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Inventory Costing and Capacity Analysis. Session 9. Learning Objectives. D istinguish variable costing from absorption costing Explain differences in operating income under absorption costing and variable costing

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learning objectives
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
Learning Objective 1

Identify what distinguishes

variable costing from

absorption costing.

inventory costing methods
Inventory-Costing Methods
  • The difference between variable costing and absorption costing is based on the treatment of fixed manufacturing overhead.

Direct

Materials

Variable

Factory

Labor

(variable)

Overhead

Work in Process Inventory

variable costing
Work in Process

Inventory

Finished Goods

Inventory

Fixed Factory

Overhead

Cost of Goods Sold

Income Summary

Variable Costing
absorption costing
Absorption Costing

Work in Process

Inventory incl fixed

costs

Finished Goods

Inventory

Cost of Goods Sold

Income Summary

learning objective 2
Learning Objective 2

Prepare income statements

under absorption costing

and variable costing.

comparing income statements
Comparing Income Statements
  • The following data pertain to Davenport Fixtures:

Year 1Year 2Total

Beginning inventory -0- 2,000 -0-

Produced 10,000 11,500 21,500

Sold 8,00013,00021,000

Ending inventory 2,000 500 500

comparing income statements1
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

comparing income statements absorption costing
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 $568,000

Cost of goods sold 428,000

Volume variance (U) 9,000

Gross margin $131,000

Nonmanufacturing costs 46,000

Operating income $ 85,000

comparing income statements absorption costing1
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
Comparing Income Statements (Variable Costing)

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

learning objective 3
Learning Objective 3

Explain differences in operating

income under absorption

costing and variable costing.

operating income absorption 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 costing1
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 1Year 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

operating income variable costing
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
Income Statements (Variable Costing)

Year 1Year 2Combined

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

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

comparison of variable and absorption costing
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 costing1
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 costing2
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 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

learning objective 4
Learning Objective 4

Understand how absorption

costing can provide undesirable

incentives for managers to

build up finished goods inventory.

u ndesirable effects of producing for 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
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
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) $291,100

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

inventory buildup1
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 buildup2
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

  • 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
learning objective 5
Learning Objective 5

Differentiate throughput

costing from variable costing

and absorption costing.

throughput costing
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

throughput costing1
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

throughput costing2
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 costing3
Throughput Costing

The 2,000 units in ending inventory

are valued as follows:

Variable

2,000 × $49 = $98,000

Throughput

2,000 × $4 = $8,000

$90,000 difference

throughput costing4
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 costing5
Throughput Costing

The 2,000 units in ending inventory

are valued as follows:

Absorption

2,000 × $53.50 =

$107,000

Throughput

2,000 × $4

= $8,000

$99,000 difference

comparison of inventory costing methods
Comparison of Inventory Costing Methods

Actual Costing

Variable

Costing

Absorption

Costing

Throughput

Costing

comparison of inventory costing methods1
Comparison of Inventory Costing Methods

Normal Costing

Variable

Costing

Absorption

Costing

Throughput

Costing

comparison of inventory costing methods2
Comparison of Inventory Costing Methods

Standard Costing

Variable

Costing

Absorption

Costing

Throughput

Costing

learning objective 6
Learning Objective 6

Describe the various

capacity concepts

that can be used in

absorption costing.

alternative denominator level concepts
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
  • 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
  • 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
  • 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
  • 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
Learning Objective 7

Understand the major factors

management considers in choosing

a capacity level to compute the

budgeted fixed overhead cost rate.

choosing a capacity level
Choosing a Capacity Level

What factors are considered

in choosing a capacity level?

Product

costing

Pricing

decision

Performance

evaluation

Financial

statements

Regulatory

requirements

Difficulty

learning objective 8
Learning Objective 8

Describe how attempts to

recover fixed costs of capacity

may lead to price increases

and lower demand.

downward demand spiral
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.
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