per unit is $5 ($50,000
4 10,000 units). The absorption costing unit product cost is $27 ($12 1 $8 1 $2 1 5). The
cost of goods sold is $189,000 (7,000 units sold 3 $27 per unit).

3. Choice d. Absorption costing income is $15,000 higher because it defers $15,000
(3,000 units 3 $5 per unit) of fixed manufacturing overhead in inventory, whereas vari-
able costing expenses the entire $50,000 of fixed manufacturing overhead during the
current period.

REVIEW PROBLEM 1: CONTRASTING VARIABLE
AND ABSORPTION COSTING

Dexter Corporation produces and sells a single product, a wooden hand loom for weaving small
items such as scarves. Selected cost and operating data relating to the product for two years are
given below:

Selling price per unit …………………………………… $50
Manufacturing

costs:

Variable per unit produced:
Direct materials ……………………………………. $11
Direct labor ………………………………………….. $6
Variable manufacturing overhead ……………. $3
Fixed manufacturing overhead per year ……… $120,000
Selling and administrative expenses:
Variable per unit sold ……………………………….. $4
Fixed per year …………………………………………. $70,000

Year 1 Year 2

Units in beginning inventory ……………… 0 2,000
Units produced during the year …………. 10,000 6,000
Units sold during the year ………………… 8,000 8,000
Units in ending inventory ………………….. 2,000 0

Required:

1. Assume the company uses absorption costing.
a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.
2. Assume the company uses variable costing.
a. Compute the unit product cost in each year.
b. Prepare an income statement for each year.
3. Reconcile the variable costing and absorption costing net operating incomes.

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Solution to Review Problem 1
1. a. Under absorption costing, all manufacturing costs, variable and fixed, are included in unit product

costs:

Year 1 Year 2

Direct materials …………………………………….. $11 $11
Direct labor ………………………………………….. 6 6
Variable manufacturing overhead …………… 3 3
Fixed manufacturing overhead
($120,000 ÷ 10,000 units) ………………….. 12
($120,000 ÷ 6,000 units) ……………………. 20
Absorption costing unit product cost ……….. $32 $40

b. The absorption costing income statements follow:

Year 1 Year 2

Sales (8,000 units × $50 per unit) ……………………………… $400,000 $400,000
Cost of goods sold (8,000 units × $32 per unit);
(2,000 units × $32 per unit) +
(6,000 units × $40 per unit) …………………………………… 256,000 304,000
Gross margin ………………………………………………………….. 144,000 96,000
Selling and administrative
expenses (8,000 units × $4 per
unit + $70,000) ……………………………………………………. 102,000 102,000
Net operating income (loss) ………………………………………. $ 42,000 $ (6,000)

2. a. Under variable costing, only the variable manufacturing costs are included in unit product costs:

Year 1 Year 2

Direct materials …………………………………….. $11 $11
Direct labor ………………………………………….. 6 6
Variable manufacturing overhead …………… 3 3
Variable costing unit product cost …………… $20 $20

b. The variable costing income statements follow:

Year 1 Year 2

Sales (8,000 units × $50 per unit) ……. $400,000 $400,000
Variable expenses:
Variable cost of goods sold
(8,000 units × $20 per unit) ……… $160,000 $160,000
Variable selling and administrative
expenses (8,000 units ×
$4 per unit) …………………………….. 32,000 192,000 32,000 192,000
Contribution margin ……………………….. 208,000 208,000
Fixed expenses:
Fixed manufacturing overhead ……… 120,000 120,000
Fixed selling and administrative
expenses ……………………………….. 70,000 190,000 70,000 190,000
Net operating income …………………….. $ 18,000 $ 18,000

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3. The reconciliation of the variable and absorption costing net operating incomes follows:

Year 1 Year 2

Variable costing net operating income ………………………….. $18,000 $ 18,000
Add fi xed manufacturing overhead costs deferred
in inventory under absorption costing
(2,000 units × $12 per unit) ……………………………………… 24,000
Deduct fi xed manufacturing overhead costs released
from inventory under absorption costing
(2,000 units × $12 per unit) ……………………………………… (24,000)
Absorption costing net operating income (loss) ………………. $42,000 $ (6, 000)

REVIEW PROBLEM 2: SEGMENTED INCOME STATEMENTS
The business staff of the law firm Frampton, Davis & Smythe has constructed the following report which breaks
down the firm’s overall results for last month into two business segments—family law and commercial law:

Family Commercial
Total Law Law

Revenues from clients ……………. $1,000,000 $400,000 $600,000
Variable expenses …………………. 220,000 100,000 120,000
Contribution margin ……………….. 780,000 300,000 480,000
Traceable fi xed expenses ………… 670,000 280,000 390,000
Segment margin ……………………. 110,000 20,000 90,000
Common fi xed expenses ………… 60,000 24,000 36,000
Net operating income (loss) …….. $ 50,000 $ (4,000) $ 54,000

However, this report is not quite correct. The common fixed expenses such as the managing partner’s sal-
ary, general administrative expenses, and general firm advertising have been allocated to the two segments
based on revenues from clients.

Required:
1. Redo the segment report, eliminating the allocation of common fixed expenses. Would the firm be

better off financially if the family law segment were dropped? (Note: Many of the firm’s commercial
law clients also use the firm for their family law requirements such as drawing up wills.)

2. The firm’s advertising agency has proposed an ad campaign targeted at boosting the revenues of
the family law segment. The ad campaign would cost $20,000, and the advertising agency claims
that it would increase family law revenues by $100,000. The managing partner of Frampton, Davis
& Smythe believes this increase in business could be accommodated without any increase in fixed
expenses. Estimate the effect this ad campaign would have on the family law segment margin and on
the firm’s overall net operating income.

Solution to Review Problem 2
1. The corrected segmented income statement appears below:

Total Family Law Commercial Law

Revenues from clients ……………… $1,000,000 $400,000 $600,000
Variable expenses …………………… 220,000 100,000 120,000
Contribution margin …………………. 780,000 300,000 480,000
Traceable fi xed expenses …………. 670,000 280,000 390,000
Segment margin ……………………… 110,000 $ 20,000 $ 90,000
Common fi xed expenses ………….. 60,000
Net operating income ………………. $ 50,000

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No, the firm would not be financially better off if the family law practice were dropped. The family
law segment is covering all of its own costs and is contributing $20,000 per month to covering the
common fixed expenses of the firm. While the segment margin for family law is much lower than for
commercial law, it is still profitable. Moreover, family law may be a service that the firm must provide
to its commercial clients in order to remain competitive.

2. The ad campaign can be estimated to increase the family law segment margin by $55,000 as follows:

Increased revenues from clients ……………………………………….. $100,000
Family law contribution margin ratio ($300,000 ÷ $400,000) … × 75%
Incremental contribution margin ……………………………………….. $ 75,000
Less cost of the ad campaign …………………………………………… 20,000
Increased segment margin ………………………………………………. $ 55,000

Because there would be no increase in fixed expenses (including common fixed expenses), the
increase in overall net operating income is also $55,000.

GLOSSARY

Absorption costing A costing method that includes all manufacturing costs—direct materials, direct
labor, and both variable and fixed manufacturing overhead—in unit product costs. (p. 238)

Common fixed cost A fixed cost that supports more than one business segment, but is not traceable in
whole or in part to any one of the business segments. (p. 250)

Segment Any part or activity of an organization about which managers seek cost, revenue, or profit
data. (p. 238)

Segment margin A segment’s contribution margin less its traceable fixed costs. It represents the margin
available after a segment has covered all of its own traceable costs. (p. 250)

Traceable fixed cost A fixed cost that is incurred because of the existence of a particular business
segment and that would be eliminated if the segment were eliminated. (p. 250)

Variable costing A costing method that includes only variable manufacturing costs—direct materials,
direct labor, and variable manufacturing overhead—in unit product costs. (p. 238)

QUESTIONS
6–1 What is the basic difference between absorption costing and variable costing?
6–2 Are selling and administrative expenses treated as product costs or as period costs under variable

costing?
6–3 Explain how fixed manufacturing overhead costs are shifted from one period to another under

absorption costing.
6–4 What are the arguments in favor of treating fixed manufacturing overhead costs as product costs?
6–5 What are the arguments in favor of treating fixed manufacturing overhead costs as period costs?
6–6 If the units produced and unit sales are equal, which method would you expect to show the higher

net operating income, variable costing or absorption costing? Why?
6–7 If the units produced exceed unit sales, which method would you expect to show the higher net

operating income, variable costing or absorption costing? Why?
6–8 If fixed manufacturing overhead costs are released from inventory under absorption costing, what

does this tell you about the level of production in relation to the level of sales?
6–9 Under absorption costing, how is it possible to increase net operating income without increasing sales?
6–10 How does Lean Production reduce or eliminate the difference in reported net operating income

between absorption and variable costing?
6–11 What is a segment of an organization? Give several examples of segments.
6–12 What costs are assigned to a segment under the contribution approach?
6–13 Distinguish between a traceable cost and a common cost. Give several examples of each.
6–14 Explain how the segment margin differs from the contribution margin.
6–15 Why aren’t common costs allocated to segments under the contribution approach?
6–16 How is it possible for a cost that is traceable to a segment to become a common cost if the

segment is divided into further segments?

Multiple-choice questions are provided on the text website at www.mhhe.com/brewer6e .

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263Variable Costing and Segment Reporting: Tools for Management

APPLYING EXCEL
Available with McGraw-Hill’s Connect® Accounting.

The Excel worksheet form that appears below is to be used to recreate portions of Review Problem 1
on pages 259–261. Download the workbook containing this form from the Online Learning Center
at www.mhhe.com/brewer6e . On the website you will also receive instructions about how to use this
worksheet form.

You should proceed to the requirements below only after completing your worksheet.

Required:
1. Check your worksheet by changing the units sold in the Data to 6,000 for Year 2. The cost of goods

sold under absorption costing for Year 2 should now be $240,000. If it isn’t, check cell C41. The
formula in this cell should be 5 IF(C26

LO2

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264 Chapter 6

is operating properly, the net operating income under both absorption costing and variable costing
should be $(34,000) for Year 2. That is, the loss in Year 2 is $34,000 under both systems. If you do not
get these answers, find the errors in your worksheet and correct them.

Why is the absorption costing net operating income now equal to the variable costing net operating
income in Year 2?

2. Enter the following data from a different company into your worksheet:

Data

Selling price per unit ………………………………. $75
Manufacturing costs:
Variable per unit produced:
Direct materials ………………………………. $12
Direct labor …………………………………….. $5
Variable manufacturing overhead ………. $7
Fixed manufacturing overhead per year …. $150,000
Selling and administrative expenses:
Variable per unit sold …………………………… $1
Fixed per year ……………………………………. $60,000

Year 1 Year 2

Units in beginning inventory ……………………. 0
Units produced during the year ……………….. 15,000 10,000
Units sold during the year ……………………….. 12,000 12,000

Is the net operating income under variable costing different in Year 1 and Year 2? Why or why not?
Explain the relation between the net operating income under absorption costing and variable costing
in Year 1. Explain the relation between the net operating income under absorption costing and variable
costing in Year 2.

3. At the end of Year 1, the company’s board of directors set a target for Year 2 of net operating income
of $500,000 under absorption costing. If this target is met, a hefty bonus would be paid to the CEO
of the company. Keeping everything else the same from part (2) above, change the units produced
in Year 2 to 50,000 units. Would this change result in a bonus being paid to the CEO? Do you think
this change would be in the best interests of the company? What is likely to happen in Year 3 to the
absorption costing net operating income if sales remain constant at 12,000 units per year?

THE FOUNDATIONAL 15
Available with McGraw-Hill’s Connect® Accounting.

Diego Company manufactures one product that is sold for $80 per unit in two geographic regions—the
East and West regions. The following information pertains to the company’s first year of operations in
which it produced 40,000 units and sold 35,000 units.

Variable costs per unit:
Manufacturing:
Direct materials ………………………………. $24
Direct labor …………………………………….. $14
Variable manufacturing overhead ………. $2
Variable selling and administrative …………… $4
Fixed costs per year:
Fixed manufacturing overhead ………………… $800,000
Fixed selling and administrative expenses …. $496,000

The company sold 25,000 units in the East region and 10,000 units in the West region. It determined that
$250,000 of its fixed selling and administrative expenses is traceable to the West region, $150,000 is

LO1, LO2, LO3
LO4

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265Variable Costing and Segment Reporting: Tools for Management

traceable to the East region, and the remaining $96,000 is a common fixed cost. The company will con-
tinue to incur the total amount of its fixed manufacturing overhead costs as long as it continues to produce
any amount of its only product.

Required:
Answer each question independently based on the original data unless instructed otherwise. You do not
need to prepare a segmented income statement until question 13.
1. What is the unit product cost under variable costing?
2. What is the unit product cost under absorption costing?
3. What is the company’s total contribution margin under variable costing?
4. What is the company’s net operating income under variable costing?
5. What is the company’s total gross margin under absorption costing?
6. What is the company’s net operating income under absorption costing?
7. What is the amount of the difference between the variable costing and absorption costing net operating

incomes? What is the cause of this difference?
8. What is the company’s break-even point in unit sales? Is it above or below the actual sales volume?

Compare the break-even sales volume to your answer for question 6 and comment.
9. If the sales volumes in the East and West regions had been reversed, what would be the company’s

overall break-even point in unit sales?
10. What would have been the company’s variable costing net operating income if it had produced and

sold 35,000 units? You do not need to perform any calculations to answer this question.
11. What would have been the company’s absorption costing net operating income if it had produced and

sold 35,000 units? You do not need to perform any calculations to answer this question.
12. If the company produces 5,000 fewer units than it sells in its second year of operations, will absorption

costing net operating income be higher or lower than variable costing net operating income in Year 2?
Why? No calculations are necessary.

13. Prepare a contribution format segmented income statement that includes a Total column and columns
for the East and West regions.

14. Diego is considering eliminating the West region because an internally generated report suggests the
region’s total gross margin in the first year of operations was $50,000 less than its traceable fixed selling
and administrative expenses. Diego believes that if it drops the West region, the East region’s sales will
grow by 5% in Year 2. Using the contribution approach for analyzing segment profitability and assuming
all else remains constant in Year 2, what would be the profit impact of dropping the West region in Year 2?

15. Assume the West region invests $30,000 in a new advertising campaign in Year 2 that increases its unit
sales by 20%. If all else remains constant, what would be the profit impact of pursuing the advertising
campaign?

EXERCISES
All applicable exercises are available with McGraw-Hill’s Connect® Accounting.

EXERCISE 6–1 Variable and Absorption Costing Unit Product Costs [LO1]
Shastri Bicycle of Mumbai, India, produces an inexpensive, yet rugged, bicycle for use on the city’s
crowded streets that it sells for 500 rupees. (Indian currency is denominated in rupees, denoted by R.)
Selected data for the company’s operations last year follow:

Units in beginning inventory ……………………….. 0
Units produced …………………………………………. 10,000
Units sold …………………………………………………. 8,000
Units in ending inventory …………………………….. 2,000
Variable costs per unit:
Direct materials ………………………………………. R120
Direct labor ……………………………………………. R140
Variable manufacturing overhead ……………… R50
Variable selling and administrative ……………. R20
Fixed costs:
Fixed manufacturing overhead …………………. R600,000
Fixed selling and administrative ……………….. R400,000

Units sold 5 9,000

TAKE
TWO

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Required:
1. Assume that the company uses absorption costing. Compute the unit product cost for one bicycle.
2. Assume that the company uses variable costing. Compute the unit product cost for one bicycle.

EXERCISE 6–2 Variable Costing Income Statement; Explanation of Difference in Net Operating
Income [LO2]
Refer to the data in Exercise 6–1 for Shastri Bicycle. The absorption costing income statement prepared by
the company’s accountant for last year appears below:

Sales …………………………………………………. R4,000,000
Cost of goods sold ………………………………. 2,960,000
Gross margin ……………………………………… 1,040,000
Selling and administrative expense ……….. 560,000
Net operating income ………………………….. R 480,000

Required:
1. Determine how much of the ending inventory consists of fixed manufacturing overhead cost deferred

in inventory to the next period.
2. Prepare an income statement for the year using variable costing. Explain the difference in net operating

income between the two costing methods.

EXERCISE 6–3 Reconciliation of Absorption and Variable Costing Net Operating Incomes [LO3]
High Tension Transformers, Inc., manufactures heavy-duty transformers for electrical switching stations.
The company uses variable costing for internal management reports and absorption costing for external
reports to shareholders, creditors, and the government. The company has provided the following data:

Year 1 Year 2 Year 3

Inventories:
Beginning (units) ……………………………… 180 150 160
Ending (units) ………………………………….. 150 160 200
Variable costing net operating income ……. $292,400 $269,200 $251,800

The company’s fixed manufacturing overhead per unit was constant at $450 for all three years.

Required:
1. Determine each year’s absorption costing net operating income. Present your answer in the form of a

reconciliation report.
2. In Year 4, the company’s variable costing net operating income was $240,200 and its absorption costing

net operating income was $267,200. Did inventories increase or decrease during Year 4? How much
fixed manufacturing overhead cost was deferred or released from inventory during Year 4?

EXERCISE 6–4 Basic Segmented Income Statement [LO4]
Caltec, Inc., produces and sells recordable CD and DVD packs. Revenue and cost information relating to
the products follow:

Product

CD DVD

Selling price per pack ……………………… $8.00 $25.00
Variable expenses per pack ……………… $3.20 $17.50
Traceable fi xed expenses per year ……. $138,000 $45,000

Common fixed expenses in the company total $105,000 annually. Last year the company produced and
sold 37,500 CD packs and 18,000 DVD packs.

Required:
Prepare a contribution format income statement for the year segmented by product lines.

Year 1 ending inventory
5 140 units

Unit sales 5 18,000 CD
packs and 37,500 DVD
packs

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267Variable Costing and Segment Reporting: Tools for Management

EXERCISE 6–5 Deducing Changes in Inventories [LO3]
Ferguson Products Inc., a manufacturer, reported $130 million in sales and a loss of $25 million in its
absorption costing income statement provided to shareholders. According to a CVP analysis prepared for
management, the company’s break-even point is $120 million in sales.

Required:
Assuming that the CVP analysis is correct, is it likely that the company’s inventory level increased,
decreased, or remained unchanged during the year? Explain.

EXERCISE 6–6 Inferring Costing Method; Unit Product Cost [LO1]
Amcor, Inc., incurs the following costs to produce and sell a single product.

Variable costs per unit:
Direct materials ………………………………………………. $10
Direct labor …………………………………………………….. $5
Variable manufacturing overhead ………………………. $2
Variable selling and administrative expenses ………. $4
Fixed costs per year:
Fixed manufacturing overhead ………………………….. $90,000
Fixed selling and administrative expenses ………….. $300,000

During the last year, 30,000 units were produced and 25,000 units were sold. The Finished Goods inven-
tory account at the end of the year shows a balance of $85,000 for the 5,000 unsold units.

Required:
1. Is the company using absorption costing or variable costing to cost units in the Finished Goods

inventory account? Show computations to support your answer.
2. Assume that the company wishes to prepare financial statements for the year to issue to its stockholders.
a. Is the $85,000 figure for Finished Goods inventory the correct amount to use on these statements

for external reporting purposes? Explain.
b. At what dollar amount should the 5,000 units be carried in inventory for external reporting purposes?

EXERCISE 6–7 Variable and Absorption Costing Unit Product Costs and Income Statements
[LO1 , LO2]
Maxwell Company manufactures and sells a single product. The following costs were incurred during the
company’s first year of operations:

Variable costs per unit:
Manufacturing:
Direct materials ……………………………………….. $18
Direct labor ……………………………………………… $7
Variable manufacturing overhead ……………….. $2
Variable selling and administrative …………………. $2
Fixed costs per year:
Fixed manufacturing overhead ………………………. $200,000
Fixed selling and administrative expenses ………. $110,000

During the year, the company produced 20,000 units and sold 16,000 units. The selling price of the
company’s product is $50 per unit.

Required:
1. Assume that the company uses absorption costing:
a. Compute the unit product cost.
b. Prepare an income statement for the year.
2. Assume that the company uses variable costing:
a. Compute the unit product cost.
b. Prepare an income statement for the year.

Sales 5 $110 million;
absorption income
5 $10 million

Fixed manufacturing
overhead 5 $120,000

TAKE
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TAKE
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3. The company’s controller believes that the company should have set last year’s selling price at $51 instead
of $50 per unit. She estimates the company could have sold 15,000 units at a price of $51 per unit, thereby
increasing the company’s gross margin by $2,000 and its net operating income by $4,000. Assuming the
controller’s estimates are accurate, do you think the price increase would have been a good idea?

EXERCISE 6–8 Segmented Income Statement [LO4]
Michaels Company segments its income statement into its East and West Divisions. The company’s overall
sales, contribution margin ratio, and net operating income are $600,000, 50%, and $50,000, respectively.
The West Division’s contribution margin and contribution margin ratio are $150,000 and 75%, respec-
tively. The East Division’s segment margin is $70,000. The company has $60,000 of common fixed costs
that cannot be traced to either division.

Required:
Prepare an income statement for Michaels Company that uses the contribution format and is segmented by
divisions. In addition, for the company as a whole and for each segment, show each item on the segmented
income statements as a percent of sales.

EXERCISE 6–9 Variable Costing Unit Product Cost and Income Statement; Break-Even [LO1 , LO2]
CompuDesk, Inc., makes an oak desk specially designed for personal computers. The desk sells for $200.
Data for last year’s operations follow:

Units in beginning inventory …………………….. 0
Units produced ………………………………………. 10,000
Units sold ………………………………………………. 9,000
Units in ending inventory …………………………. 1,000
Variable costs per unit:
Direct materials …………………………………… $ 60
Direct labor …………………………………………. 30
Variable manufacturing overhead …………… 10
Variable selling and administrative …………. 20
Total variable cost per unit ……………………….. $120

Fixed costs:
Fixed manufacturing overhead ………………. $300,000
Fixed selling and administrative …………….. 450,000
Total fi xed costs ……………………………………… $750,000

Required:
1. Assume that the company uses variable costing. Compute the unit product cost for one computer desk.
2. Assume that the company uses variable costing. Prepare a contribution format income statement for

the year.
3. What is the company’s break-even point in terms of units sold?

EXERCISE 6–10 Absorption Costing Unit Product Cost and Income Statement [LO1, LO2]
Refer to the data in Exercise 6–9 for CompuDesk. Assume in this exercise that the company uses absorp-
tion costing.

Required:
1. Compute the unit product cost for one computer desk.
2. Prepare an income statement.

EXERCISE 6–11 Segmented Income Statement [LO4]
Bovine Company, a wholesale distributor of DVDs, has been experiencing losses for some time, as shown
by its most recent monthly contribution format income statement below:

Sales …………………………………………………. $1,500,000
Variable expenses ………………………………. 588,000

Contribution margin …………………………….. 912,000
Fixed expenses …………………………………… 945,000

Net operating loss ……………………………….. $ (33,000)

Fixed manufacturing
overhead 5 $250,000

See Exercise 6-9

TAKE
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269Variable Costing and Segment Reporting: Tools for Management

In an effort to isolate the problem, the president has asked for an income statement segmented by geo-
graphic market. Accordingly, the Accounting Department has developed the following data:

Geographic

Market

South Central North

Sales …………………………………………….. $400,000 $600,000 $500,000
Variable expenses as a percentage
of sales ………………………………………. 52% 30% 40%
Traceable fi xed expenses ………………… $240,000 $330,000 $200,000

Required:
1. Prepare a contribution format income statement segmented by geographic market, as desired by the

president.
2. The company’s sales manager believes that sales in the Central geographic market could be increased

by 15% if monthly advertising were increased by $25,000. Would you recommend the increased
advertising? Show computations to support your answer.

EXERCISE 6–12 Variable and Absorption Costing Unit Product Costs and Income Statements
[LO1 , LO2, LO3]
Fletcher Company manufactures and sells one product. The following information pertains to each of the
company’s first two years of operations:

Variable costs per unit:
Manufacturing:
Direct materials …………………………………………… $20
Direct labor …………………………………………………. $12
Variable manufacturing overhead …………………… $4
Variable selling and administrative …………………….. $3
Fixed costs per year:
Fixed manufacturing overhead ………………………….. $200,000
Fixed selling and administrative expenses …………. $80,000

During its first year of operations, Fletcher produced 50,000 units and sold 40,000 units. During its second
year of operations, it produced 40,000 units and sold 50,000 units. The selling price of the company’s
product is $50 per unit.

Required:
1. Assume the company uses variable costing:
a. Compute the unit product cost for year 1 and year 2.
b. Prepare an income statement for year 1 and year 2.
2. Assume the company uses absorption costing:
a. Compute the unit product cost for year 1 and year 2.
b. Prepare an income statement for year 1 and year 2.
3. Explain the difference between variable costing and absorption costing net operating income in year 1.

Also, explain why the two net operating incomes differ in year 2.

EXERCISE 6–13 Variable Costing Income Statement; Reconciliation [LO2, LO3]
Morey Company has just completed its first year of operations. The company’s absorption costing income
statement for the year appears below:

Morey Company
Income Statement

Sales (40,000 units × $33.75 per unit) ……………………………….. $1,350,000
Cost of goods sold (40,000 units × $21 per unit) …………………. 840,000
Gross margin ………………………………………………………………….. 510,000
Selling and administrative expenses ………………………………….. 420,000
Net operating income ………………………………………………………. $ 90,000

Variable expense percentage
for Central 5 75%

Fixed manufacturing
overhead 5 $400,000

TAKE
TWO
TAKE
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270 Chapter 6

The company’s selling and administrative expenses consist of $300,000 per year in fixed expenses and
$3 per unit sold in variable expenses. The company’s $21 per unit product cost shown on the previous page
is computed as follows:

Direct materials ……………………………………………………………….. $10
Direct labor …………………………………………………………………….. 4
Variable manufacturing overhead ………………………………………. 2
Fixed manufacturing overhead ($250,000 ÷ 50,000 units) ……. 5
Absorption costing unit product cost…………………………………… $21

Required:
1. Redo the company’s income statement in the contribution format using variable costing.
2. Reconcile any difference between the net operating income on your variable costing income statement

and the net operating income on the absorption costing income statement.

EXERCISE 6–14 Working with a Segmented Income Statement [LO4]
Marple Associates is a consulting firm that specializes in information systems for construction and land-
scaping companies. The firm has two offices—one in Houston and one in Dallas. The firm classifies the
direct costs of consulting jobs as variable costs. A segmented contribution format income statement for the
company’s most recent year is given below:

Office

Total Company Houston Dallas

Sales …………………………………… $750,000 100.0% $150,000 100% $600,000 100%
Variable expenses ………………… 405,000 54.0 45,000 30 360,000 60
Contribution margin ………………. 345,000 46.0 105,000 70 240,000 40
Traceable fi xed expenses ………. 168,000 22.4 78,000 52 90,000 15
Office segment margin …………… 177,000 23.6 $ 27,000 18% $150,000 25%
Common fi xed expenses
not traceable to offices ……….. 120,000 16.0
Net operating income ……………. $ 57,000 7.6%

Required:
1. By how much would the company’s net operating income increase if Dallas increased its sales by

$75,000 per year? Assume no change in cost behavior patterns.
2. Refer to the original data. Assume that sales in Houston increase by $50,000 next year and that sales

in Dallas remain unchanged. Assume no change in fixed costs.
a. Prepare a new segmented income statement for the company using the above format. Show both

amounts and percentages.
b. Observe from the income statement you have prepared that the CM ratio for Houston has remained

unchanged at 70% (the same as in the above data) but that the segment margin ratio has changed.
How do you explain the change in the segment margin ratio?

EXERCISE 6–15 Working with a Segmented Income Statement [LO4]
Refer to the data in Exercise 6–14. Assume that Dallas’ sales by major market are as follows:

Market

Dallas
Construction

Clients

Landscaping

Clients

Sales ………………………………. $600,000 100% $400,000 100% $200,000 100%
Variable expenses ……………. 360,000 60 260,000 65 100,000 50

Contribution margin ………….. 240,000 40 140,000 35 100,000 50
Traceable fi xed expenses ….. 72,000 12 20,000 5 52,000 26
Market segment margin …….. 168,000 28 $120,000 30% $ 48,000 24%
Common fi xed expenses
not traceable to markets …. 18,000 3
Office segment margin ………. $150,000 25%

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271Variable Costing and Segment Reporting: Tools for Management

The company would like to initiate an intensive advertising campaign in one of the two markets during
the next month. The campaign would cost $8,000. Marketing studies indicate that such a campaign would
increase sales in the construction market by $70,000 or increase sales in the landscaping market by $60,000.

Required:
1. In which of the markets would you recommend that the company focus its advertising campaign?

Show computations to support your answer.
2. In Exercise 6–14, Dallas shows $90,000 in traceable fixed expenses. What happened to the $90,000 in

this exercise?

All applicable problems are available with McGraw-Hill’s Connect ® Accounting .

PROBLEM 6–16A Variable and Absorption Costing Unit Product Costs and Income Statements;
Explanation of Difference in Net Operating Income [LO1 , LO2, LO3]
Brock Company produces and sells an industrial product. The company has just opened a new plant to
manufacture the product, and the following cost and revenue data have been provided for the first month
of the plant’s operation:

Beginning inventory …………………………………………………………. 0
Units produced ……………………………………………………………….. 40,000
Units sold ……………………………………………………………………….. 35,000
Selling price per unit ………………………………………………………… $60
Selling and administrative expenses:
Variable per unit …………………………………………………………… $2
Fixed (total) …………………………………………………………………. $560,000
Manufacturing costs
Direct materials cost per unit …………………………………………. $15
Direct labor cost per unit ……………………………………………….. $7
Variable manufacturing overhead cost per unit …………………. $2
Fixed manufacturing overhead cost (total) ……………………….. $640,000

Required:
1. Assume that the company uses absorption costing.
a. Determine the unit product cost.
b. Prepare an income statement for the month.
2. Assume that the company uses variable costing.
a. Determine the unit product cost.
b. Prepare a contribution format income statement for the month.
3. Explain the reason for any difference in the ending inventory balances under the two costing methods

and the impact of this difference on reported net operating income.

PROBLEM 6–17A Variable and Absorption Costing Unit Product Costs and Income Statements
[LO1 , LO2]
Nickelson Company manufactures and sells one product. The following information pertains to each of the
company’s first three years of operations:

Variable costs per unit:
Manufacturing:
Direct materials …………………………………….. $25
Direct labor …………………………………………… $16
Variable manufacturing overhead …………….. $5
Variable selling and administrative ………………. $2
Fixed costs per year:
Fixed manufacturing overhead ……………………. $300,000
Fixed selling and administrative expenses ……. $180,000

CHECK FIGURE
(1b) Net operating income:

$70,000; (2b) Net
operating loss: $10,000

CHECK FIGURE
(3b) Year 3 net operating

income: $(60,000)

PROBLEMS Alternate problem set is available on the text website and in Connect® Accounting.

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272 Chapter 6

During its first year of operations Nickelson produced 60,000 units and sold 60,000 units. During its sec-
ond year of operations it produced 75,000 units and sold 50,000 units. In its third year, Nickelson produced
40,000 units and sold 65,000 units. The selling price of the company’s product is $56 per unit.

Required:
1. Compute the company’s break-even point in units sold.
2. Assume the company uses variable costing:
a. Compute the unit product cost for year 1, year 2, and year 3.
b. Prepare an income statement for year 1, year 2, and year 3.
3. Assume the company uses absorption costing:
a. Compute the unit product cost for year 1, year 2, and year 3.
b. Prepare an income statement for year 1, year 2, and year 3.
4. Compare the net operating income figures that you computed in requirements 2 and 3 to the

break-even point that you computed in requirement 1. Which net operating income figures seem
counterintuitive? Why?

PROBLEM 6–18A Variable Costing Income Statement; Reconciliation [LO2, LO3]
During Denton Company’s first two years of operations, the company reported absorption costing net
operating income as follows:

Year 1 Year 2

Sales (@ $50 per unit) ……………………………… $1,000,000 $1,500,000
Cost of goods sold (@ $34 per unit) …………… 680,000 1,020,000
Gross margin ………………………………………….. 320,000 480,000
Selling and administrative expenses* …………. 310,000 340,000
Net operating income ………………………………. $ 10,000 $ 140,000

* $3 per unit variable; $250,000 fi xed each year.

The company’s $34 unit product cost is computed as follows:

Direct materials …………………………………………………………….. $ 8
Direct labor ………………………………………………………………….. 10
Variable manufacturing overhead ……………………………………. 2
Fixed manufacturing overhead ($350,000 ÷ 25,000 units) …. 14
Absorption costing unit product cost………………………………… $34

Production and cost data for the two years are given below:

Year 1 Year 2

Units produced …………… 25,000 25,000
Units sold …………………… 20,000 30,000

Required:
1. Prepare a variable costing contribution format income statement for each year.
2. Reconcile the absorption costing and variable costing net operating income figures for each year.

e celx

CHECK FIGURE
(1) Year 2 net operating

income: $210,000

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PROBLEM 6–19A Comprehensive Problem with Labor Fixed [LO1 , LO2, LO3]
Advance Products, Inc., has just organized a new division to manufacture and sell specially designed tables
using select hardwoods for personal computers. The division’s monthly costs are shown in the schedule below:

Manufacturing costs:
Variable costs per unit:
Direct materials …………………………………… $86
Variable manufacturing overhead …………… $4
Fixed manufacturing overhead costs (total) … $240,000
Selling and administrative costs:
Variable …………………………………………………. 15% of sales
Fixed (total) ……………………………………………. $160,000

Advance Products regards all of its workers as full-time employees and the company has a long-standing
no-layoff policy. Furthermore, production is highly automated. Accordingly, the company includes its
labor costs in its fixed manufacturing overhead. The tables sell for $250 each.

During the first month of operations, the following activity was recorded:

Units produced ………………. 4,000
Units sold ………………………. 3,200

Required:

1. Compute the unit product cost under:
a. Absorption costing.
b. Variable costing.
2. Prepare an income statement for the month using absorption costing.
3. Prepare a contribution format income statement for the month using variable costing.
4. Assume that the company must obtain additional financing. As a member of top management, which

of the statements that you have prepared in (2) and (3) above would you prefer to take with you to
negotiate with the bank? Why?

5. Reconcile the absorption costing and variable costing net operating incomes in (2) and (3) above.

PROBLEM 6–20A Prepare and Reconcile Variable Costing Statements [LO1 , LO2, LO3]
Linden Company manufactures and sells a single product. Cost data for the product follow:

Variable costs per unit:
Direct materials …………………………………. $ 6
Direct labor ……………………………………….. 12
Variable factory overhead ……………………. 4
Variable selling and administrative ……….. 3
Total variable costs per unit ……………………. $25

Fixed costs per month:
Fixed manufacturing overhead …………….. $240,000
Fixed selling and administrative …………… 180,000
Total fi xed cost per month ………………………. $420,000

The product sells for $40 per unit. Production and sales data for May and June, the first two months
of operations, are as follows:

Units
Produced

Units
Sold

May ……………………….. 30,000 26,000
June ………………………. 30,000 34,000

e celx

CHECK FIGURE
(2) Net operating income:

$40,000

CHECK FIGURE
(2) June net operating

income: $90,000

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Income statements prepared by the accounting department, using absorption costing, are presented below:

May June

Sales ………………………………………………… $1,040,000 $1,360,000
Cost of goods sold ……………………………… 780,000 1,020,000
Gross margin …………………………………….. 260,000 340,000
Selling and administrative expenses …….. 258,000 282,000
Net operating income …………………………. $ 2,000 $ 58,000

Required:
1. Determine the unit product cost under:
a. Absorption costing.
b. Variable costing.
2. Prepare contribution format variable costing income statements for May and June.
3. Reconcile the variable costing and absorption costing net operating incomes.
4. The company’s Accounting Department has determined the break-even point to be 28,000 units per

month, computed as follows:

Fixed cost per month

_____________________
Unit contribution margin

= $420,000 __________
$15 per unit

= 28,000 units

Upon receiving this figure, the president commented, “There’s something peculiar here. The controller
says that the break-even point is 28,000 units per month. Yet we sold only 26,000 units in May, and the
income statement we received showed a $2,000 profit. Which figure do we believe?” Prepare a brief expla-
nation of what happened on the May income statement.

PROBLEM 6–21A Absorption and Variable Costing; Production Constant, Sales Fluctuate
[LO1 , LO2, LO3]
Sandi Scott obtained a patent on a small electronic device and organized Scott Products, Inc., to produce
and sell the device. During the first month of operations, the device was very well received on the market,
so Ms. Scott looked forward to a healthy profit. For this reason, she was surprised to see a loss for the
month on her income statement. This statement was prepared by her accounting service, which takes great
pride in providing its clients with timely financial data. The statement follows:

Scott Products, Inc.
Income Statement

Sales (40,000 units) ………………………………………. $200,000
Variable expenses:
Variable cost of goods sold …………………………. $80,000
Variable selling and administrative expenses …. 30,000 110,000
Contribution margin ………………………………………. 90,000
Fixed expenses:
Fixed manufacturing overhead …………………….. 75,000
Fixed selling and administrative expenses …….. 20,000 95,000
Net operating loss …………………………………………. $ (5,000)

Ms. Scott is discouraged over the loss shown for the month, particularly because she had planned to
use the statement to encourage investors to purchase stock in the new company. A friend, who is a CPA,
insists that the company should be using absorption costing rather than variable costing. He argues that if
absorption costing had been used, the company would probably have reported a profit for the month.

Selected cost data relating to the product and to the first month of operations follow:

Units produced …………………………………………….. 50,000
Units sold …………………………………………………….. 40,000
Variable costs per unit:
Direct materials ………………………………………….. $1.00
Direct labor ……………………………………………….. $0.80
Variable manufacturing overhead …………………. $0.20
Variable selling and administrative expenses …. $0.75

CHECK FIGURE
(1b) Net operating income:

$10,000; (3a) Net
operating income:
$40,000

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275Variable Costing and Segment Reporting: Tools for Management

Required:
1. Complete the following:
a. Compute the unit product cost under absorption costing.
b. Redo the company’s income statement for the month using absorption costing.
c. Reconcile the variable and absorption costing net operating income (loss) figures.
2. Was the CPA correct in suggesting that the company really earned a “profit” for the month? Explain.
3. During the second month of operations, the company again produced 50,000 units but sold 60,000 units.

(Assume no change in total fixed costs.)
a. Prepare a contribution format income statement for the month using variable costing.
b. Prepare an income statement for the month using absorption costing.
c. Reconcile the variable costing and absorption costing net operating incomes.

PROBLEM 6–22A Restructuring a Segmented Income Statement [LO4]
Brabant NV of the Netherlands is a wholesale distributor of Dutch cheeses that it sells throughout the
European Community. Unfortunately, the company’s profits have been declining, which has caused con-
siderable concern. To help understand the condition of the company, the managing director of the com-
pany has requested that the monthly income statement be segmented by sales territory. Accordingly, the
company’s accounting department has prepared the following statement for March, the most recent month.
(The Dutch currency is the euro which is designated by €.)

Sales Territory

Southern
Europe

Middle
Europe

Northern
Europe

Sales ………………………………………………………… €300,000 €800,000 € 700,000

Territorial expenses (traceable):
Cost of goods sold ………………………………….. 93,000 240,000 315,000
Salaries …………………………………………………. 54,000 56,000 112,000
Insurance ………………………………………………. 9,000 16,000 14,000
Advertising …………………………………………….. 105,000 240,000 245,000
Depreciation …………………………………………… 21,000 32,000 28,000
Shipping ………………………………………………… 15,000 32,000 42,000
Total territorial expenses ……………………………… 297,000 616,000 756,000

Territorial income (loss)
before corporate expenses ………………………. 3,000 184,000 (56,000)

Corporate expenses:
Advertising (general) ……………………………….. 15,000 40,000 35,000
General administrative …………………………….. 20,000 20,000 20,000
Total corporate expenses…………………………….. 35,000 60,000 55,000
Net operating income (loss) ………………………… € (32,000) €124,000 €(111,000)

Cost of goods sold and shipping expenses are both variable; other costs are all fixed. Brabant NV
purchases cheeses at auction and from farmers’ cooperatives, and it distributes them in the three territo-
ries listed above. Each of the three sales territories has its own manager and sales staff. The cheeses vary
widely in profitability; some have a high margin and some have a low margin. (Certain cheeses, after hav-
ing been aged for long periods, are the most expensive and carry the highest margins.)

Required:
1. List any disadvantages or weaknesses that you see to the statement format illustrated above.
2. Explain the basis that is apparently being used to allocate the corporate expenses to the territories. Do

you agree with these allocations? Explain.
3. Prepare a new segmented contribution format income statement for March. Show a Total column as

well as data for each territory. In addition, for the company as a whole and for each sales territory,
show each item on the segmented income statement as a percent of sales.

4. Analyze the statement that you prepared in (3) above. What points that might help to improve the
company’s performance would you bring to management’s attention?

CHECK FIGURE
(3) Middle Europe segment

margin: €184,000

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PROBLEM 6–23A Prepare and Interpret Statements; Changes in Both Sales and Production; Lean
Production [LO1 , LO2, LO3]
Memotec, Inc., manufactures and sells a unique electronic part. Operating results for the first three years of
activity were as follows (absorption costing basis):

Year 1 Year 2 Year 3

Sales ……………………………………………………………. $1,000,000 $800,000 $1,000,000
Cost of goods sold …………………………………………. 800,000 560,000 850,000
Gross margin ………………………………………………… 200,000 240,000 150,000
Selling and administrative expenses ………………… 170,000 150,000 170,000
Net operating income (loss) …………………………….. $ 30,000 $ 90,000 $ (20,000)

Sales dropped by 20% during Year 2 due to the entry of several foreign competitors into the market.
Memotec had expected sales to remain constant at 50,000 units for the year; production was set at 60,000 units
in order to build a buffer of protection against unexpected spurts in demand. By the start of Year 3, man-
agement could see that spurts in demand were unlikely and that the inventory was excessive. To work off
the excessive inventories, Memotec cut back production during Year 3, as shown below:

Year 1 Year 2 Year 3

Production in units …………… 50,000 60,000 40,000
Sales in units ………………….. 50,000 40,000 50,000

Additional information about the company follows:
a. The company’s plant is highly automated. Variable manufacturing costs (direct materials, direct labor,

and variable manufacturing overhead) total only $4 per unit, and fixed manufacturing overhead costs
total $600,000 per year.

b. Fixed manufacturing overhead costs are applied to units of product on the basis of each year’s
production. That is, a new fixed overhead rate is computed each year.

c. Variable selling and administrative expenses are $2 per unit sold. Fixed selling and administrative
expenses total $70,000 per year.

d. The company uses a FIFO inventory flow assumption.
Memotec’s management can’t understand why profits tripled during Year 2 when sales dropped by

20%, and why a loss was incurred during Year 3 when sales recovered to previous levels.

Required:
1. Prepare a contribution format variable costing income statement for each year.
2. Refer to the absorption costing income statements above.
a. Compute the unit product cost in each year under absorption costing. (Show how much of this cost

is variable and how much is fixed.)
b. Reconcile the variable costing and absorption costing net operating incomes for each year.
3. Refer again to the absorption costing income statements. Explain why net operating income was

higher in Year 2 than it was in Year 1 under the absorption approach, in light of the fact that fewer units
were sold in Year 2 than in Year 1.

4. Refer again to the absorption costing income statements. Explain why the company suffered a loss in
Year 3 but reported a profit in Year 1, although the same number of units was sold in each year.

5. a. Explain how operations would have differed in Year 2 and Year 3 if the company had been using
Lean Production with the result that ending inventory was zero.

b. If Lean Production had been in use during Year 2 and Year 3, and the predetermined overhead
rate is based on 50,000 units per year, what would the company’s net operating income (or
loss) have been in each year under absorption costing? Explain the reason for any differences
between these income figures and the figures reported by the company in the statements above.

e celx

CHECK FIGURE
(1) Year 3 net operating

income: $30,000

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277Variable Costing and Segment Reporting: Tools for Management

PROBLEM 6–24A Segmented Income Statements [LO4]
Vega Foods, Inc., has recently purchased a small mill that it intends to operate as one of its subsidiaries.
The newly acquired mill has three products that it offers for sale—wheat cereal, pancake mix, and flour.
Each product sells for $10 per package. Materials, labor, and other variable production costs are $3.00 per
bag of wheat cereal, $4.20 per bag of pancake mix, and $1.80 per bag of flour. Sales commissions are 10%
of sales for any product. All other costs are fixed.

The mill’s income statement for the most recent month is given below:

Product Line

Total
Company

Wheat
Cereal

Pancake
Mix Flour

Sales ………………………………………. $600,000 $200,000 $300,000 $100,000

Expenses:
Materials, labor, and other ……… 204,000 60,000 126,000 18,000
Sales commissions ……………….. 60,000 20,000 30,000 10,000
Advertising …………………………… 123,000 48,000 60,000 15,000
Salaries ……………………………….. 66,000 34,000 21,000 11,000
Equipment depreciation …………. 30,000 10,000 15,000 5,000
Warehouse rent …………………….. 12,000 4,000 6,000 2,000
General administration …………… 90,000 30,000 30,000 30,000
Total expenses …………………………. 585,000 206,000 288,000 91,000
Net operating income (loss) ……….. $ 15,000 $ (6,000) $ 12,000 $ 9,000

The following additional information is available about the company:
a. The same equipment is used to mill and package all three products. In the above income statement,

equipment depreciation has been allocated on the basis of sales dollars. An analysis of equipment
usage indicates that it is used 40% of the time to make wheat cereal, 50% of the time to make pancake
mix, and 10% of the time to make flour.

b. All three products are stored in the same warehouse. In the above income statement, the warehouse
rent has been allocated on the basis of sales dollars. The warehouse contains 24,000 square feet of
space, of which 8,000 square feet are used for wheat cereal, 14,000 square feet are used for pancake
mix, and 2,000 square feet are used for flour. The warehouse space costs the company $0.50 per
square foot per month to rent.

c. The general administration costs relate to the administration of the company as a whole. In the above
income statement, these costs have been divided equally among the three product lines.

d. All other costs are traceable to the product lines.
Vega Foods’ management is anxious to improve the mill’s 2.5% margin on sales.

Required:
1. Prepare a new contribution format segmented income statement for the month. Adjust the allocation

of equipment depreciation and warehouse rent as indicated by the additional information provided.
2. After seeing the income statement in the main body of the problem, management has decided to

eliminate the wheat cereal because it is not returning a profit, and to focus all available resources on
promoting the pancake mix.

a. Based on the statement you have prepared, do you agree with the decision to eliminate the wheat
cereal? Explain.

b. Based on the statement you have prepared, do you agree with the decision to focus all available
resources on promoting the pancake mix? Assume that an ample market is available for all three
products. (Hint: compute the contribution margin ratio for each product.)

CHECK FIGURE
(1) Flour segment margin:

$42,000

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278 Chapter 6

BUILDING YOUR SKILLS

ANALYTICAL THINKING [LO4]
The most recent monthly contribution format income statement for Reston Company is given below:

Reston Company
Income Statement

For the Month Ended May 31

Sales …………………………………… $900,000 100.0%
Variable expenses ………………… 408,000 45.3
Contribution margin ………………. 492,000 54.7
Fixed expenses …………………….. 465,000 51.7
Net operating income ……………. $ 27,000 3.0%

Management is disappointed with the company’s performance and is wondering what can be done to
improve profits. By examining sales and cost records, you have determined the following:
a. The company is divided into two sales territories—Central and Eastern. The Central Territory

recorded $400,000 in sales and $208,000 in variable expenses during May. The remaining sales and
variable expenses were recorded in the Eastern Territory. Fixed expenses of $160,000 and $130,000
are traceable to the Central and Eastern Territories, respectively. The rest of the fixed expenses are
common to the two territories.

b. The company is the exclusive distributor for two products—Awls and Pows. Sales of Awls and Pows
totaled $100,000 and $300,000, respectively, in the Central Territory during May. Variable expenses
are 25% of the selling price for Awls and 61% for Pows. Cost records show that $60,000 of the Central
Territory’s fixed expenses are traceable to Awls and $54,000 to Pows, with the remainder common to
the two products.

Required:
1. Prepare contribution format segmented income statements, first showing the total company broken

down between sales territories and then showing the Central Territory broken down by product line. In
addition, for the company as a whole and for each segment, show each item on the segmented income
statements as a percent of sales.

2. Look at the statement you have prepared showing the total company segmented by sales territory.
What points revealed by this statement should be brought to management’s attention?

3. Look at the statement you have prepared showing the Central Territory segmented by product lines.
What points revealed by this statement should be brought to management’s attention?

ETHICS CHALLENGE [LO2]
Aristotle Constantinos, the manager of DuraProducts’ Australian Division, is trying to set the production
schedule for the last quarter of the year. The Australian Division had planned to sell 100,000 units during
the year, but current projections indicate sales will be only 78,000 units in total. By September 30 the fol-
lowing activity had been reported:

Units

Inventory, January 1 ………………………….. 0
Production ………………………………………… 72,000
Sales ……………………………………………….. 60,000
Inventory, September 30 …………………….. 12,000

Demand has been soft, and the sales forecast for the last quarter is only 18,000 units.
The division can rent warehouse space to store up to 30,000 units. The division should maintain a

minimum inventory level of at least 1,500 units. Mr. Constantinos is aware that production must be at least
6,000 units per quarter in order to retain a nucleus of key employees. Maximum production capacity is
45,000 units per quarter.

e celx
CHECK FIGURE
(1) Central segment

margin: $32,000

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279Variable Costing and Segment Reporting: Tools for Management

Due to the nature of the division’s operations, fixed manufacturing overhead is a major element of
product cost.

Required:
1. Assume that the division is using variable costing. How many units should be scheduled for production

during the last quarter of the year? (The basic formula for computing the required production for
a period in a company is: Expected sales 1 Desired ending inventory 2 Beginning inventory 5
Required production.) Show computations and explain your answer. Will the number of units scheduled
for production affect the division’s reported profit for the year? Explain.

2. Assume that the division is using absorption costing and that the divisional manager is given an
annual bonus based on the division’s net operating income. If Mr. Constantinos wants to maximize
his division’s net operating income for the year, how many units should be scheduled for production
during the last quarter? [See the formula in (1) above.] Explain.

3. Identify the ethical issues involved in the decision Mr. Constantinos must make about the level of
production for the last quarter of the year.

CASE [LO4]
The American Association of Acupuncturists is a professional association for acupuncturists that has
10,000 members. The association operates from a central headquarters but has local chapters throughout
North America. The association’s monthly journal, American Acupuncture, features recent developments
in the field. The association also publishes special reports and books, and it sponsors courses that qualify
members for the continuing professional education credit required by state certification boards. The asso-
ciation’s statement of revenues and expenses for the current year is presented below:

American Association of Acupuncturists
Statement of Revenues and Expenses

For the Year Ended December 31

Revenues ……………………………………………………… $970,000

Expenses:
Salaries …………………………………………………….. 440,000
Occupancy costs ………………………………………… 120,000
Distributions to local chapters ………………………. 210,000
Printing ……………………………………………………… 82,000
Mailing ………………………………………………………. 24,000
Continuing education instructors’ fees ……………. 60,000
General and administrative ………………………….. 27,000
Total expenses ………………………………………………. 963,000
Excess of revenues over expenses ………………….. $ 7,000

The board of directors of the association has requested that you construct a segmented income state-
ment that shows the financial contribution of each of the association’s four major programs— membership
service, journal, books and reports, and continuing education. The following data have been gathered to
aid you:
a. Membership dues are $60 per year, of which $15 covers a one-year subscription to the association’s

journal. The other $45 pays for general membership services.
b. One-year subscriptions to American Acupuncture are sold to nonmembers and libraries at $20 per

subscription. A total of 1,000 of these subscriptions were sold last year. In addition to subscriptions,
the journal generated $50,000 in advertising revenues. The costs per journal subscription, for members
as well as nonmembers, were $4 for printing and $1 for mailing.

c. A variety of technical reports and professional books were sold for a total of $70,000 during the year.
Printing costs for these materials totaled $25,000, and mailing costs totaled $8,000.

d. The association offers a number of continuing education courses. The courses generated revenues of
$230,000 last year.

e. Salary costs and space occupied by each program and the central staff are as follows:

CHECK FIGURE
(1) Journal segment

margin: $95,000

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280 Chapter 6

Salaries
Space Occupied

(square feet)

Membership services……………….. $170,000 3,000
Journal …………………………………… 60,000 1,000
Books and reports …………………… 40,000 1,000
Continuing education ……………….. 50,000 2,000
Central staff ……………………………. 120,000 3,000
Total ………………………………………. $440,000 10,000

f. The $120,000 in occupancy costs incurred last year includes $20,000 in rental cost for a portion of
the warehouse used by the Membership Services program for storage purposes. The association has a
flexible rental agreement that allows it to pay rent only on the warehouse space it uses.

g. Printing costs other than for journal subscriptions are for books and reports related to Continuing
Education.

h. Distributions to local chapters are for general membership services.
i. General and administrative expenses include costs relating to overall administration of the association

as a whole. The association’s central staff does some mailing of materials for general administrative
purposes.

j. The expenses that can be traced or assigned to the central staff, as well as any other expenses that
are not traceable to the programs, will be treated as common costs. It is not necessary to distinguish
between variable and fixed costs.

Required:
1. Prepare a contribution format segmented income statement for the American Association of Acupuncturists

for last year. This statement should show the segment margin for each program as well as results for the
association as a whole.

2. Give arguments for and against allocating all costs of the association to the four programs.
(CMA, adapted)

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