Inventory Costing and Capacity Analysis

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Inventory Costing and Capacity Analysis. Chapter 9. Learning Objective 1. Identify what distinguishes variable costing from absorption costing. Inventory-Costing Methods. The difference between variable costing and absorption costing is based on the

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### Inventory Costingand Capacity Analysis

Chapter 9

Learning Objective 1

Identify what distinguishes

variable costing from

absorption costing.

Inventory-Costing Methods

The difference between variable costing

and absorption costing is based on the

Variable Costing

Direct

Materials

Variable

Factory

Labor

Variable

Work in Process Inventory

Variable Costing

Work in Process

Inventory

Finished Goods

Inventory

Fixed Factory

Labor

Cost of Goods Sold

Income Summary

Learning Objective 2

Prepare income statements

under absorption costing

and variable costing.

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 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)

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.

Comparing Income Statements(Absorption Costing)

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 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

Net contribution margin = \$160,000

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

Explain differences in operating

income 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

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

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

Income Statements (Absorption Costing)

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)

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

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

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

Income Statements(Variable Costing)

Year 1Year 2Combined

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 Variableand Absorption Costing

Variable costing operating income Year1: \$76,000

Absorption costing operating income Year1: \$85,000

Absorption costing operating income is \$9,000 higher.

Why?

Comparison of Variableand 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

Comparison of Variableand 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?

Comparison of Variableand 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

Higher cost of goods sold under

absorption costing: \$ 6,750

Comparison of Variableand 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

Comparison of Variableand Absorption Costing

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

Understand how absorption

costing can provide undesirable

incentives for managers to

build up finished goods inventory.

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?

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

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

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?

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

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

Learning Objective 5

Differentiate throughput

costing from variable costing

and absorption 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 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?

Nonmanufacturing Costs:

Variable \$2.00 × 8,000 \$16,000

Fixed 30,000

Total \$46,000

Throughput Costing
Variable costing operating income: \$76,000

Throughput costing operating loss: \$14,000

Difference in operating income: \$90,000

Throughput Costing

How can this difference be explained?

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

Absorption costing operating income: \$85,000

Throughput costing operating loss: \$14,000

Difference in operating income: \$99,000

Throughput Costing

How can this difference be explained?

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 InventoryCosting Methods

Actual Costing

Variable

Costing

Absorption

Costing

Throughput

Costing

Comparison of InventoryCosting Methods

Normal Costing

Variable

Costing

Absorption

Costing

Throughput

Costing

Comparison of InventoryCosting Methods

Standard Costing

Variable

Costing

Absorption

Costing

Throughput

Costing

Learning Objective 6

Describe the various

capacity concepts

that can be used in

absorption costing.

Alternative Denominator-LevelConcepts

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

Learning Objective 7

Understand the major factors

management considers in choosing

a capacity level to compute the

Choosing a Capacity Level

What factors are considered

in choosing a capacity level?

Product

costing

Pricing

decision

Performance

evaluation

Financial

statements

Regulatory

requirements

Difficulty

Decision Making

Assume that Lloyd’s Bicycles’ standard

hours are 2 hours per unit.

What is the budgeted fixed manufacturing

Decision Making

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

Learning Objective 8

Describe how attempts to

recover fixed costs of capacity

and lower demand.

Downward Demand Spiral

The downward demand spiral is the continuing

reduction in demand that occurs when the prices

of competitors are not met and demand drops.

Learning Objective 9

Explain how the capacity

level chosen to calculate

cost rate affects the

production-volume variance.

Effect on Financial Statements

Assume that Lloyd’s Bicycles actually used

8,400 machine-hours during the year.

What is the production volume variance?

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

Production Volume Variance

Normal capacity:

(7,500 – 8,400) × \$26.67 = \$24,003

Master-budget capacity:

(6,000 – 8,400) × \$33.33 = \$79,992