© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 1 Cost Management Measuring, Monitoring, and Motivating Performance Prepared by Gail Kaciuba Midwestern State University Chapter 14 Measuring and Assigning Costs for Income Statements

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 2 Chapter 14: Measuring and Assigning Costs for Income Statements Learning objectives Q1: How are absorption costing income statements constructed? Q2: What factors affect the choice of production volume measures for allocating fixed overhead? Q3: How are variable costing income statements constructed? Q4: How are throughput costing income statements constructed? Q5: What are the uses and limitations of absorption, variable, and throughput costing income statements?

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 3 Q1: Absorption Costing Income Statements Under absorption costing, fixed manufacturing overhead is an inventoriable cost. GAAP requires the use of absorption costing. Absorption costing income statements are prepared using the traditional format. Expenses are grouped by function. Manufacturing costs deducted above the gross margin subtotal. Nonmanufacturing costs deducted below the gross margin subtotal.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 4 Q1: Absorption Costing Income Statement Example Russell Corporation produces a product that sells for $10. In 2005, there were 10,000 units in beginning finished goods inventory. The company expected to produce, and actually did produce, 80,000 units, and 62,000 units were sold. The costs incurred in 2005 are shown below. Given the cost information below, compute the inventoriable costs per unit under absorption costing.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 5 Suppose that the Russell Corporation uses the LIFO inventory method. Prepare an absorption costing income statement for Q1: Absorption Costing Income Statement Example Note that cost of goods sold is based on the 2005 per-unit manufacturing costs because: (1) Russell is using LIFO, and (2) production exceeded sales in Note that cost of goods sold is based on the 2005 per-unit manufacturing costs because: (1) Russell is using LIFO, and (2) production exceeded sales in 2005.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 6 Q2: Actual versus Estimated Denominator Levels Normal costing (chapter 5) uses an estimated, rather than an actual, denominator level for the overhead cost allocation base. If an actual denominator level is used, information is not timely. Using an estimated denominator level provides a smoothing effect, for two reasons: Numerator reason Denominator reason

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 7 Q2: Various Measures of Production Volume Supply-based measures of capacity: The maximum possible capacity, with no allowance for downtime, is known as theoretical capacity. Theoretical capacity, reduced by an allowance for normal downtime, is known as practical capacity. Demand-based measures of capacity: The average use of capacity of several years is known as normal capacity. The anticipated use of capacity for the upcoming year is known as budgeted capacity or expected capacity.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 8 Q2: Effect of Denominator Volume on the Income Statement When denominator volume is different than actual volume, there is a fixed overhead volume variance. The volume variance is the difference between budgeted fixed overhead and applied fixed overhead. If material, the volume variance is closed to Work in process, Finished goods, and Cost of goods sold at year-end.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 9 Q2: Absorption Costing Income Statement & Volume Variance Example Russell Corporation produces a product that sells for $10. In 2005, there were 10,000 units in beginning finished goods inventory. The company expected to produce 100,000 units in However, it actually produced 80,000 units and sold 62,000 units. The costs incurred in 2005 are shown below. Compute the inventoriable costs per unit under absorption costing. Note that choice of denominator level affects only the fixed overhead cost per unit.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 10 Q2: Absorption Costing Income Statement & Volume Variance Example Suppose that the Russell Corporation uses the LIFO inventory method and that the volume variance is considered material. Assume that the balances in WIP, FG, and CGS, before any adjustment for the volume variance, were at a ratio of 1:2:7 at 12/31/05. There was no fixed overhead spending variance in Compute the volume variance and prepare the year-end entry to close the Fixed overhead control account. Note that the unfavorable volume variance equals the underapplied fixed overhead because there was no spending variance for fixed overhead. Budgeted fixed overhead $100,000 Fixed overhead applied (80,000 units x $1/unit) 80,000 Unfavorable fixed overhead volume variance $20,000 Fixed overhead control20,000 Work in process [(1/10) x 20,000]2,000 Finished goods [(2/10) x 20,000]4,000 Cost of good sold [(7/10) x 20,000]14,000

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 11 Q2: Absorption Costing Income Statement & Volume Variance Example Using the cost information on slide #8 and the volume variance you calculated on the prior slide, prepare an absorption costing income statement for 2005.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 12 Q3: Variable Costing Income Statements Under variable costing, fixed manufacturing overhead is a period cost. Variable costing income statements are used internally only. Variable costing income statements are prepared using the contribution format. Expenses are grouped by cost behavior. Variable costs deducted above the contribution margin subtotal. Fixed costs deducted below the contribution margin subtotal.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 13 Q3: Variable Costing Income Statement Example Russell Corporation produces a product that sells for $10. In 2005, there were 10,000 units in beginning finished goods inventory. The company expected to produce, and actually did produce, 80,000 units, and 62,000 units were sold. The costs incurred in 2005 are shown below. Compute the inventoriable costs per unit under variable costing.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 14 Suppose that the Russell Corporation uses the LIFO inventory method. Prepare a variable costing income statement for Q3: Variable Costing Income Statement Example Note that cost of goods sold is based on the 2005 per-unit manufacturing costs because Russell is using LIFO.

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 15 Suppose that the Russell Corporation uses the LIFO inventory method. Reconcile the income under variable costing you determined on the prior slide with the $218,300 income under absorption costing computed on slide #4. Q3: Variable Costing Income Statement Example Variable costing income$195,800 Add: fixed overhead attached to the increase in inventory (18,000 units x $1.25/unit) 22,500 Absorption costing income $218, 300

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 16 Q4: Throughput Costing Income Statements Under throughput costing, all manufacturing costs except direct materials are period costs. Throughput costing income statements are used internally only; useful when most manufacturing costs are not variable in the short run. Throughput costing income statements are prepared using a new format. Sales – cost of goods sold (direct materials only) = throughput margin

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 17 Q4: Throughput Costing Income Statement Example Russell Corporation produces a product that sells for $10. In 2005, there were 10,000 units in beginning finished goods inventory. The company expected to produce, and actually did produce, 80,000 units, and 62,000 units were sold. The costs incurred in 2005 are shown below. Suppose that the Russell Corporation uses the LIFO inventory method. Prepare a throughput costing income statement for Note that DL and VO costs expensed based on units produced, not units sold

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 18 Q4: Throughput Costing Income Statement Example continued Reconcile the income under throughput costing you computed on the prior slide to the income under variable costing computed on slide #13 and to the income under absorption costing computed on slide #4. Throughput costing income $151,700 Add: Costs attached to the increase in inventory: Direct labor (18,000 units x $1.60/unit) 28,800 Variable overhead (18,000 units x $0.85/unit) 15,300 Variable costing income$195,800 Add: fixed overhead attached to the increase in inventory (18,000 units x $1.25/unit) 22,500 Absorption costing income $218, 300 Throughput costing income $151,700 Add: Costs attached to the increase in inventory: Direct labor (18,000 units x $1.60/unit) 28,800 Variable overhead (18,000 units x $0.85/unit) 15,300 Variable costing income$195,800 Add: fixed overhead attached to the increase in inventory (18,000 units x $1.25/unit) 22,500 Absorption costing income $218, 300

© John Wiley & Sons, 2005 Chapter 14: Measuring and Assigning Costs for Income Statements Eldenburg & Wolcott’s Cost Management, 1eSlide # 19 Q5: Uses and Limitations of the Three Income Statement Methods Absorption costing is used for external reporting but may not be best for performance evaluation purposes. Variable and throughput costing avoid incentives to build up inventory levels. Throughput costing may be useful for some short- term decision making. Under absorption costing, if practical capacity is used as the denominator level, the fixed overhead rate is a useful measure of the cost of capacity, and the volume variance helps measure the use of capacity.