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Inventory Costing and Capacity Analysis

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Inventory Costingand Capacity Analysis

Chapter 9

- Inventory Costing Methods
- Denominator Issues
- Example: working backwards
- BEPs: VC versus AC
- Solution to extra problem (on webpage)

- All manufacturing cost are considered inventoriable:
- All variable mfg. costs (both direct & indirect)
- All fixed mfg. costs (both direct & indirect)

- Separates costs by business function.
- Other costing terms:
- Super-full absorption costing: includes some mfg. related admin costs—used for tax.
- Full-product costing: costs from all areas of value chain are attached to product costs—for L-T pricing.

- All variable manufacturing costs are considered inventoriable.
- Separates costs by cost behavior.
- Some managers call this direct costing which is a poor choice of name. Why?

- Also called super-variable costing.
- Only variable direct materials are inventoriable. Assumes that only DM are variable in the short run.
- Reduces incentives to build up inventories.
- Relatively new and not widely used.

- Managers make a number of accounting choices that affect income, for example:

The difference between variable costing

and absorption costing is based on the

treatment of fixed manufacturing costs.

AC includes fixed mfg. costs in cost of inventory, while VC does not. VC expenses all fixed costs as period costs.

The following data pertain to Davenport Pencils:

Produce one product: #2 pencils. 1 box = 1 gross.

Sales price = $8/box; Sold 40,000 boxes

DM = $3 / box; DL = $0.50 / box

VMOH = $0.25 / box

FMOH = $100,000 / year

Sales commission = $0.75 / box

Fixed admin. expenses = $30,000 / year

Budget = actual production = 50,000 boxes

What is the cost per box under VC?

$3.00 + 0.50 + 0.25 = $3.75

What is the cost per box under AC?

$3.00 + 0.50 + 0.25 + 2.00* = $5.75

* Fixed mfg. OH rate = $2.00 / box = $100,000 / 50,000 boxes

Absorption Costing

Revenue$320,000

CoGS230,000

GM90,000

S&A60,000

Op. Inc.$ 30,000

Variable Costing

Revenue$320,000

VC180,000

CM 140,000

FC130,000

Op. Inc.$ 10,000

Variable costing operating income : $10,000

Absorption costing operating income : $30,000

Absorption costing operating income is

$20,000 higher.

Why?

Production exceeds sales.

The 10,000 unit increase in ending inventory

are valued as follows:

Absorption costing: 10,000 × $5.75 =$ 57,500

Variable costing: 10,000 × $3.75 =$ 37,500

Difference:$ 20,000

COGS

Absorption costing: 40,000 X $5.75 = $230,000

Variable costing: 40,000 X $3.75 = $150,000

Plus all the fixed mfg. OH = $100,000

Lower costs recognized under

absorption costing: $ 20,000

Under absorption costing, each of the additional 10,000 boxes in ending inventory is storing $2/box cost that will be expensed later when sold.

10,000 units of inventory × $2.00 = $20,000

Absorption costing

operating income

–

Variable costing

operating income

EQUALS

Fixed manufacturing

costs in ending

inventory under

absorption costing

–

Fixed manufacturing

costs in beginning

inventory under

absorption costing

What happens over the long run?

How might you mitigate the incentive to build up inventory?

Theoretical capacity

Practical capacity

Normal capacity

Master-budget capacity

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.

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?

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

- The larger the denominator level, the:
- Lower the budgeted FM rate.
- Lower Fixed Mfg. costs in E.Inv.
- Higher the unfavorable PVV for fixed OH
Remember—Fixed mfg. are either expensed in the period or stored in E.Inv.

What denominator level would you want to use for tax purposes? [practical is required for tax]

Assume that Lloyd’s Bicycles’ standard

hours are 2 hours per unit.

What is the budgeted fixed manufacturing

overhead cost per unit?

Theoretical capacity: $20 × 2 = $40.00

Practical capacity: $23.53 × 2 = $47.06

Normal capacity: $26.67 × 2 = $53.34

Master-budget capacity: $33.33 × 2 = $66.66

QQQ Company has op. income of $120,000 under absorption costing, and op. income would be $100,000 under variable costing.

FMOH = $500,000

Budgeted and actual production = 200,000 units.

Did inventory increase or decrease during the period? By how much?

- Answer depends on the FMOH rate for B.Inv and choice of inventory cost-flow method (FIFO, WA, LIFO, etc.).
- Assume no change in FMOH rate. Then choice of cost-flow method does not matter.
- FMOH rate = $500k / 200k = $2.50 / unit

- Unique solution under Variable Costing:
- BEPvc = Total FC / UCM

- Solution depends on production level under Absorption Costing:
- BEPac = [Total FC + (FM rate* (BEPac – Units Produced))] / UCM
- BEPac = [Total FC – (FMR*UP)] / (UCM – FMR)
What happens to the BEP when more units are produced?