Inventory Costing and Capacity Analysis

1
Inventory Costing and Capacity Analysis

• Chapter 9

2
Introduction

• The reported income number captures the attention
  of managers in a way few other numbers do.
• This chapter examines two types of cost
  accounting choices in which the reported income
  number of manufacturing companies is affected by
  inventories.

3
Learning Objectives

• Identify the fundamental feature that
  distinguishes variable costing from absorption
  costing
• Prepare income statements under absorption
  costing and variable costing
• Explain differences in operating income under
  absorption costing and variable costing

4
Learning Objectives

• Understand how absorption costing can provide
  undesirable incentives for managers
• Differentiate throughput costing from variable
  costing and absorption costing
• Describe the various denominator-level capacity
  concepts that can be used in absorption costing

5
Learning Objectives

• Explain how the choice of the denominator level
  affects the production-volume variance
• Describe how attempts to recover fixed costs of
  capacity may lead to a downward demand spiral

6
Learning Objective 1

• Identify the fundamental feature that
  distinguishes variable costing from absorption
  costing

7
Inventory-Costing Methods

• Variable costing and absorption costing methods
  differences are based on the treatment of
  fixed manufacturing overhead.

8
Inventory-Costing Methods

• Under variable costing, fixed manufacturing
  overhead costs are excluded from inventoriable
  costs and are a cost of the period in which
  they are incurred.
• Under absorption costing, these costs are
  inventoriable and become expenses only when a
  sale occurs.

9
Inventory-Costing Methods

• Under both methods all nonmanufacturing costs in
  the value chain (such as research and
  development and marketing), whether variable or
  fixed, are recorded as expenses when incurred.

10
Variable Costing

• All variable manufacturing costs are assigned
  to production and they become part of the
  unit cost.
• Fixed costs are charged to the Income Summary.

11
Variable Costing

• Direct Material Inventory
  
  
  Payroll
  Work-in-Process Variable
  Inventory
  factory
  labor
  Variable Overhead

12
Variable Costing

• Payroll Work-in-Process
  Fixed Inventory
  factory
  labor
  Income Summary
  Finished Goods Cost of
  Goods Sold

13
Learning Objective 2

• Prepare income statements under absorption
  costing and variable costing

14
Comparing Income Statements

• The following data pertain to Fredonia Fixtures
• Finished goods Year 1 Year 2 Total
  Inventory Units
  Beginning -0- 2,000
  -0- inventory
  
  Produced 10,000 11,500 21,500
  Sold 8,000
  13,000 21,000
  Ending inventory 2,000 500 500

15
Comparing Income Statements

• The following information is on a per unit basis
• Sales price 71.00
• Variable manufacturing costs
  Direct materials 4.00
  Direct manufacturing labor 21.00
  Indirect manufacturing costs 24.00
• Fixed manufacturing costs 4.50

16
Comparing Income Statements (Absorption Costing)

• Total fixed production costs are 54,000
  at a normal capacity of 12,000 units.
• Fixed nonmanufacturing costs are 30,000 per
  year.
• Variable nonmanufacturing costs are 2.00 per
  unit sold.

17
Comparing Income Statements (Absorption Costing)

• What are the revenues for Year 1?
• 8,000 71 568,000
• What is the cost of goods sold?
• 8,000 53.50 428,000
• Is there a volume variance?
• (12,000 10,000) 4.50 9,000 underallocated
  fixed manufacturing costs

18
Comparing Income Statements (Absorption Costing)

• What is the gross margin?
• 568,000 (428,000 9,000) 131,000
• What are the nonmanufacturing costs?
• 8,000 units sold 2.00 16,000 variable costs
  30,000 fixed costs 46,000

19
Comparing Income Statements (Absorption Costing)

• What is the operating income before taxes?
• 131,000 46,000 85,000

20
Comparing Income Statements (Absorption Costing)

• Absorption
  Revenues 568,000
• Cost of goods sold 428,000
• Volume variance (U) 9,000
• Gross margin 131,000
• Nonmanufacturing costs 46,000
• Operating income 85,000

21
Comparing Income Statements (Variable Costing)

• Revenues for Year 1 are 568,000.
• What is the cost of goods sold?
• 8,000 49 392,000
• What is the manufacturing contribution margin?
• 568,000 392,000 176,000

22
Comparing Income Statements (Variable Costing)

• What is the net contribution margin?
• 176,000 16,000 variable nonmanufacturing
  costs 160,000 net contribution margin.
• What is the operating income before taxes?
• 160,000 54,000 fixed indirect manufacturing
  costs 30,000 fixed nonmanufacturing costs
  76,000

23
Comparing Income Statements (Variable Costing)

• 
  Variable
  Revenues 568,000
• Cost of goods sold 392,000
• Variable nonmanufacturing costs 16,000
• Contribution margin 160,000
• Fixed manufacturing costs 54,000
• Fixed nonmanufacturing costs 30,000
• Operating income 76,000

24
Learning Objective 3

• Explain differences in operating income under
  absorption costing and variable costing

25
Operating Income (Absorption Costing)

• What are revenues for Year 2?
• 13,000 71 923,000
• What is the cost of goods sold?
• 13,000 53.50 695,500
• Is there a volume variance?
• (12,000 11,500) 4.50 2,250 underallocated
  fixed manufacturing costs

26
Operating Income (Absorption Costing)

• What is the gross margin?
• 923,000 (695,500 2,250) 225,250
• What are the nonmanufacturing costs?
• 13,000 units sold 2.00 26,000 variable
  costs 30,000 fixed costs 56,000

27
Operating Income (Absorption Costing)

• What is the operating income before taxes?
• 225,250 56,000 169,250
• What is the operating income for the two years
  combined?
• 85,000 169,250 254,250

28
Income Statements (Absorption Costing)

• Year 1
  Year 2 Combined
  
  Revenues 568,000 923,000 1,491,000
• Cost of goods sold 428,000 695,500
  1,123,500
• Volume variance (U) 9,000 2,250
  11,250
• Gross margin 131,000 225,250 356,250
• Nonmfg. costs 46,000 56,000
  102,000
• Operating income 85,000 169,250
  254,250

29
Operating Income (Variable Costing)

• Revenues for Year 2 are 923,000.
• What is the cost of goods sold?
• 13,000 49 637,000
• What is the manufacturing contribution margin?
• 923,000 637,000 286,000

30
Operating Income (Variable Costing)

• What is the net contribution margin?
• 286,000 26,000 variable nonmanufacturing
  costs 260,000 net contribution margin
• What is the operating income before taxes?
• 260,000 54,000 fixed manufacturing costs
  30,000 fixed nonmanufacturing costs
  176,000

31
Operating Income (Variable Costing)

• What is the combined operating income for the
  two years under variable costing?
• 76,000 176,000 252,000

32
Income Statements(Variable Costing)

• Year 1 Year 2
  Combined
  
  Revenues 568,000 923,000 1,491,000
• Cost of goods sold 392,000 637,000
  1,029,000
• Mfg. contr. margin 176,000 286,000
  462,000
• Variable nonmfg. 16,000 26,000
  42,000
• Net contr. margin 160,000 260,000
  420,000

33
Income Statements(Variable Costing)

• Year 1
  Year 2 Combined Net contr. margin 160,000
  260,000 420,000
• Fixed mfg. costs 54,000 54,000
  108,000
• Fixed nonmfg. costs 30,000 30,000
  60,000
• Operating income 76,000 176,000 252,000

34
Comparison of Variable and Absorption Costing

• Inventory values are smaller with variable
  costing because it capitalizes only 49.00
  variable cost as asset.
• Inventory values using absorption costing have
  an additional 4.50 fixed factory overhead per
  unit.

35
Comparison of Variable and Absorption Costing

• Variable costing operating income Year 1 76,000
  
  Absorption costing operating income Year 1
  85,000
• Absorption costing operating income is 9,000
  higher.
• Why?

36
Comparison of Variable and Absorption Costing

• Production exceeds sales in Year 1.
• The 2,000 units in ending inventory are valued
  as follows
  Absorption costing Variable costing
  2,000 53.50 2,000 49
  107,000 98,000

9,000 Difference
37
Comparison of Variable and Absorption Costing

• Variable costing operating income Year 2
  176,000
• Absorption costing operating income Year 2
  169,250
• Variable costing operating income is 6,750
  higher.
• Why?

38
Comparison of Variable and Absorption Costing

• Sales exceeded units produced in Year 2.
• 13,000 11,500 1,500 decrease in inventory
• Absorption costing
  1,500 53.50 80,250
• Variable costing
  1,500 49.00 73,500
• 80,250 73,500 6,750 higher cost of goods
  sold under absorption costing

39
Comparison of Variable and Absorption Costing

• Variable costing combined net income 252,000
• Absorption costing combined net income 254,250
• 254,250 252,000 2,250 absorption costing
  higher
• 500 units in inventory 4.50 2,250

40
Comparison of Variable and Absorption Costing

• Absorption costing operating income
• Variable costing operating income
• Fixed manufacturing costs in ending inventory
  under absorption costing
• Fixed manufacturing costs in beginning inventory
  under absorption costing

41
Comparison of Variable and Absorption Costing

• Absorption costing operating income Year 2
  169,250 Variable costing operating income Year
  2 176,000 (6,750)
• Fixed manufacturing cost in ending inventory
  under absorption costing 2,250 Fixed
  manufacturing cost in beginning inventory under
  absorption costing 9,000 (6,750)

42
Learning Objective 4

• Understand how absorption costing can provide
  undesirable incentives for managers

43
Inventory Buildup

• Absorption costing enables a manager to increase
  operating income in a specific period by
  increasing the production schedule, even if there
  is no customer demand for the additional
  production.

44
Inventory Buildup

• Assume that Fredonia Fixtures produced 4,400
  units in Year 1 and sold 4,100.
• What is the production volume variance?
• (12,000 4,400) 4.50 34,200 U
• What is the net operating income or loss
  for the period?

45
Inventory Buildup

• Revenues (4,100 71) 291,100
• Cost of goods sold
  (4,100 53.50) 219,350
• Volume variance 34,200
• Gross margin 37,550
• Nonmanufacturing costs 38,200
• Net loss 650

46
Inventory Buildup

• How many units are in ending inventory?
• 4,400 4,100 300
• How much cost is in ending inventory?
• 300 53.50 16,050

47
Inventory Buildup

• Suppose that management decides to produce
  9,000 units next year.
• Sales remain the same (4,100 units).
• What is the volume variance?
• (12,000 9,000) 4.50 13,500 U
• What is the operating income or loss?

48
Inventory Buildup

• Revenues (4,100 71) 291,100
• Cost of goods sold
  (4,100 53.50) 219,350
• Volume variance 13,500
• Gross margin 58,250
• Nonmanufacturing costs 38,200
• Net income 20,050

49
Inventory Buildup

• How many units are in ending inventory?
• 300 9,000 4,100 5,200
• How much cost is in ending inventory?
• 5,200 53.50 278,200

50
Inventory Buildup

• Sales volume remained constant during the two
  years.
• Variable expenses also remained constant.

51
Inventory Buildup

• By increasing inventory level in the second year,
  management can show a net income rather than a
  loss.
• What are some undesirable effects of producing
  for inventory?

52
Inventory Buildup

• Production of items that absorb minimal fixed
  manufacturing costs may be delayed.
• A plant manager may accept a particular order to
  increase production even though another plant in
  the same company is better suited to handle that
  order.
• A plant manager may defer maintenance.

53
Revising Performance Evaluation

• Budget carefully and use inventory planning.
• Discontinue the use of absorption costing for
  internal reporting and instead use variable
  costing.
• Incorporate a carrying charge for inventory.
• Change the time period used to evaluate
  performance.

54
Revising Performance Evaluation

• Include nonfinancial as well as financial
  variables in the measures used to evaluate
  performance.
• Ending inventory in units this period
  Ending inventory in units last period
• Sales in units this period
  Ending inventory in units this period

55
Learning Objective 5

• Differentiate throughput costing from variable
  costing and absorption costing

56
Throughput Costing...

• treats all costs except those related to
  variable direct materials as period costs.
• Only direct materials costs are inventoriable
  costs.
• What are Fredonia Fixtures revenues in Year
  1?
• 8,000 71 568,000

57
Throughput Costing

• What are the variable cost of goods sold?
• Direct materials only 4.00 8,000 32,000
• What are other manufacturing costs for the year?

58
Throughput Costing

• Manufacturing Costs
  Labor 21.00 10,000 210,000
  Indirect
  costs 24.00 10,000 240,000 Fixed
  costs 54,000 Total manufacturing
  costs 504,000
• What are other nonmanufacturing costs for the
  year?

59
Throughput Costing

• Nonmanufacturing Costs
  Variable 2.00 8,000 16,000
  Fixed 30,000 Total 46,000

60
Throughput Costing

• Revenues 568,000
• Variable direct materials
  cost of goods sold 32,000
• Throughput contribution margin 536,000
• Manufacturing costs 504,000 Nonmanufacturing
  costs 46,000
• Operating loss 14,000

61
Throughput Costing

• Variable costing operating income 76,000
• Throughput costing operating loss 14,000
• Difference in operating income 90,000
• How can this difference be explained?

62
Throughput Costing

• The 2,000 units in ending inventory are valued as
  follows

Variable 2,000 49 98,000
Throughput 2,000 4 8,000
90,000 Difference
63
Throughput Costing

• Absorption costing operating income 85,000
• Throughput costing operating loss 14,000
• Difference in operating income 99,000
• How can this difference be explained?

64
Throughput Costing

• The 2,000 units in ending inventory are valued as
  follows

Absorption 2,000 53.50 107,000
Throughput 2,000 4 8,000
99,000 Difference
65
Comparison of Inventory Costing Methods
Actual Costing
Absorption Costing
Throughput Costing
Variable Costing
66
Comparison of Inventory Costing Methods
Normal Costing
Absorption Costing
Throughput Costing
Variable Costing
67
Comparison of Inventory Costing Methods
Standard Costing
Absorption Costing
Throughput Costing
Variable Costing
68
Learning Objective 6

• Describe the various denominator-level capacity
  concepts that can be used in absorption costing

69
Alternative Denominator-Level Concepts

• The choice of the denominator used to allocate
  budgeted fixed manufacturing costs to
  products can greatly affect the numbers a normal
  or standard costing system will report prior
  to the end of an accounting period.

70
Alternative Denominator-Level Concepts

• Theoretical capacity
• Practical capacity
• Normal capacity
• Master-budget capacity

71
Theoretical Capacity

• Theoretical capacity (maximum or ideal capacity)
  is the denominator level concept that is based
  on producing at full (peak) efficiency all the
  time.

72
Practical Capacity

• Practical capacity is the denominator-level
  concept that reduces theoretical capacity by
  unavoidable operating interruptions.
• The use of practical capacity is required by the
  IRS.

73
Normal Capacity

• Normal capacity is the denominator-level concept
  based on the level of capacity utilization that
  satisfies average customer demand over several
  periods.
• It includes seasonal, cyclical, and trend factors.

74
Master-Budget Capacity

• Master-budget capacity is the denominator-level
  concept based on the expected level of capacity
  utilization for the next budget period (typically
  one year).

75
Budgeted Fixed Manufacturing Overhead Rate

• The use of these four denominator levels
  (denominator level capacity) can affect the
  budgeted fixed manufacturing overhead rate.

76
Budgeted Fixed Manufacturing Overhead Rate

• Lloyds Bicycles produces bicycle parts for
  domestic and foreign markets.
• Fixed overhead costs are 200,000 within the
  relevant range of the various capacity volume.

77
Budgeted Fixed Manufacturing Overhead Rate

• Assume that the theoretical capacity is 10,000
  machine hours, practical capacity is 85,
  normal capacity is 75, and master-budget
  capacity is 60.
• What is the budgeted fixed manufacturing overhead
  rate at the various capacity levels?

78
Budgeted Fixed Manufacturing Overhead Rate

• Theoretical 100 200,000
  10,000 20.00/machine hour
• Practical 85
  200,000 8,500 23.53/machine hour
• Normal 75
  200,000 7,500 26.67/machine hour
• Master-budget 60
  200,000 6,000 33.33/machine hour

79
Learning Objective 7

• Explain how the choice of the denominator level
  affects the production-volume variance

80
Effect on Financial Statements

• The magnitude of the production-volume variance
  in an absorption costing system will be affected
  by the choice of the denominator level.
• Assume that Lloyds Bicycles actually used 8,400
  machine hours during the year.
• What is the production volume variance?

81
Production Volume Variance

• Production volume variance (Denominator level
  Actual level) Budgeted
  fixed manufacturing overhead rate
• Theoretical capacity (10,000 8,400)
  20.00 32,000 U
• Practical capacity (8,500 8,400) 23.53
  2,353 U

82
Production Volume Variance

• Normal capacity (7,500 8,400) 26.67
  24,003
• Master-budget capacity (6,000 8,400)
  33.33 79,992

83
Learning Objective 8

• Describe how attempts to recover fixed costs of
  capacity may lead to a downward demand spiral

84
Decision Making

• Cost data from a normal or standard costing
  system are often used in pricing or
  product-emphasis decisions.
• Assume that Lloyds Bicycles standard hours are 2
  hours per unit.
• What is the budgeted fixed manufacturing overhead
  cost per unit?

85
Decision Making

• Using theoretical capacity, budgeted fixed
  overhead per unit is 20 2 40.00.
• Using practical capacity, budgeted fixed overhead
  per unit is 23.53 2 47.06.
• Using normal capacity, budgeted fixed overhead
  per unit is 26.67 2 53.34.
• Using master-budget capacity, budgeted fixed
  overhead per unit is 33.33 2 66.66

86
Downward Demand Spiral

• The use of normal capacity utilization or
  master-budget capacity utilization can result in
  capacity costs being spread over a small number
  of output units.
• The downward demand spiral is the continuing
  reduction in demand that occurs when the prices
  of competitors are not met and demand drops.

87
End of Chapter 9