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Variable Costing & Segmented Income Statement

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I. Income Statements

This first module reviews variable costing. We are going to significantly amend the traditional financial income statement and the way in which we interpret the numbers for many types of internal decisions. The result is a powerful tool that is useful in virtually every aspect of a business career.

Below is a partial example of a simple external financial (absorption) income statement.

Revenues (Sales)

$10,000

less Cost of Goods Sold ( or Cost of Sales)

4,000

Gross Profit (Gross Margin)

$6,000

Operating Expenses

3,500

Net Income

$2,500

=====

Now, compare the above format to the variable costing approach below.

Revenue (Sales)

$10,000

Variable Costs

2,000

Contribution Margin

$8,000

Fixed Costs

5,500

Net Income

$2,500

=====

Note that there are two essential differences in these statements.

First, there is major difference in the way costs are organized. In the absorption income statement, costs are organized by function – product costs versus operating costs. In the variable costing income statement, costs are organized by behavior – variable costs versus fixed costs.

Second, the traditional statement uses cost of goods sold as the intermediate step while the variable costing approach margin uses contribution margin as the intermediate step.

Some essential points in this module are:

Costs organized by cost behavior can be more useful to decision makers than costs organized by function.

Contribution margin is a very relevant point of information. It tells the user of the statement the net benefit to the organization that is the result of the activity. That is, we will incur the fixed costs in any event. The variable costs are incurred only as the activity level increases. Thus, the contribution margin (the difference between revenue and variable costs) is a measure of the benefit of that activity.

Net income will be the same under both approaches only when there is no change in beginning or ending inventory (assuming constant prices).

II. A List of Accounting Terms

Cost behavior refers to how a cost will react to changes in the level of activity within the relevant range. The most commonly used classifications of cost behavior are variable and fixed costs:

Variable cost – A cost that varies, in total, in direct proportion to changes in the level of activity. However, variable cost per unit is constant.

Fixed cost – A cost that remains constant, in total, regardless of changes in the level of the activity. However, if expressed on a per-unit basis, the average fixed cost per unit varies inversely with changes in activity.

Mixed cost – A cost that has both a variable and a fixed component. These costs need to be broken down into two components by using a modeling approach.

Cost classifications for assigning costs to cost objects:

Cost object – Anything for which cost data are desired including products, customers, jobs, organizational subunits, etc. For purposes of assigning costs to cost objects, costs are classified two ways:

Direct costs – Costs that can be easily and conveniently traced to a specified cost object.

Indirect costs – Costs that cannot be easily and conveniently traced to a specified cost object.

Common costs – Indirect costs incurred to support a number of cost objects. These costs cannot be traced to any individual cost object.

Cost classifications for decision-making

It is important to realize that every decision involves a choice between at least two alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. To make decisions, it is essential to have a grasp on three concepts:

Differential costs (or incremental costs) – A difference in cost between any two alternatives (a difference in revenue between two alternatives is called differential revenue).

Differential costs can be either fixed or variable.

Opportunity cost- The potential benefit that is given up when one alternative is selected over another.

These costs are not usually entered into the accounting records of an organization, but must be explicitly considered in all decisions.

Sunk cost – A cost that has already been incurred and that cannot be changed now or in the future.

Behavioral income statement (variable costing) terms:

Contribution margin – Sales (revenues) minus variable costs.

Segment margin – Contribution margin minus direct fixed (direct, traceable) costs.

Common fixed costs – Direct fixed costs (untraceable) are subtracted from the segment margin to arrive at operating income.

Operating income – Income from operations.

Allocated expenses – Common fixed costs allocated to products (services, product lines, etc.) based on some type of formula.

Note that terminology is somewhat inconsistent, but it something we just have to live with. It is not only readings that use inconsistent terminology, but the same holds true for the workplace.

III. Cost Behavior

We will further elaborate on some of the terms introduced above that will be used throughout the course. See below for definitions and explanations.

Variable costs

A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level.
An activity base (also called a cost driver) is a measure of what causes the incurrence of variable costs. As the level of the activity base increases, the total variable cost increases proportionally.
Units produced (or sold) is not the only activity base within companies. A cost can be considered variable if it varies with activity bases such as miles driven, machine hours, or labor hours.
Variable costs remain constant if expressed on a per-unit basis. For example, the cost per minute talked is constant, that is, two cents per minute.

You cannot assume that a certain type of cost is always variable or fixed. Examine the facts of each situation before deciding whether a cost is fixed or variable. For example, a company’s employment policy may determine whether direct labor costs are fixed or variable with respect to volume of output.

True variable versus step-variable costs

True variable costs – The amount used during the period varies in direct proportion to the activity level. The traditional long-distance phone bill is an example of a true variable cost.
Step-variable costs – A resource that is obtainable only in large chunks and whose costs change only in response to fairly wide changes in activity. An example is a cost for a group rather than an individual.

Fixed costs

A fixed cost is a cost whose total dollar amount remains constant as the activity level changes. For example, paying one amount for long-distance calling regardless of usage. Average fixed costs per unit decrease as the activity level increases.

Types of fixed costs

Committed fixed costs

These costs are long-term in nature (i.e., greater than one year).

Discretionary fixed costs

These costs usually arise from annual decisions by management to spend in certain fixed cost areas. Advertising may be an example.

Trends

The trend in many industries is toward greater fixed costs relative to variable costs. Automation leads to higher fixed costs.

Mixed costs (also called semi-variable costs)

A mixed cost contains both variable and fixed cost elements.

For example, utility bills often contain fixed and variable cost components. The fixed portion of the utility bill is constant regardless of kilowatt hours consumed. This cost represents the minimum cost that is incurred to have the service ready and available for use. The variable portion of the bill varies in direct proportion to the consumption of kilowatt-hours.

An equation can be used to express the relationship between mixed costs and the level of the activity. This equation can be used to calculate what the total mixed cost would be for any level of activity.
Required Reading

accountingexplanation.com. (n.d.). Advantages, Disadvantages, and Limitations of Variable Costing Systems. From http://www.accountingexplanation.com/advantages_disadvantages_limitations_of_variable_costing.htm

Martin, J. R. (n.d.) Management Accounting: Concepts, Techniques, and Controversial Issues – Chapter 11: Conventional Linear Cost Volume Profit Analysis. Retrieved from http://maaw.info/Chapter11.htm

Slideshare. (n.d.). Determining How Costs Behave. Retrieved from http://www.slideshare.net/mingxinlu/cost-accounting-determining-how-cost-behaves

Walther, l. (2014). Principles of Accounting. Chapter Twenty-Three: Reporting to Support Managerial Decisions. Retrieved from http://www.principlesofaccounting.com/

Walther, l. (2014). Principles of Accounting. Chapter Twenty-Three. Segment Reporting [Video File]. Retrieved from http://www.principlesofaccounting.com/youtube_player_poa/player.html?filename=rEY0UWHYCEM
Optional Resource(s)

Case Assignment

Adding and Dropping Products

TYZ Company

Preparing a segmented income statement for various scenarios assists management in determining the estimated financial impact of making one choice over another. It is expected that you understand how costs behave and that you are familiar with the contribution margin concept. This case expands on these ideas by examining different types of fixed costs.

The company we are looking at in this module makes two products and is considering adding one more since the company has excess capacity. One aspect of making this decision is to screen the various scenarios to determine the potential profitability. Financial information alone does not tell us what to do, but it is a good start.

TYZ Company currently manufactures two products, Y and Z. The company has the capacity to make one additional product, with two (P1 and P2) currently under consideration. The forecasted annual sales and related costs for each “new” product are as follows.

Product P1

Product P2

Sales

$320,000

$320,000

Variable costs

Production (%)

50%

70%

Selling and administrative (%)

10%

5%

Direct fixed expenses

$25,000

$12,500

See below for the income statement for last year’s operations for TYZ Company.

Product Y

Product Z

Total

Sales

$275,000

$400,000

$675,000

Less variable expenses

Production

100,000

200,000

300,000

Selling and administrative

20,000

60,000

80,000

Contribution margin

$155,000

$140,000

$295,000

Less direct fixed expenses

10,000

55,000

65,000

Segment margin

$145,000

$85,000

$230,000

Less common fixed expenses

75,000

Net income

$155,000

=======

Common fixed costs are allocated to each product line on the basis of sales revenues.

Required:

Computations (use Excel).

Prepare a variable costing income statement that includes products Y, Z, and P1. Repeat for products Y, Z, and P2.
What if P2’s variable production costs were reduced to 55% of sales? Prepare another variable costing income statement to show the change.
Suppose that you could add both P1 and P2, if either Y or Z is dropped. Would you drop one of the current products to add both P1 and P2? Show computations in Excel that will support a written answer in the memo.

Memo (use Word).

Analyze the computations in Excel and evaluate the three related proposals before making a recommendation.

Do you recommend adding product P1 or P2?
Do the lower production costs change your recommendation?
See question 3 above.
Which of the products looks the most profitable? Assuming no restraint on customer demand or resources, which product would you choose in order to maximize profitability? What about qualitative, as opposed to quantitative, concerns?

Write a 4- or 5-paragraph memo to the owner of the business. Start with an introduction and end with a recommendation. Each of the four or five paragraphs should have a heading.

Short essay (use Word).

Read the background information and do additional research as needed to comment on the following topics.

Discuss the importance of understanding the difference between the contribution margin and segment margin for purposes of making business decisions.
Discuss and provide examples for complimentary and substitution effects when determining product mix.

Start with an introduction and end with a summary or conclusion. Use headings and include proper references. Maximum length of two pages.
Assignment Expectations

Each submission should include two files: (1) An Excel file; and (2) A Word document. The Word document shows the memo first and short essay last. Assume a knowledgeable business audience and use required format and length. Individuals in business are busy and want information presented in an organized and concise manner.

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