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Chapter 06 - Lecture Notes
6-10
fixed cost of the Fritos business
segment of PepsiCo.
(2). The maintenance cost for the building
in which Boeing 747s are assembled
is a traceable fixed cost of the 747
business segment of Boeing.
b. A common fixed cost is a fixed cost that
supports the operations of more than one
segment, but is not traceable in whole or in
part to any one segment. Examples of
common fixed costs include:
(1). The salary of the CEO of General
Motors is a common fixed cost of the
various divisions of General Motors.
(2). The cost of heating a Safeway or
Kroger grocery store is a common
fixed cost of the various departments
– groceries, produce, bakery, etc.
c. It is important to realize that the traceable
fixed costs of one segment may be a
common fixed cost of another segment.
For example:
(1). The landing fee paid to land an
airplane at an airport is traceable to a
particular flight, but it is not traceable
to first-class, business-class, and
economy-class passengers.
Helpful Hint: In practice, a great deal of disagreement exists
about what costs are traceable and what costs are common.
Some people claim that except for direct materials, virtually
all costs are common fixed costs that cannot be traced to
products. Others assert that all costs are traceable to
products; there are no common costs. The truth probably lies
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somewhere in the middle – many costs can be traced to
products but not all costs.
d. A segment margin is computed by
subtracting the traceable fixed costs of a
segment from its contribution margin.
(1). The segment margin is a valuable tool
for assessing the long-run
profitability of a segment.
(2). Allocating common costs to segments
reduces the value of the segment
margin as a guide to long-run
segment profitability.
Helpful Hint: Explain that a segment should not
automatically be eliminated if its segment margin is negative.
If a company that produces hair-styling products
discontinues its styling gel, sales on its shampoo and
conditioner might fall due to the unavailability of the
eliminated product.
B. Segmented income statements – an example
i. Assume that Webber, Inc. has two divisions – the
Computer Division and the Television Division.
1. The contribution format income statement for
the Television Division is as shown. Notice:
a. Cost of goods sold consists of variable
manufacturing costs.
b. Fixed and variable costs are listed in
separate sections.
c. Contribution margin is computed by
taking sales minus variable costs.
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d. The divisional segment margin represents
the Television Division’s contribution to
overall company profits.
2. The Television Division’s results can be rolled
into Webber, Inc.’s overall results as shown.
Notice:
a. The results of the Television and Computer
Divisions sum to the results shown for the
whole company.
b. The common costs for the company as a
whole ($25,000) are not allocated to the
divisions.
3. The Television Division’s results can also be
broken down into smaller segments. This enables
us to see how traceable fixed costs of the
Television Division can become common costs
of smaller segments.
a. Assume that the Television Division can be
broken down into two major product lines –
Regular and Big Screen.
b. Assume that the segment margins for these
two product lines are as shown.
c. Of the $90,000 of fixed costs that were
previously traceable to the Television
Division, $80,000 ($45,000 + $35,000) is
traceable to the two product lines and
$10,000 is a common cost.
C. Segmented income statements—decision making and
break-even analysis
i. To illustrate how the Television Division’s results
can be used for decision making, assume Webber
believes that if the Television Division spends
$5,000 additional dollars on advertising it will
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increase sales of Regular and Big Screen
televisions by 5%. Webber can compute the profit
impact of this course of action as follows:
1. The Regular contribution margin would increase
by $5,250.
2. The Big Screen contribution margin would
increase by $2,250.
3. The Television Division’s segment margin would
increase by $2,500.
Learning Objective 5: Compute companywide and segment
break-even points for a company with traceable fixed costs.
ii. To demonstrate how to calculate companywide
and segmented break-even points, let’s refer back
to the companywide income statement segmented
into the Television and Compute Divisions.
1. The companywide break-even point is computed
by dividing the sum of the company’s traceable
fixed costs and common fixed costs by the
company’s overall contribution margin ratio.
a. This equation can be used to compute
Webber’s companywide break-even point of
$361,111.
2. A business segment’s break-even point is
computed by dividing its traceable fixed costs by
its contribution margin ratio.
a. Using this equation, the break-even point for
the Television Division is $180,000.
b. The break-even point for the Computer
Division is $133,333.
3. Notice that the companywide common fixed costs
are excluded from the segment break-even
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calculations. This occurs because the common
fixed costs are not traceable to segments and they
are not influenced by segment-level decisions.
V. Segmented income statements—common mistakes
A. Omission of costs
i. The costs assigned to a segment should include all
the costs attributable to that segment from the
company’s entire value chain as discussed in Chapter
12.
1. Since only manufacturing costs are included in
product costs under absorption costing, those
companies that choose to use absorption costing
for segment reporting purposes will omit from
their profitability analysis all “upstream” and
“downstream” costs.
a. “Upstream” costs include research and
development and product design costs.
b. “Downstream” costs include marketing,
distribution, and customer service costs.
c. Although these “upstream” and
“downstream” costs are nonmanufacturing
costs, they are just as essential to
determining product profitability as are
manufacturing costs. Omitting them from
profitability analysis will result in the
undercosting of products.
Helpful Hint: An example of a company with a very high
amount of upstream and downstream costs is a
pharmaceutical company such as Merck. A great deal of its
costs are comprised of research and development and
marketing.
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B. Inappropriate methods for assigning traceable costs to
segments
i. Failure to trace costs directly
1. Costs that can be traced directly to specific
segments of a company should not be allocated
to other segments. Rather, such costs should be
charged directly to the responsible segment. For
example:
a. The rent for a branch office of an insurance
company should be charged directly against
the branch office rather than included in a
companywide overhead pool and then
spread throughout the company.
iii. Inappropriate allocation base
1. Some companies allocate costs to segments using
arbitrary bases. Costs should be allocated to
segments for internal decision making purposes
only when the allocation base actually drives the
cost being allocated. For example:
a. Sales are frequently used to allocate selling
and administrative expenses to segments.
This should only be done if sales drive these
expenses.
C. Arbitrarily dividing common costs among segments
i. Common costs should not be arbitrarily allocated
to segments based on the rationale that “someone
has to cover the common costs” for two reasons:
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1. First, this practice may make a profitable business
segment appear to be unprofitable. If the segment
is eliminated the revenue lost may exceed the
traceable costs that are avoided.
2. Second, allocating common fixed costs forces
managers to be held accountable for costs that
they cannot control.
Quick Check – common costs
V. Income statements—an external reporting perspective
A. Companywide income statements
i. Practically speaking, absorption costing is
required for external reports in the United
States. IFRS also require absorption costing for
external reports.
ii. Probably because of the cost of maintaining two
separate costing systems, most companies use
absorption costing for their external and internal
reports.
iii. With all of the advantages of the contribution
approach, one may wonder why the absorption
approach is used at all. Perhaps the biggest reason
is because:
1. Advocates of absorption costing argue that it
better matches costs with revenues. They
contend that fixed manufacturing costs are just as
essential to manufacturing products as are the
variable costs.
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2. Advocates of variable costing view fixed
manufacturing costs as capacity costs. They
argue that fixed manufacturing costs would be
incurred even if no units were produced.
B. Segmented financial information
i. U.S. GAAP and IFRS require publicly-traded
companies to include segmented financial data in
their annual reports. These rulings have implications
for internal segment reporting because:
1. They mandate that companies must prepare
external segmented reports using the same
methods that they use for internal segmented
reports. This requirement motivates managers to
avoid using the contribution approach for internal
reporting purposes because if they did they would
be required to:
a. Share this sensitive data with the public.
b. Reconcile these reports with applicable rules
for consolidated reporting purposes.
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