Chapter 9

Inventory Costing and Capacity Analysis

Overview of Absorption and Variable Costing

Absorption Costing
Direct Materials

Variable Costing Product Costs

Product Costs

Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead

Period Costs

Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses

Period Costs

Manufacturing Cost Flows

Costs
Material Purchases Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Selling and Administrative Work in Process Cost of Goods Sold

Balance Sheet Inventories

Raw Materials

Income Statement Expenses

Finished Goods

Period Costs

Selling and Administrative

Data for Stassen Company for 2009

Stassen uses standard costing Stassens management wants to prepare an income statement for 2009 (the fiscal year just ended) to evaluate the performance of the telescope product line

Data for Stassen Company for 2009 (Cont)

The operating information for the year is: Units Beginning Inventory Production Sales 0 8,000 6,000

Ending Inventory

2,000

Data for Stassen Company for 2009 (Cont)

Actual price and cost data for 2009 are:
Selling Price Variable Manufacturing cost per unit Direct material cost per unit $1,000 $110

Direct manufacturing labor cost per unit Manufacturing overhead cost per unit Total variable manufacturing cost per unit Variable marketing cost per unit sold Fixed manufacturing costs (all indirect) Fixed marketing costs (all indirect)

40 50 $200 $185 $1,080,000 $1,380,000

Data for Stassen Company for 2009 (Cont)

Stassen incurs manufacturing and marketing costs only the cost driver for all variable manufacturing costs is units produced the cost driver for variable marketing costs is units sold There are no price variances, efficiency variances, or spending variances. Therefore the budgeted (standard) price and cost data for 2009 are the same as the actual price and cost data

Data for Stassen Company for 2009 (Cont)

Work-in-process inventory is zero. Stassen budgeted production of 8,000 units for 2009. This was used to calculate the budgeted fixed manufacturing cost per unit of $135 ($1,080,000/8,000 units). Stassen budgeted sales of 6,000 units for 2009, which is the same as the actual sales for 2009.

Data for Stassen Company for 2009 (Cont)

The actual production for 2009 is 8,000 units As a result, there is no production volume variance for manufacturing costs in 2009. Later examples, based on data for 2010 and 2011, do include production-volume variances However, even in those cases the income statements contain no variances other than the production-volume variance All variances are written off to cost of goods sold in the period (year) in which they occur

Unit Cost Computations

Number of units produced annually Variable costs per unit: Direct materials, direct labor, and variable mfg. overhead Selling & administrative expenses per unit sold Fixed costs per year: Manufacturing overhead Selling & administrative expenses 8,000

$ $

200 185

$1.08 mil $1.38 mil

Unit (Inventoriable) Cost Computations

Unit product cost is determined as follows:

Absorption Costing Direct materials, direct labor, and variable mfg. overhead Fixed mfg. overhead ($? ? units) Unit product cost

Variable Costing

Selling and administrative expenses are always treated as period expenses and deducted from revenue.

Comparative Income Statements

Reconciliation
We can reconcile the difference between absorption and variable income as follows:
Variable costing net operating income $ 1,230,000 Add: Fixed mfg. overhead costs deferred in inventory (2,000 units $135 per unit) 270,000 Absorption costing net operating income $ 1,500,000

Fixed mfg. overhead Units produced

$1,080,000 8,000 units

= $135.00 per unit

Fixed Manufacturing Costs Expensed for Different Sales Levels

Variable Costing Absorption Costing
Fixed Manufacturing Costs

Fixed Manufacturing Costs

Units Sold Ending Included in Inventory Inventory

Included in Inventory
=$135 X Ending Inv. $270,000 $135,000 $0

Amount Expensed
=$135 X Units Sold $810,000 $945,000 $1,080,000

Amount Expensed $1,080,000 $1,080,000 $1,080,000

6,000 7,000 8,000

2,000 1,000 0

$0 $0 $0

Data for Stassen Company for 2009, 2010, 2011

In both 2010 and 2011, Stassen has a productionvolume variance because actual telescope production differs from the budgeted level of production of 8,000 units per year used to calculate budgeted fixed manufacturing cost per unit. The actual quantities sold for 2010 and 2011 are the same as the sales quantities budgeted for these respective years, which are given in units in the following table:

Production/Sales Data for 2009, 2010, 2011

2009 Beginning Inventory Production Sales Ending Inventory 0 8,000 6,000 2,000 2010 2,000 5,000 6,500 500 2011 500 10,000 7,500 3,000

All other 2009 data given earlier for Stassen also apply for 2010 and 2011.

Comparative Income Statements Three Years

Operating Income Summary

2009
1. Absorption-costing operating income
2. Variable-costing operating income

2010

2011
$2,490,000 $2,152,500 $337,500 13.6%

$1,500,000 $1,335,000 $1,230,000 $1,537,500 $270,000 18.0% $(202,500) (15.2%)

3. Difference
4. Difference as a % of absorption-costing operating income

Operating Income Differences

Fixed manufacturing costs in ending inventory under absorption costing ($135 x 2,000 units) $270,000 ($135 X 500 units) ($202,500) ($135 x 3,000 units) $337,500 ($135 x 500 units) ($135 X 2,000 units) Fixed manufacturing costs in beginning inventory under absorption costing ($135 x 0 units)

Absorptioncosting operating income 2009 $1,500,000

Variable-costing operation income $1,230,000 $270,000

= = = = = =

2010

$1,335,000

$1,537,500 ($202,500)

2011

$2,490,000

$2,152,500 $337,500

Summary

Performance Issues and Absorption Costing

Managers may seek to manipulate income by producing too many units Production beyond demand will increase the amount of inventory on hand This will result in more fixed costs being capitalized as inventory That will leave a smaller amount of fixed costs to be expensed during the period Profit increases, along with stock prices, and potentially so does a managers bonus

Income Effects of Inventory Buildup

Other Manipulation Schemes Beyond Simple Overproduction

Deciding to manufacture products that absorb the highest amount of fixed costs, regardless of demand (cherry-picking) Accepting an order to increase production, even though another plant in the same firm is better suited to handle that order Deferring maintenance for extra production

Inventories and Costing Methods

One way to prevent the unnecessary buildup of inventory for bonus purposes is to base managers bonuses on profit calculated using Variable Costing Drawback: complicated system of producing two inventory figures one for external reporting and the other for bonus calculations

Management Countermeasures for Profit Manipulation Schemes

Careful budgeting and inventory planning Incorporate an internal carrying charge for inventory Change (lengthen) the period used to evaluate performance Include nonfinancial as well as financial variables in the measures to evaluate performance

Denominator-Level Capacity Concepts

Consider the Stassen Company example again. Recall that the annual fixed manufacturing costs of the production facility are $1,080,000 Stassen uses absorption costing with standard costs for external reporting purposes, and it calculates its budgeted fixed manufacturing rate on a per unit basis Lets examine four different capacity levels used as a denominator to compute the budgeted fixed manufacturing cost rate: theoretical capacity, practical capacity, normal capacity utilization, and master-budget capacity utilization

Effect on Budgeted Fixed Manufacturing Cost Rate

Budget Budgeted Capacity Fixed Level (in Manufacturing units) Cost per Unit 18,000 12,000 10,000 8,000 $60 $90 $108 $135

Denominator- Level Capacity Concept Theoretical capacity Practical capacity Normal capacity utilization Master-budget capacity utilization

Budgeted Fixed Manufacturing Costs per Year $1,080,000 $1,080,000 $1,080,000 $1,080,000

Total Budgeted Manufacturing Cost per Unit

DenominatorLevel Capacity Concept Theoretical capacity

Budgeted Variable Manufacturing Cost per Unit

$200

Budgeted Fixed Manufacturing Cost per Unit

$60

Budgeted Total Manufacturing Cost per Unit

$260

Practical capacity
Normal capacity utilization Master-budget capacity utilization

$200
$200 $200

$90
$108 $135

$290
$308 $335

Downward Demand Spiral

Master-Budget Capacity Utilization Denominator Level (Units) Budgeted Variable Manufacturing Cost per Unit Budgeted Fixed Budgeted Total Manufacturing Manufacturing Cost per Unit Cost per Unit

8,000 6,000 4,000

$200 $200 $200

$135 $180 $270

$335 $380 $470

3,000

$200

$360

$560