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 from

absorption 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

Learning Objective 2

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

Learning Objective 3

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 beginninginventory under

absorption costing

–

EQUALS

–

Learning Objective 4

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

Learning Objective 5

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

AbsorptionAbsorption CostingCosting

ThroughputThroughput CostingCosting

VariableVariable CostingCosting

Comparison of Inventory Costing Methods

Normal CostingNormal Costing

AbsorptionAbsorption CostingCosting

ThroughputThroughput CostingCosting

VariableVariable CostingCosting

Comparison of Inventory Costing Methods

Standard CostingStandard Costing

AbsorptionAbsorption CostingCosting

ThroughputThroughput CostingCosting

VariableVariable CostingCosting

Learning Objective 6

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).

Learning Objective 7

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

Learning Objective 8

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.