Principles of Accounting
Chapter 23Reporting to Support Managerial Decisions1
Learning GoalsVariable costing versus absorption costingSegment
reportingMeasures of residual incomeConcepts in allocating service
department costsLeveraging modern information systems to enable
better decisions#Absorption CostingAlso known as full costingNormal
manufacturing costs are considered product costs and included in
inventoryAs sales occur, the cost of inventory is transferred to
cost of goods sold, which reduces gross profitSelling, general, and
administrative costs (SG&A) are classified as period
expensesMethod required for external reporting
#3Variable CostingOnly variable production costs are assigned to
inventory and cost of goods soldFixed manufacturing costs are
regarded as period expenses along with SG&A costsWill be
incurred no matter how much is produced
#Absorption CostingThe rationale for absorption costing is that
it causes a product to be measured and reported at its complete
costJust because costs like fixed manufacturing overhead are
difficult to identify with a particular unit of output does not
mean that they were not a cost of that outputBut the approach may
not always provide the best signals for management decisions
#Service Department CostsNot all discrete units within a
business organization are focused on production of the end
productEx) Janitorial services, cafeterias, health clinics, and the
like support productive unitsCosts are allocated to measure full
product cost and discourage waste and inefficiency
#41Variable Costing
#Variable Costing ExampleAssume a company produces 10,000 units
of a productPer-unit costs are $2 for direct material, $3 for
direct labor, and $4 for variable factory overhead Fixed factory
overhead is $10,000Under absorption costing, the product cost is
$10 per unit$9 from the variable components$2 + $3 + $4$1 of
allocated fixed factory overhead $10,000 / 10,000 unitsUnder
variable costing, the product cost is $9 per unitOnly the variable
production costs are included
#Variable Costing ExampleAssume the company is approached to
sell one additional unit at $9.50; this sale will not result in any
added SG&A cost or otherwise impact other salesBased on
absorption costing methods, the additional unit appears to produce
a loss of $0.50It appears that the correct decision is to not make
the saleVariable costing suggests a profit of $0.50The information
appears to support a decision to make the sale
#Variable Costing ExampleNo other costs will be generated by
accepting this proposed transactionIf management was limited to
absorption costing information, this opportunity would likely have
been passed upSimilar problems occur with unsold seats on airlines
and tickets at sports clubsThe cost of additional seats is nominal
so almost any amount of revenue that can be generated has a
positive contribution to profit
#Variable CostingTraps must be avoidedA business must ultimately
recover the fixed factory overhead and all other business
costsTotal units sold must provide enough margin to accomplish this
purposeIf a company offers special deals on a selective basis,
regular customers may become alienated or hold out for lower
prices
#Avoiding a Downward SpiralVariable costing data are quite
useful in avoiding incorrect decisions about product
discontinuationEx) Assume that a company offers 3 productsEach is
being produced in equal proportionThe company is fully able to meet
customer demand from existing capacityThe company is not incurring
any variable costs relating to SG&A
#Avoiding a Downward Spiral
#Avoiding a Downward SpiralFrom the absorption costing data, it
appears that Product A is yielding a negative gross profitA manager
may target it for discontinuationIf A is no longer produced,
however, B and C will each have to absorb more fixed factory
overheadThe revised cost data show elimination will actually reduce
overall profitability!
#Avoiding a Downward Spiral
#Avoiding a Downward SpiralThe $15 selling price for Product A
at least covered its variable cost and contributed toward coverage
of the businesss unavoidable fixed cost burdenEliminating
unprofitable products can result in a series of successive shifts
in overhead to other remaining productsThis, in turn, can cause
other products to also appear unsuccessfulVariable costing
techniques help guide decisions
#Variable CostingVariable costing is not a panaceaA good manager
must consider business problems from multiple perspectives
#Income Statements
For now, assume that Nepal sells all that it produces, resulting
in no beginning or ending inventory
#Income StatementsBecause Nepal does not carry inventory, the
income is the same under absorption and variable costingThe
difference is only in the manner of presentationNote that gross
profit is not the same as contribution marginWhen inventory levels
fluctuate, the periodic income will differ between the two
methods
#Impact of InventoryThe following income statements are
identical to those previously illustrated, except sales and
variable expenses are reduced by 10%Assume that the units relating
to the 10% reduction were nevertheless manufactured
#
Impact of Inventory
#Impact of InventoryIn the previous statements, income is higher
under absorption costing by $15,000Under absorption costing, total
production costs were $450,000 10% ($45,000) is now diverted into
inventoryUnder variable costing, total product costs were
$300,00010% ($30,000) would be assigned to inventory$15,000 more is
assigned to inventory under absorption costingThis coincides with
the income difference
#Impact of Inventory
The top set of cups initially contains the costs incurred in the
manufacturing process.
With absorption costing, those cups must be emptied into either
cost of goods sold or ending inventory.
#
Impact of InventoryUnder variable costing, the ending inventory
cup contains less.
Specifically, there is no fixed factory overhead in ending
inventory.
#Impact of InventoryA reduction in inventory during a period
will cause the opposite effect from that shownA portion of the
contents of the beginning inventory cup would be transferred to
expense commensurate with the decrease in inventorySince the
inventory cup contains less under variable costing, expect expenses
to be lower and income to be higher
#Segment ReportingA segment is a discrete business unit for
which separate financial information is prepared and evaluated by
an operating decision maker within the organizationThe decision
maker usually has authority to allocate resources and judge
performance of the unitA segment might be a region, territory,
division, product category, department, or other
classificationSegmentation is highly subjectiveThe goal is to
divide/allocate overall performance outcomes to the various moving
pieces that make up the entire entity
#Segment IncomeGreat care must be taken to develop a very
logical structure for evaluating the income of individual
segmentsIndirect costs may be necessary costs for the overall
organization to functionBut, how are they to be allocated to
segments?Direct costs can become indirect as they are pushed down
within an organizationEx) Electricity costs for a shared
apartmentDirect cost of the apartment, but an indirect allocated
cost for an individual
#Segment IncomeBusinesses often develop models for allocating
indirect costs to business unitsThe allocation scheme is often the
subject of debate and consternationEach business unit may feel its
profit measurement is unduly burdened by more than a fair share of
indirect cost absorption
#Contribution Income StatementInternal-use documentIdentifies
each segments controllable elementsCosts that cannot be traced
directly to a subunit are considered only at higher levels
#Case StudyZen Computers is a diversified company with two
primary divisions: Computer Hardware and Systems SupportThe
Hardware unit focuses on personal computers (PCs) and personal
digital entertainment devices (PDEs)
#
#Case StudySegment margins were computed for each productHelp
identify if each product is supporting its imbedded cost
structureSegment margin differs from controllable contribution
marginManagement is charged with controlling certain costsA
business unit may incur additional fixed costs that are beyond the
control of managementUncontrollable fixed costs must be considered
in evaluating business unit viability, independent of the
assessment of management performance
#Case StudyCertain costs incurred by the hardware division could
not be assigned to a specific product segmentThese costs are
included in the totals of the hardware division, but are not useful
in evaluating the performance of the individual products
#
The hardware division is carried forward into the corporate
summary report and totaled together with results of the systems
division
#Case StudyCertain general corporate expenses were not traceable
to individual divisions/productsThey are only taken into
consideration in the overall corporate income calculationsThis type
of contribution income statement reporting removes the bias that
can result from arbitrary allocation of common costsIt is also
sometimes helpful in identifying which business segments are
targets for expansion, restructure, or discontinuance
#External Segment ReportingManagement may be reluctant to share
disaggregated segment information for external reportingDoes not
want to attract competitor attention to well-performing units or
call attention to mistakes of poor-performing unitsReporting rules
require public companies to present a limited amount of financial
information for each business segmentRevenues, operating profits,
and identifiable assets of each significant segmentReconciliation
to corporate totals
#
#Residual Income
The units are not far apart in overall profitabilityHowever,
once the cost of capital is placed on the evaluative scale, it
appears that the galvanizing unit is doing far better
#Residual IncomeCautions with residual income:Short-run vs.
long-run considerationsA single years data is rarely
conclusiveAccounting rule impactsEx) Investing heavily in R&D
will reduce operating income in current periodsArbitrary hurdle
rate
#Service Department CostsThe direct method transfers the cost of
a service department directly to the productive departments that
rely on the servicesUsually based upon a logical benchmarkEx)
Square footage, number of employees, etc.
#Take the cost directly to the profit center
42Direct Method ExampleBenjamin Printing has two production
departmentsPrinting is highly automatedBinding relies on a far more
labor-intensive processThe departments are supported by maintenance
and cafeteria service unitsMaintenance activities are driven by the
amount of machinery requiring service and repairCafeteria services
are directly related to the size of the labor pool
#Natural costs: salaries to the people who work there
43
#Know this! This is the direct method
Maintenance is the number of machinesCafeteria is the number of
employeesYou allocate the cost
44Service Department CostsThe direct approach ignores that
service departments may provide support to other service
departmentsEx) Benjamins maintenance employees eat in the
cafeteria, tooIssue mitigated by step method of allocationAn
identified service departments cost is first allocated to other
units, including other service departmentsThe resulting costs of
the other service departments are allocated to production
#45
#Step Methodyou close up one unit at a time out of the service
departmentCafeteria is going to get closed up first and maintenance
gets some of that cost
**Clicker problems when we come back to class46Service Cost
AllocationIt is quite possible to identify a number of interactions
between various service departmentsThere is no mathematical limit
to the number of step allocations that can be madeCalculus could be
used to achieve numerous simultaneous allocationsCompanies are
usually content to rely on direct or very simplified step
allocations of service department costs
#Information SystemsConsider the accompanying data set revealing
that $24,819,500 was spent on compensationEach line item
corresponds to an employee groupingSuppose the manager for this
business is charged with reducing total compensation costs to
$24,000,000. What category should be cut?
#
#Information SystemsThe same data can be rearranged in a
different fashion, by object of expenditurePerhaps the revised
display provides added insight into cost control opportunitiesSome
specific expenditure category might be targeted for reduction if it
is viewed as discretionary or not critical to the productive
mission of the entity
#
#Information SystemsThe data might be further arranged into an
even more detailed matrix format for closer inspectionViewing data
only by line item or only by object of expenditure can greatly
limit insight into business operationsModern accounting systems
enable organizing and rearranging data sets with relative ease
#
#Business DashboardsDashboards can be used to monitor business
information on a real-time basisEasily customized by each
managerSpecific line items on a dashboard can be clicked to open
windows of additional data in support of the key metrics
displayed
#
#Key TermsAbsorption Costing: Also known as full costing -- a
costing method where inventory absorbs direct costs and variable
and fixed factory overheadContribution Income Statement: An
internal report that identifies each segment's controllable
elements; the contribution margin, controllable fixed costs,
uncontrollable fixed costs, and segment marginDashboard: Customized
business software that delivers key real time business data in an
easily monitored layout Direct Method / Allocating Service Cost: An
allocation process whereby service department costs are assigned
directly to productive departments (compare to step method)
#Key TermsResidual Income: An internal assessment technique that
adjusts income for a presumed cost of capital (or other threshold
rate of return); operating income - (operating assets X cost of
capital) Segment: A business unit for which separate financial
information is evaluated by an operating decision maker who
allocates resources and judges performance of the unitStep Method /
Allocating Service Cost: An allocation process whereby some service
department costs may be assigned to other service departments as
part of a sequential methodologyVariable Costing: A costing method
where inventory absorbs direct costs and variable factory overhead;
the income statement identifies the contribution margin
#
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Created October 1, 2011
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