Inventory Costing and Capacity Analysis

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Inventory Costingand Capacity Analysis

• Chapter 9

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OverviewChapter 9

• Inventory Costing Methods
• Denominator Issues
• Example working backwards
• BEPs VC versus AC
• Solution to extra problem (on webpage)

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Absorption Costing

• All manufacturing cost are considered
  inventoriable
• All variable mfg. costs (both direct indirect)
• All fixed mfg. costs (both direct indirect)
• Separates costs by business function.
• Other costing terms
• Super-full absorption costing includes some mfg.
  related admin costsused for tax.
• Full-product costing costs from all areas of
  value chain are attached to product costsfor L-T
  pricing.

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Variable Costing

• All variable manufacturing costs are considered
  inventoriable.
• Separates costs by cost behavior.
• Some managers call this direct costing which is a
  poor choice of name. Why?

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Throughput Costing

• Also called super-variable costing.
• Only variable direct materials are inventoriable.
  Assumes that only DM are variable in the short
  run.
• Reduces incentives to build up inventories.
• Relatively new and not widely used.

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STOP! The big picture

• Managers make a number of accounting choices that
  affect income, for example

Costing Systems Fixed Mfg. Costs Flow of Costs
Actual AC Job FIFO
Normal VC Process LIFO
Standard Tput Avg.
Other Specific I.D.
Standard
Retail
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Inventory-Costing Methods
The difference between variable costing and
absorption costing is based on the treatment of
fixed manufacturing costs.
AC includes fixed mfg. costs in cost of
inventory, while VC does not. VC expenses all
fixed costs as period costs.
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Comparing Income StatementsAbsorption vs.
Variable Costing
The following data pertain to Davenport Pencils
Produce one product 2 pencils. 1 box 1
gross. Sales price 8/box Sold 40,000
boxes DM 3 / box DL 0.50 / box VMOH
0.25 / box FMOH 100,000 / year Sales
commission 0.75 / box Fixed admin. expenses
30,000 / year Budget actual production
50,000 boxes
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Comparing Income Statements
What is the cost per box under VC?
3.00 0.50 0.25 3.75
What is the cost per box under AC?
3.00 0.50 0.25 2.00 5.75 Fixed mfg.
OH rate 2.00 / box 100,000 / 50,000 boxes
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Comparing Income Statements
Absorption Costing Revenue 320,000 CoGS 230,000
GM 90,000 SA 60,000 Op. Inc. 30,000
Variable Costing Revenue 320,000 VC 180,000
CM 140,000 FC 130,000 Op. Inc. 10,000
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Comparison of Variableand Absorption Costing
Variable costing operating income 10,000
Absorption costing operating income 30,000
Absorption costing operating income is 20,000
higher.
Why?
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Comparison of Variableand Absorption Costing
Production exceeds sales.
The 10,000 unit increase in ending inventory are
valued as follows
Absorption costing 10,000 5.75 57,500
Variable costing 10,000 3.75 37,500
Difference 20,000
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Comparison of Variableand Absorption Costing
COGS
Absorption costing 40,000 X 5.75 230,000
Variable costing 40,000 X 3.75
150,000 Plus all the fixed mfg. OH 100,000
Lower costs recognized under absorption
costing 20,000
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Comparison of Variableand Absorption Costing
Under absorption costing, each of the additional
10,000 boxes in ending inventory is storing
2/box cost that will be expensed later when sold.
10,000 units of inventory 2.00 20,000
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Comparison of Variableand Absorption Costing
Absorption costing operating income
Variable costing operating income

EQUALS
Fixed manufacturing costs in ending inventory
under absorption costing
Fixed manufacturing costs in beginning inventory
under absorption costing

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Absorption Costing Inventory Buildup
What happens over the long run?
How might you mitigate the incentive to build up
inventory?
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Alternative Denominator-LevelConcepts
Theoretical capacity
Practical capacity
Normal capacity
Master-budget capacity
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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.
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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?
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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
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Effect of Denominator Level Choice

• The larger the denominator level, the
• Lower the budgeted FM rate.
• Lower Fixed Mfg. costs in E.Inv.
• Higher the unfavorable PVV for fixed OH
• RememberFixed mfg. are either expensed in the
  period or stored in E.Inv.
• What denominator level would you want to use for
  tax purposes? practical is required for tax

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Decision Making
Assume that Lloyds Bicycles standard hours are
2 hours per unit.
What is the budgeted fixed manufacturing overhead
cost per unit?
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Decision Making
Theoretical capacity 20 2 40.00
Practical capacity 23.53 2 47.06
Normal capacity 26.67 2 53.34
Master-budget capacity 33.33 2 66.66
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Exerciseworking backward

• QQQ Company has op. income of 120,000 under
  absorption costing, and op. income would be
  100,000 under variable costing.
• FMOH 500,000
• Budgeted and actual production 200,000 units.

Did inventory increase or decrease during the
period? By how much?
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In-class problem

• Answer depends on the FMOH rate for B.Inv and
  choice of inventory cost-flow method (FIFO, WA,
  LIFO, etc.).
• Assume no change in FMOH rate. Then choice of
  cost-flow method does not matter.
• FMOH rate 500k / 200k 2.50 / unit

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Calculation of BE points

• Unique solution under Variable Costing
• BEPvc Total FC / UCM
• Solution depends on production level under
  Absorption Costing
• BEPac Total FC (FM rate (BEPac Units
  Produced)) / UCM
• BEPac Total FC (FMRUP) / (UCM FMR)
• What happens to the BEP when more units are
  produced?