CHAPTER 9 INVENTORY COSTING

Absorption costing The cost of a unit of product consists of: Direct materials Direct labor Manufacturing overhead

Variable costing Direct materials The cost of a unit of product consists of only variable manufacturing costs: Direct materials Direct labor Variable manufacturing overhead

Overview of Absorption and Variable Costing Direct Materials Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses Variable Costing Absorption Costing Product Costs Period Costs

Note: Manufacturing Cost Flows Balance Sheet Costs Inventories Income Statement Expenses Material Purchases Work in Process Finished Goods Raw Materials Direct Labor Variable Manufacturing Overhead Absorption costing Cost of Goods Sold Selling and Administrative Fixed Manufacturing Overhead Variable costing Selling and Administrative Period Costs

Harvey Co. Variable costs per unit: Direct materials $5 Direct labor 3 Variable manufacturing overhead 2 Variable selling & admin. expenses 2 Monthly fixed costs: Fixed manufacturing overhead $50,000 Fixed selling & admin. expenses 35,000 Selling price per unit: $30 Assume normal output is 10,000 units per month.

Harvey Co.

Product cost - Absorption costing Harvey Co. Product cost - Absorption costing Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Total cost per unit

Harvey Co.

Product cost - Variable costing Harvey Co. Product cost - Variable costing Direct materials 5 Direct labor 3 Variable manufacturing overhead 2 Total cost per unit 10

Harvey Co.

Income Comparison of Absorption and Variable Costing Let’s compare the methods (February).

Harvey Co. Income reconciliation

Extending the Example Let’s look at the second quarter of operations for Harvey Company.

Harvey Co.

Harvey Co.

Harvey Co.

Harvey Co. Income reconciliation

Summary

Quick Check 1 Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. . .

Quick Check 2 Which method will produce the highest retained earnings? a. Absorption costing b. Variable costing c. There would be no difference in retained earnings under the two methods. d. It depends ...

Quick Check 3 Which method will produce the highest cumulative profit? a. Absorption costing b. Variable costing c. There would be no difference in cumulative profit under the two methods. d. It depends ...

Advantages of the Variable Approach Management finds it easy to understand. Consistent with CVP analysis. Net operating income is closer to net cash flow. Profit is not affected by changes in inventories. Consistent with standard costs and flexible budgeting. Impact of fixed costs on profits emphasized. Easier to estimate profitability of products and segments.

Advantages of the Absorption Approach They are the numbers that appear on our external reports. All manufacturing costs must be assigned to products to properly match revenues and costs. Depreciation, taxes, insurance and salaries are just as essential to products as variable costs.

Which approach should we follow? Variable or Absorption costing?

Impact of JIT Inventory Methods In a JIT inventory system . . . Production tends to equal sales . . . So, the difference between variable and absorption income tends to disappear.

End of chapter 9