Confirming Pages CHAPTER OUTLINE Overview of Variab.docx

Confirming Pages
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 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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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
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
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
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
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:

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

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
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
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
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
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
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
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 .
operating income*
Units produced ,
Units sold
Inventories decrease Absorption costing net
operating income ,
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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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
c. Its absorption costing net operating income will be
$15,000 lower than its variable
d. Its absorption costing net operating income will be
$15,000 higher than its variable
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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
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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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.
Prepare a segmented income
statement that differentiates
traceable fixed costs from
common fixed costs and use it
to make decisions.
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250 Chapter 6
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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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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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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254 Chapter 6
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:
40,000
15,000
25,000 55,000
Contribution margin ...................................... 120,000 50,000

70,000
30,000 40,000
Product-line segment margin........................ 50,000 $20,000 $
30,000
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:
8,000
10,000
37,000 18,000
Contribution margin ...................................... 70,000 63,000
7,000
15,000 10,000
Sales-channel segment margin .................... 45,000 $ 48,000 $

(3,000)
traceable to individual sales channels ...... 15,000
Product-line segment margin ................... $ 30,000
Product Line
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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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Management
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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258 Chapter 6
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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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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260 Chapter 6
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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Management
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.

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