The Islamic University –Gaza Inventory Costing Dr. Hisham Madi

Comparing income statements for multiple years

Comparing income statements for multiple years Why do variable costing and absorption costing usually report different operating income numbers if inventory increases during an accounting period, less operating income will be reported under variable costing than absorption costing. Conversely, if inventory decreases, more operating income will be reported under variable costing than absorption costing

Variable Costing and the Effect of Sales and Production on Operating Income change in operating income under variable costing is driven solely by changes in the quantity of units actually sold

Absorption Costing and Performance Measurement Absorption costing is the required inventory method for external reporting in most countries and internal reporting as well. Because it is cost-effective and less confusing to managers to use one common method of inventory costing for both external and internal reporting and performance evaluation. Another advantage of absorption costing is that it measures the cost of all manufacturing resources, whether variable or fixed, necessary to produce inventory.

Absorption Costing and Performance Measurement Many companies use inventory costing information for long-run decisions, such as pricing and choosing a product mix One problem with absorption costing is that it enables a manager to increase operating income in a specific period by increasing production—even if there is no customer demand for the additional production To r educe t he undesirable incentives t o build up inventories t hat absorption costing can create, a number of companies use variable costing for internal reporting

Undesirable Buildup of Inventories How does operating income (absorption costing)for 2013 change as the production levels changes? the production-volume variance is written off to cost of goods sold at the end of each year. Beginning inventory of 2,000 units and sales of 6,500 units for 2013 are unchanged

Undesirable Buildup of Inventories Can top management implement checks and balances that limit managers from producing for inventory under absorption costing? producing for inventory cannot completely be prevented There are many subtle ways a manager can produce for inventory may not be easy to detect

Undesirable Buildup of Inventories 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. To increase product ion, a manager may defer maint- enance beyond the current period. Although operating income in this period may increase as a result, future operating income could decrease by a larger amount if repair costs increase and equipment becomes less efficient.

Undesirable Buildup of Inventories A Stassen manager who built up ending inventories of telescopes to 4,500 units in 2013 would have to further increase ending inventories in 2014 to increase that year’s operating income by producing for inventory. There are limits to how much inventory levels can be increased over time (because of physical constraints on storage space and management supervision and controls). Such limits reduce the likelihood of incurring some of absorption costing’s undesirable effects

Throughput Costing direct material costs are included as inventoriable costs. All other costs are costs of the period in which they are incurred Variable direct manufacturing labor costs and variable manufacturing overhead costs are regarded as period costs and are deducted as expenses of the period. Only the $110 direct material cost per unit is inventoriable under throughput costing, compared with $335 per unit for absorption costing and $200 per unit for variable costing.

Throughput Costing

Throughput Costing