Absorption Costing and GAAP

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Absorption Costing and GAAP
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Two Ways To Treat Fixed Manufacturing Overhead

• Variable Costing
• a.k.a. direct costing
• Fixed Mfg O/H is a Period Cost
• Focus is on Contri-bution Margin
• This isnt G.A.A.P.

• Absorption Costing
• a.k.a. full costing
• Fixed Mfg O/H is an Inventoriable Cost
• Focus is on Gross Margin
• This is G.A.A.P.

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What Costs Are Included In Inventory?
Non-manufacturing costs (e.g. selling, general
admin.)
Variable manufac- turing costs ( any direct,
fixed costs)
Variable Costing
Absorption Costing
Fixed Manufacturing Overhead
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Accounting Research Bulletins

• Issued by the Committee on Accounting Procedure
• In 1953, ARB 43 revised and/or restated all
  previous bulletins.
• Bulletins 44 through 51 were issued subsequently.
• In 1959, the newly-formed Accounting Principles
  Board passed a resolution establishing the
  continuing authority of the ARBs, until such time
  as the APB issued new rules replacing specific
  provisions.

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ARB Chapter 4, Inventory PricingStatement 2
A major objective of accounting for inventories
is the proper determination of income through the
process of matching appropriate costs against
revenues.
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ARB Chapter 4, Inventory PricingDiscussion of
Statement 2
In accounting for the goods in the inventory at
any point of time, the major objective is the
matching of appropriate costs against revenues in
order that there may be a proper determination of
the realized income. Thus, the inventory at any
given date is the balance of costs applicable to
goods on hand remaining after the matching of
absorbed costs with concurrent revenues.
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ARB Chapter 4, Inventory PricingStatement 3
The primary basis of accounting for inventories
is cost, which has been defined generally as the
price paid or consideration given to acquire an
asset. As applied to inventories, cost means in
principle the sum of the applicable expenditures
and charges directly or indirectly incurred in
bringing an article to its existing condition and
location.
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ARB Chapter 4, inventory pricingDiscussion of
Statement 3
The definition of cost as applied to inventories
is understood to mean acquisition and production
cost, and its determination involves many
problems. Under some circumstances, items such
as idle facility expense, excessive spoilage,
double freight, and rehandling costs may be so
abnormal as to require treatment as current
period charges rather than as a portion of the
inventory cost. Also, general and administrative
expenses should be included as period charges,
except for the portion of such expenses that may
be clearly related to production and thus
constitute a part of inventory costs .
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ARB Chapter 4, inventory pricingDiscussion of
Statement 3
It should also be recognized that the exclusion
of all overhead from inventory costs does not
constitute an accepted accounting procedure.
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Cost Allocations to InventorySteve Landekich
- An article reporting the results of a
survey. - The article appeared in the magazine
Management Accounting. - March 1973.
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Cost Allocations to InventorySteve Landekich
- The principal survey question was do you
allocate (at least on a broad- brush basis) all
expenditures that are indirectly related to
production? - The question was asked
separately for annual financial reporting and
for management (internal) reporting. - 1,200
usable responses were received.
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Cost Allocations to InventorySteve Landekich
Financial Reporting Internal Reporting
Yes, we allocate all expenses. 44 42
No, we do not allocate all expenses. 56 58
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Cost Allocations to InventorySteve Landekich
For the firms that do not allocate all expenses,
here is the percentage of those firms that do not
allocate each type of expense Service department
costs 23 69 General and administrative 75
87 Depreciation 24 Property
taxes 28 Repairs and maintenance 17 Fire
and casualty insurance 26
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Cost Allocations to InventorySteve Landekich
For the firms that do not allocate all expenses,
here are the reasons given, in decreasing order
of frequency 1. Method of allocation would be
too arbitrary 2. The result would be
misleading 3. Amount is not significant 4. Not
considered inventory costs 5. Considered period
costs
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SFAS 151, Inventory CostsAn amendment to ARB No.
43
Under some circumstances, items such as idle
facility expense, excessive spoilage, double
freight, and rehandling costs may be so abnormal
as to require treatment as current period charges
rather than as a portion of the inventory cost.
This statement requires that those items be
recognized as current-period charges regardless
of whether they meet the criterion of so
abnormal. In addition, this Statement requires
that allocation of fixed production overhead to
the costs of conversion be based on the normal
capacity of the production facilities.
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SFAS 151

• Purpose to improve comparability of cross-border
  financial reporting to align with the
  International Accounting Standards Board (IAS
  2).
• ARB 43 did not define so abnormal.
• SFAS 151 was approved unanimously by the FASB in
  2004, and applies to inventory costs incurred
  during fiscal years beginning after June 15, 2005.

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SFAS 151
Variable production overheads are allocated to
each unit of production on the basis of the
actual use of the production facilities. However,
the allocation of fixed production overheads to
the costs of conversion is based on the normal
capacity of the production facilities.
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SFAS 151
Normal capacity refers to a range of production
levels. Normal capacity is the production
expected to be achieved over a number of periods
or seasons under normal circumstances, taking
into account the loss of capacity resulting from
planned maintenance. Some variation in
production levels from period to period is
expected and establishes the range of normal
capacity.
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SFAS 151
The range of normal capacity will vary based on
business- and industry-specific factors.
Judgment is required to determine when a
production level is abnormally low (that is,
outside the range of expected variation in
production). Examples of factors that might be
anticipated to cause an abnormally low production
level include significantly reduced demand, labor
and materials shortages, and unplanned facility
or equipment downtime.
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SFAS 151
The actual level of production may be used if it
approximates normal capacity. In periods of
abnormally high production, the amount of fixed
overhead allocated to each unit of production is
decreased to that inventories are not measured
above cost. The amount of fixed overhead
allocated to each unit of production is not
increased as a consequence of abnormally low
production or idle plant.
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SFAS 151
Unallocated overheads are recognized as an
expense in the period in which they are
incurred. Other items such as abnormal freight,
handling costs, and amounts of wasted materials
(spoilage) require treatment as current period
charges rather than as a portion of the inventory
cost.
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SFAS 151
Also, under most circumstances, general and
administrative expenses should be included as
period charges, except for the portion of such
expenses that may be clearly related to
production and thus constitute a part of
inventory costs (product charges). Selling
expenses constitute no part of inventory costs.
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SFAS 151
Many respondents to the Exposure Draft noted
that incorporating the guidance from IAS 2 that
states that fixed production overhead costs
should be allocated to inventory based on the
normal capacity of the production facility
would result in recognition of all unfavorable
volume variances as a period expense, while
favorable variances that are normal would be
recognized in inventory. Those respondents noted
that under ARB 43, Chapter 4, volume variances
are recognized as a period cost only when the so
abnormal criterion is met.
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SFAS 151
to address respondents concerns, the Board
decided that the amendment should include
guidance slightly more detailed than that in IAS
2 regarding normal capacity. In particular, the
Board decided to add guidance clarifying that
normal capacity refers to a range of production
levels within which ordinary variations in
production levels are expected. The Board
believes the amendment to ARB 43, Chapter 4, as
modified, will not lead to significant changes in
inventory accounting practice.