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. 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. Inventory-Costing Methods

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

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:

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:

65. Comparison of Inventory Costing Methods

66. Comparison of Inventory Costing Methods

67. Comparison of Inventory Costing Methods

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 Lloyd’s 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 Lloyd’s 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 Lloyd’s 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.