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Chapter 6: Variable Costing and Segment Reporting – Tools for Management

Absorption Costing
A costing method that includes all manufacturing costs – direct materials, direct labor, and both variable and fixed manufacturing overhead – in unit product costs
Common Fixed Cost
A fixed cost that supports more than one business segment, but is not traceable in whole or in part to any one of the business segments
Segment
Any part or activity of an organization about which mangers seek cost, revenue, or profit data
Segment Margin
A segment’s contribution margin less its traceable fixed costs; represents the margin available after a segment has covered all of its own traceable costs
Traceable Fixed Cost
A fixed cost that is incurred because of the existence of a particular business segment and that would be eliminated if the segment were eliminated
Variable Costing
A costing method that includes only variable manufacturing costs – direct materials, direct labor, and variable manufacturing overhead – in unit product costs
What is the basic difference between absorption costing and variable costing?
The basic difference between variable costing and absorption costing is how each method accounts for fixed manufacturing overhead costs – all other costs are treated the same under the two methods

Under variable costing, only those manufacturing costs that vary with output are treated as product costs; 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

Absorption costing treats all manufacturing costs a product costs, regardless of whether they are variable or fixed; fixed manufacturing overhead costs are included as part of the costs to work in process inventories; only when the units are sold do these costs flow through to the income statement as part of cost of goods sold

Are selling and administrative expenses treated as product costs or as period costs under variable costing?
Selling and administrative expenses are treated as period costs under variable costing
How are fixed manufacturing overhead costs shifted from one period to another under absorption costing?
Under absorption costing, fixed maufacturing overhead costs are included as part of the costs to work in process inventories; only when the units are sold do these costs flow through to the income statement as part of cost of goods sold
What are the arguments in favor of treating fixed manufacturing overhead costs as product costs?
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; fixed costs are just as essential to manufacturing products as are the variable costs
What are the arguments in favor of treating fixed manufacturing overhead costs as period costs?
Advocates of variable costing argue that fixed manufacturing costs are not really the costs of any particular unit of product, but that they are costs incurred to have the capacity to make products during a particular period, and will be incurred even if nothing is made during the period; whether a unit is made or not, the fixed manufacturing costs will be exactly the same; since fixed manufacturing costs are not part of the costs of producing a particular unit of product, the matching principle dictates that they should be charged to the current period
If units produced and unit sales are equal, which method (absorption costing or variable costing) would you expect to show the higher net operating income?
When units produced equals units sold, there is no change in inventories, and thus, the absorption costing net operating income and the variable costing net operating income will be equal
If fixed manufacturing overhead costs are released from inventory under absorption costs, what does this tell you about the level of production in relation to the level of sales?
If fixed manufacturing overhead costs are released from inventory under absorption costing, this tells you that inventories decreases, which means that units produced were greater than units sold
Under absorption costing, how is it possible to increase net operating income without increasing sales?
Under absorption costing, net operating income can be increased without increasing sales my increasing the number of units produced; when units produced is greater than units sold, inventories increase, as does net operating income
How does Lean Production reduce or eliminate the difference in reported net operating income between absorption and variable costing?
For companies that use Lean Production, the number of units produced tends to equal the number of units sold; this occurs because goods are produced in response to customer orders, thereby eliminating finished goods inventories and reducing work in process inventory to almost nothing
What costs are assigned to a segment under the contribution approach?
Traceable fixed costs and common fixed costs
How does the segment margin differ from the contribution margin?
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, 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
Why aren’t common costs allocated to segments under the contribution approach?
Common costs will continue regardless of whether the segment exists or not; any allocation of common costs to segment reduces the value of the segment margin as a measure of long-run segment profitability and segment performance
How is it possible for a cost that is traceable to a segment to become a common cost if the segment is divided into further segments?
There are often limits to how far down an organization a cost can be traced, therefore, costs that are traceable to a segment may become common as that segment is divided into smaller segment units
Should a company allocate its common fixed expenses to business segments when computing the break-even point for those segments? Explain.
No; allocating common fixed expenses to business segments artificially inflates each segments break-even point

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