Segmented variable costing income statement

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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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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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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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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 costing

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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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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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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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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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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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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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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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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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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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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Confirming Pages

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.