Session 9 Analysis - Otto von Guericke University · PDF fileInventory Costing and Capacity...

Cost Accounting Horngreen, Datar, Foster

Inventory Costing and Capacity Analysis

Session 9


Learning Objectives

� Distinguish variable costing from absorption costing� Explain differences in operating income under absorption costing and

variable costing� Understand how absorption costing can provide undesirable incentives

for managers� Differentiate throughput costing from variable costing and absorption

costing� Denominator-level capacity concepts that can be used in absorption

costing� Explain effects of the denominator level on the production-volume

variance� How attempts to recover fixed costs of capacity may lead to a downward

demand spiral


Learning Objective 1

Identify what distinguishesvariable costing fromabsorption costing.


Inventory-Costing Methods

� The difference between variable costing and absorption costing is based on the treatment of fixed manufacturing overhead.

DirectMaterials

VariableFactoryLabor

(variable)Overhead

Work in Process Inventory


Variable Costing

Work in ProcessInventory

Finished GoodsInventory

Cost of Goods Sold

Income Summary

Fixed FactoryOverhead


Absorption Costing

Work in ProcessInventory incl fixed

costs

Finished GoodsInventory

Cost of Goods Sold

Income Summary



Prepare income statementsunder absorption costing

and variable costing.


Comparing Income Statements

� The following data pertain to Davenport Fixtures:

Year 1 Year 2 TotalBeginning inventory -0- 2,000 -0-Produced 10,000 11,500 21,500Sold 8,000 13,000 21,000Ending inventory 2,000 500 500


Comparing Income Statements

� The following information is on a per unit basis:

Sales price: $71.00Variable manufacturing costs:

Direct materials: $ 4.00Direct manufacturing labor: $21.00Indirect manufacturing costs: $24.00

Fixed manufacturing costs: $ 4.50


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.

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


Comparing Income Statements(Absorption Costing)

� Revenues for Year 1 are $568,000.� What is the cost of goods sold?

• 8,000 × $53,5 = $428,000

� What is the Gross margin?• $568,000 – $428,000 –$9.000 = $131,000• Operating Income = $131,000 - $46,000 = $85,000


Comparing Income Statements (Variable Costing)

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



Explain differences in operatingincome under absorption

costing and variable costing.


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� 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


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

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


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

� 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


Income Statements (Variable Costing)

Year 1 Year 2 CombinedRevenues $ 568,000 $923,000 $1,491,000Cost of goods sold 392,000 637,000 1,029,000Mfg. contr. margin $176,000 $286,000 $ 462,000Variable nonmfg. 16,000 26,000 42,000Net contr. margin $160,000 $260,000 $ 420,000Fixed mfg. costs 54,000 54,000 108,000Fixed nonmfg. costs 30,000 30,000 60,000Operating income $ 76,000 $176,000 $252,000


Comparison of Variableand 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.

� 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?


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: 2,000 × $53.50 = $107,000� Variable costing: 2,000 × $49.00 = $ 98,000� Difference: $ 9,000

� 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� Higher cost of goods sold under absorption costing: $ 6,750


Comparison of Variable and Absorption Costing

� Variable costing combined net income: $252,000� Absorption costing combined net income: $254,250� Absorption costing is higher by $2,250 � 500 units in inventory × $4.50 = $2,250

Absorption costingoperating income

Variable costingoperating income

Fixed manufacturingcosts in endinginventory under

absorption costing

Fixed manufacturingcosts in beginning

inventory underabsorption costing

–

EQUALS

–



Understand how absorptioncosting can provide undesirable

incentives for managers tobuild up finished goods inventory.


Undesirable effects of producing for inventory

� 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.


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.� Lengthen the time period used to evaluate performance.� 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


Inventory Buildup

� Assume that Davenport 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?

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


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

� 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?


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

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



Differentiate throughputcosting from variable costing

and absorption costing.


Throughput Costing

Revenues $568,000Variable direct materials

cost of goods sold 32,000Throughput contribution margin $536,000Manufacturing costs 504,000Nonmanufacturing costs 46,000Operating loss $ 14,000


Throughput Costing

Manufacturing Costs:Labor $21.00 × 10,000 $210,000Indirect costs $24.00 × 10,000 240,000Fixed costs 54,000Total manufacturing costs $504,000


Throughput Costing

� What are other nonmanufacturing costs for the year? � Nonmanufacturing Costs:

• Variable $2.00 × 8,000 $16,000• Fixed 30,000• Total $46,000

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


Throughput Costing

The 2,000 units in ending inventoryare valued as follows:

Variable2,000 × $49 = $98,000

Throughput2,000 × $4 = $8,000

$90,000 difference


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?


Throughput Costing

The 2,000 units in ending inventoryare valued as follows:

Absorption2,000 × $53.50 =

$107,000

Throughput2,000 × $4= $8,000

$99,000 difference


Comparison of Inventory Costing Methods

Actual CostingActual Costing

AbsorptionAbsorptionCostingCosting

ThroughputThroughputCostingCosting

VariableVariableCostingCosting



Normal CostingNormal Costing






Standard CostingStandard Costing






Describe the variouscapacity conceptsthat can be used inabsorption costing.


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 (absorption) costing system will report prior to the end of an accounting period.

� Theoretical capacity� Practical capacity� Normal capacity� Master-budget capacity


Theoretical Capacity

� Theoretical capacity xt

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


Practical Capacity

� Practical capacity xp

is the denominator-level concept that reduces theoretical capacity by unavoidable operating interruptions.

� The use of practical capacity is required by the Internal Revenue Service (IRS).


Normal Capacity

� Normal capacity xn

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.


Master-Budget Capacity

� Master-budget capacity xm

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



Understand the major factorsmanagement considers in choosing

a capacity level to compute thebudgeted fixed overhead cost rate.


Choosing a Capacity Level

What factors are consideredin choosing a capacity level?

Productcosting

Pricingdecision

Performanceevaluation

Financialstatements

Regulatoryrequirements Difficulty



Describe how attempts torecover fixed costs of capacity

may lead to price increasesand lower demand.


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.


True or False??

� When variable costing is used, the firm will be looking for the gross margin.

� The income under variable costing will never be the same as the income under absorption costing.

� Under variable costing, only the quantity of units sold drives operating income, the production level has no impact at all.

� Theoretical capacity is the capacity level that represents what the firm is able to obtain under reasonable circumstances.

� In the short run, capacity costs are usually fixed.


Pick your Choice I:

� TTF, Inc., which just began business this year, has the following information about JJI, the only product that it produces and sells. JJI sells for $25 per unit. During the current year, 20,000 units of JJI were sold. During the period, TTF manufactured 22,000 units of JJI. The following costs were available: variable costs per unit: direct materials -$ 8; direct labor - $4; variable manufacturing overhead - $2; variable selling - $3. The indirect fixed costs for TTF were manufacturing costs $55,000 and marketing $33,000. What is the unit cost to be recorded in inventory under absorption costing?

� $14.00 � $16.50 � $17.00 � $19.50


Pick your Choice II:

� POR has the following information with regard to capacity. Theoretical capacity is 100,000 units, practical capacity is 80,000 units, normal capacity is 75,000 units, and the current period master-budget capacity is 70,000 units. During the current period the actual level achieved was 72,000 units. If the fixed manufacturing costs for the period were budgeted at $300,000 and the firm uses normal capacity as its activity level, what would the production-volume variance be for the current period?

� $0 � $12,000 Unfavorable � $12,000 Favorable � $15,000 Unfavorable

Session 9 Analysis - Otto von Guericke University · PDF fileInventory Costing and Capacity...

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