Cost Accounting Horngreen, Datar, Foster Inventory Costing and Capacity Analysis Session 9

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster Learning Objective 1 Identify what distinguishes variable costing from absorption costing.

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster Variable Costing Work in Process Inventory Finished Goods Inventory Cost of Goods Sold Income Summary Fixed Factory Overhead

Cost Accounting Horngreen, Datar, Foster Absorption Costing Work in Process Inventory incl fixed costs Finished Goods Inventory Cost of Goods Sold Income Summary

Cost Accounting Horngreen, Datar, Foster Learning Objective 2 Prepare income statements under absorption costing and variable costing.

Cost Accounting Horngreen, Datar, Foster Comparing Income Statements  The following data pertain to Davenport Fixtures: Year 1Year 2 Total Beginning inventory -0- 2, Produced10,00011,50021,500 Sold 8,00013,00021,000 Ending inventory 2,

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster Learning Objective 3 Explain differences in operating income under absorption costing and variable costing.

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster 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 1 Year 2 Combined Revenues$568,000 $923,000 $1,491,000 Cost of goods sold 428, ,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 Operating income$ 85,000 $169,250 $ 254,250

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster Income Statements (Variable Costing) Year 1 Year 2 Combined Revenues $ 568,000$923,000$1,491,000 Cost of goods sold 392, ,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 Fixed nonmfg. costs 30,000 30,000 60,000 Operating income $ 76,000$176,000 $252,000

Cost Accounting Horngreen, Datar, Foster Comparison of Variable and 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?

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster 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 Fixed manufacturing costs in ending inventory under absorption costing Fixed manufacturing costs in beginning inventory under absorption costing – EQUALS –

Cost Accounting Horngreen, Datar, Foster Learning Objective 4 Understand how absorption costing can provide undesirable incentives for managers to build up finished goods inventory.

Cost Accounting Horngreen, Datar, Foster 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.

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster 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?

Cost Accounting Horngreen, Datar, Foster Inventory Buildup  How many units are in ending inventory? ,000 – 4,100 = 5,200  How much cost is in ending inventory? 5,200 × $53.50 = $278,200 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

Cost Accounting Horngreen, Datar, Foster Learning Objective 5 Differentiate throughput costing from variable costing and absorption costing.

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster Throughput Costing Manufacturing Costs: Labor $21.00 × 10,000$210,000 Indirect costs $24.00 × 10, ,000 Fixed costs 54,000 Total manufacturing costs$504,000

Cost Accounting Horngreen, Datar, Foster 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?

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster 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?

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster Comparison of Inventory Costing Methods Actual Costing Absorption Costing CostingThroughput Variable

Cost Accounting Horngreen, Datar, Foster Comparison of Inventory Costing Methods Normal Costing Absorption Costing CostingThroughput Variable

Cost Accounting Horngreen, Datar, Foster Comparison of Inventory Costing Methods Standard Costing Absorption Costing CostingThroughput Variable

Cost Accounting Horngreen, Datar, Foster Learning Objective 6 Describe the various capacity concepts that can be used in absorption costing.

Cost Accounting Horngreen, Datar, Foster 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

Cost Accounting Horngreen, Datar, Foster Theoretical Capacity  Theoretical capacity x t (maximum or ideal capacity) is the denominator level concept that is based on producing at full (peak) efficiency all the time.

Cost Accounting Horngreen, Datar, Foster Practical Capacity  Practical capacity x p 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).

Cost Accounting Horngreen, Datar, Foster Normal Capacity  Normal capacity x n 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.

Cost Accounting Horngreen, Datar, Foster Master-Budget Capacity  Master-budget capacity x m is the denominator-level concept based on the expected level of capacity utilization for the next budget period (typically one year).

Cost Accounting Horngreen, Datar, Foster Learning Objective 7 Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate.

Cost Accounting Horngreen, Datar, Foster Choosing a Capacity Level What factors are considered in choosing a capacity level? Product costing Pricing decision Performance evaluation Financial statements Regulatory requirements Difficulty

Cost Accounting Horngreen, Datar, Foster Learning Objective 8 Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand.

Cost Accounting Horngreen, Datar, Foster 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.