8-1 Inventory Valuation Approaches and Just-in- Time Inventory Management C hapter 8 Prepared by...

Inventory Valuation Inventory Valuation Approaches and Just-Approaches and Just-

in-Time Inventory in-Time Inventory ManagementManagement

Inventory Valuation Inventory Valuation Approaches and Just-Approaches and Just-

in-Time Inventory in-Time Inventory ManagementManagement

CChaptehapterr

Prepared by Douglas Cloud

Pepperdine University

Prepared by Douglas Cloud

Pepperdine University

1. Explain the primary characteristics of the absorption costing and variable costing inventory valuation methods.

2. Prepare absorption costing and variable costing income statements.

3. Evaluate the benefits and limitations of variable costing.

ObjectivesObjectivesObjectivesObjectives

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

4. Describe just-in-time (JIT) inventory management and discuss how it is used to reduce raw materials, work-in-process, and finished goods inventories.

5. Explain the change required in performance evaluation and record keeping when an organization adopts the JIT approach to inventory management.

ObjectivesObjectivesObjectivesObjectives

A Comparison of AbsorptionA Comparison of Absorption and Variable Costing and Variable Costing

Absorption Costing

Direct materialsDirect labor

Variable manufacturing overheadFixed manufacturing overhead

Product CostsProduct Costs

Variable Costing

Direct materialsDirect labor

Variable manufacturing overhead

Product CostsProduct Costs

Absorption Costing

Variable selling and administrativeFixed selling and administrative

Period CostsPeriod Costs

Variable Costing

Variable selling and administrativeFixed selling and administrativeFixed manufacturing overhead

Period CostsPeriod Costs

Basic ConceptsBasic ConceptsBasic ConceptsBasic Concepts

Absorption costing treats fixed manufacturing overhead as

product cost...

Absorption costing treats fixed manufacturing overhead as

product cost...

…whereas, variable costing treats fixed manufacturing overhead as a period cost.

Basic ConceptsBasic ConceptsBasic ConceptsBasic Concepts

Nutech Company manufactured 4,000 units.

Cost per Unit Using Variable Costing

Direct materials $ 7Direct labor 5Variable manufacturing overhead 4Total unit cost $16

Inventory ValuationsInventory ValuationsInventory ValuationsInventory Valuations

Nutech Company manufactured 4,000 units.

Cost per Unit Using Absorption Costing

Direct materials $ 7Direct labor 5Variable manufacturing overhead 4Fixed manufacturing overhead ($8,000 ÷ 4,000 units) 2Total unit cost $18

Inventory ValuationsInventory ValuationsInventory ValuationsInventory Valuations

Contribution FormatContribution FormatContribution FormatContribution Format

Sales $000Less variable expenses:

Cost of goods sold (000Selling (000Administrative (000

Contribution margin $000Less fixed expenses:

Manufacturing (000Selling (000Administrative (000

Net income $000

Functional FormatFunctional FormatFunctional FormatFunctional Format

Sales $000Less cost of goods sold (000Gross profit $000Less operating expenses:

Selling (000Administrative (000

Net income $000

Comparison (Production Constant)Comparison (Production Constant)Comparison (Production Constant)Comparison (Production Constant)

Absorption Costing--Production Equals Sales

Sales (4,000 @ $30) $120,000Less cost of goods sold (at $18/unit) - 72,000Gross profit $ 48,000Selling and administrative expenses:

Variable (at $3 per unit) $ 12,000Administrative 10,000Total - 22,000

Net income $ 26,000

JuneJune

Variable Costing--Production Equals Sales

Sales (4,000 @ $30 per unit) $120,000Variable expenses:

Cost of goods sold (@ $16 per unit) $ 64,000Selling and administrative (@ $3/unit) 12,000

Total - 76,000Contribution margin $ 44,000Fixed expenses:

Manufacturing overhead $ 8,000Selling and administrative 10,000Total - 18,000

Net income $ 26,000

JuneJune

Absorption Costing--Production Exceeds Sales

Sales (2,500 @ $30 per unit) $75,000Less cost of goods sold (at $18/unit) -45,000Gross profit $30,000Selling and administrative expenses:

Variable (at $3 per unit) $ 7,500Administrative 10,000Total -17,500

Net income $12,500

JulyJulyJulyJuly

Variable Costing--Production Exceeds Sales

Sales (2,500 @ $30 per unit) $ 75,000Variable expenses:

Total -47,500Contribution margin $ 27,500Fixed expenses:

Net income $ 9,500

JulyJulyJulyJuly

Reconciliation of Income DifferencesReconciliation of

Income Differences

Variable costing net income

$9,500

Increase (or minus decrease) in inventoried fixed manufacturing overhead

+ $3,000

=Absorption costing net income

= $12,500

1,500 units x $2 per unit

Absorption Costing--Sales Exceed Production

Sales (5,500 @ $30/unit) $165,000Less cost of goods sold (at $18/unit) - 99,000Gross profit $ 66,000Selling and administrative expenses:

Variable (at $3 per unit) $ 16,500Administrative 10,000Total - 26,500

Net income $ 39,500

AugustAugustAugustAugust

Variable Costing--Sales Exceed Production

Total -104,500Contribution margin $ 60,500Fixed expenses:

Net income $ 42,500

AugustAugustAugustAugust

1,500 units x $2 per unit1,500 units x $2 per unit

Beginning inventory

Reconciliation of Income DifferencesReconciliation of

Income Differences

Absorption costing net income

Decrease (or minus increase) in inventoried fixed manufacturing overhead

=Variable costing net income

$39,500 + $3,000 = $42,500

Comparison (Sales Constant)Comparison (Sales Constant)Comparison (Sales Constant)Comparison (Sales Constant)

Sales (4,000 @ $30) $120,000Beginning inventory $ -0-Variable manufacturing costs 64,000Fixed manufacturing costs 8,000Cost of goods available $ 72,000Less ending inventory -0-Cost of goods sold - 72,000

Gross profit $ 48,000

Continued next slide OctoberOctoberOctoberOctober

Gross profit $ 48,000Selling and administrative expenses:

Variable (at $3 per unit) $ 12,000Fixed 10,000Total - 22,000

Net income $ 26,000

OctoberOctoberOctoberOctober

Variable Costing--Production Equals Sales

Net income $ 26,000

OctoberOctoberOctoberOctober

Sales (4,000 @ $30) $120,000Beginning inventory $ -0-Variable manufacturing costs 80,000Fixed manufacturing costs 8,000Cost of goods available $ 88,000Less ending inventory 17,600Cost of goods sold - 70,400

Continued next slide

NovemberNovemberNovemberNovember

Net income $ 27,600

Variable Costing--Production Exceeds Sales

Net income $ 26,000

NovemberNovember1,000 units x $1.60 per unit1,000 units x $1.60 per unit

Ending inventory

Reconciling of Income Differences

$26,000 + $1,600 = $27,600

Sales (4,000 @ $30) $120,000Beginning inventory $ 17,600Variable manufacturing costs 51,200Fixed manufacturing costs 8,000Cost of goods available $ 76,800Less ending inventory 3,700Cost of goods sold - 73,100

Continued next slide

DecemberDecemberDecemberDecember

Net income $ 24,900

Variable Costing--Sales Exceed Production

Net income $ 26,000

1,000 units x $1.60 per unit1,000 units x $1.60 per unit

Beginning inventory200 units x $2.50 per unit200 units x $2.50 per unit

Beginning inventory

Reconciling of Income Differences

$24,900 + $1,600 = $26,000– $500

Inventories have value only to the extent that they avoid the necessity of incurring

costs in the future.

Inventories have value only to the extent that they avoid the necessity of incurring

costs in the future.

Proponents of Proponents of Variable Variable CostingCosting

Another advantage is that variable costing matches

revenue with the direct cost of producing those

revenues.

Another advantage is that variable costing matches

revenue with the direct cost of producing those

revenues.

Fixed manufacturing costs are incurred for only one

purpose, namely to manufacture the product.

Fixed manufacturing costs are incurred for only one

purpose, namely to manufacture the product.

Proponents of Proponents of Absorption Absorption

CostingCosting

By omitting fixed costs from inventory, variable costing

understates long-run variable costs and misleads decision makers into underestimating

true production costs.

By omitting fixed costs from inventory, variable costing

understates long-run variable costs and misleads decision makers into underestimating

true production costs.

Theory of Constraints

Emphasis on: Throughput

Product cost components:

Direct materials

Variable Costing

Emphasis on: Contribution margin

Direct materialsDirect laborVariable manufacturing

overhead

Traditional Absorption

Costing

Emphasis on: Gross profit

Direct materialsDirect laborVariable manufacturing

overheadFixed manufacturing

overhead

ABC Absorption

Costing

Emphasis on: Gross profit

Direct materialsDirect laborManufacturing overhead

Unit levelBatch levelProduct levelFacility level

Full ABC

Emphasis on: Net income

Direct materialsDirect laborUnit level costsBatch level costsProduct level costsOrder level costsCustomer level costsMarket segment level costsFacility levels costs

Just-in-Time (JIT)Just-in-Time (JIT)Just-in-Time (JIT)Just-in-Time (JIT)

JIT is a comprehensive inventory management philosophy that stresses policies, procedures, and attitudes by managers and other workers that result in the efficient production of high quality goods while maintaining the minimum

level of inventories.

1. Developing long-term relationships with a limited number of vendors.

2. Selecting vendors on the basis of service and material quality, as well as price.

3. Establishing procedures for employees to order materials for current needs directly from approved vendors.

4. Accepting vendor deliveries directly to the shop floor or department store.

The JIT approach to reducing raw materials includes:

Just-in-Time (JIT)Just-in-Time (JIT)Just-in-Time (JIT)Just-in-Time (JIT)

Dysfunctional Effects of Traditional Dysfunctional Effects of Traditional Performance MeasuresPerformance Measures

To achieve quantity discounts and favorable prices, a purchasing agent may order excessive inventory, thereby increasing subsequent storage, obsolescence, and handling.

To obtain a low price, a purchasing agent may order from a supplier whose not been certified as meeting quality specifications.

ContinuedContinuedContinuedContinued

Dysfunctional Effects of Traditional Dysfunctional Effects of Traditional Performance MeasuresPerformance Measures

To avoid having idle employees and equipment, a supervisor may refuse to halt production to determine the quality problem, thereby increasing inspection, rework, and spoiled costs.

To obtain low fixed costs per unit under absorption costing, a supervisor may produce in excess of current needs, thereby causing subsequent increase in storage, obsolescence, and handling costs.

Performance EvaluationPerformance Evaluation

When applied to a specific item of raw materials or finished goods inventory turnover is

computed as follows:

Inventory turnover =Annual demand in units

Average inventory (in units)

When stated in dollars, inventory turnover can be used as a measure of

the overall success of the organization in reducing inventory.

Inventory turnover =Cost of goods sold

Average inventory (in dollars)

Cycle Time =

Setup Time +

Proc-essing Time

+Move-ment Time

+Wait-ing

Inspec-tion

Cycle efficiency =Processing time

Cycle time

Product CostingProduct CostingProduct CostingProduct Costing

Another advantage of JIT is that it reduces the

amount of detailed bookkeeping.

Another advantage of JIT is that it reduces the

amount of detailed bookkeeping.

Also, many of the distinctions and arguments regarding

absorption versus variable costing are moot.

Also, many of the distinctions and arguments regarding

absorption versus variable costing are moot.

CChapter

The The EndEndThe The EndEnd

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