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Inventory Costing and Capacity Analysis

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Title: 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
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