Inventory Costing and Capacity Analysis Chapter 9 Inventory Costing and Capacity Analysis

Introduction The reported income number captures the attention of managers in a way few other numbers do. This chapter examines two types of cost accounting choices in which the reported income number of manufacturing companies is affected by inventories. Variable costing and absorption costing methods treat fixed manufacturing overhead differently: Under variable costing, fixed manufacturing overhead costs are excluded from inventoriable costs and are a cost of the period in which they are incurred. Under absorption costing, these costs are inventoriable and become expenses only when a sale occurs. Under both methods all nonmanufacturing costs in the value chain (such as research and development and marketing), whether variable or fixed, are recorded as expenses when incurred.

Variable Overhead Variable Costing All variable manufacturing costs are assigned to production and they become part of the unit cost. Fixed costs are charged to the Income Summary Direct Material Inventory Payroll Work-in-Process Inventory Variable factory labor Variable Overhead

Variable Costing Payroll Work-in-Process Inventory Fixed factory labor Income Summary Finished Goods Cost of Goods Sold Absorption costing

Comparison of Variable and Absorption Costing Inventory values are smaller with variable costing because it capitalizes only variable cost as asset. Inventory values using absorption costing have an additional fixed factory overhead per unit Income in periods of increasing (decreasing) inventory are higher (lower) with absorption costing than with variable costing 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

Inventory Buildup Absorption costing enables a manager to increase operating income in a specific period by increasing the production schedule, even if there is no customer demand for the additional production. While the utilized part of fixed costs is inventoried, production volume variance is not. Reducing volume variance by producing to inventory reduces a loss due to low demand loss is shifted to the future unless demand rises Cost in inventory fixed cost in inventory

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.

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. Sales in units this period ÷ Ending inventory in units this period Ending inventory in units this period ÷ Ending inventory in units last period

Throughput Costing... treats all costs except those related to variable direct materials as period costs. Only direct materials costs are inventoriable costs. Inventoriable costs absorption costing variable costing Throughput costing Reported loss absorption costing variable costing Throughput costing Flexible cost budget loss Revenue, both periods sales volume production volume

Comparison of Inventory Costing Methods Actual or Normal or Standard Costing Variable Costing Absorption Costing Throughput Costing

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. Alternative Denominator-Level Concepts Theoretical capacity xt (maximum or ideal capacity) based on producing at full (peak) efficiency all the time. Practical capacity xp reduces theoretical capacity by unavoidable operating interruptions The use of practical capacity is required by the IRS. Normal capacityxn based on the level of capacity utilization that satisfies average customer demand over several periods includes seasonal, cyclical, and trend factors. Master-budget capacity xm based on the expected level of capacity utilization for the next budget period (typically one year).

Budgeted Fixed Manufacturing Overhead Rate for xt negative volume variance Budgeted Fixed cost volume variance for normal capacity volume variance for xp Slope = fixed overhead rate xm xn xp xt xa

Decision Making Cost data from a normal or standard costing system are often used in pricing or product-emphasis decisions. 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. Downward demand spiral: continuing reduction in demand that occurs when the prices of competitors are not met and demand drops. f2 f1 D2 D1

CCs for chapter 9 9-21 (3%) 9-23 (5%) 9-33 (3%) 9-17 (5%) 9-19 (5%) 9-25 (=11.9-24)(3%) 9-37 (10%) 9-41 (10%) (new in 12) If not otherwise indicated problems identical to 11th ed. Please explain the problem statement, give the data, and explain your solution. Mere results will not yield satisfactory grade.

Data 9-37 Denominator level choice Standard for Actual units of output: 70 000 Budgeted fixed overhead: $120 000 at practical capacity: fixed manuf. overhead spending variance: 10 000 (U) production volume variance: $36 000 (U) at normal capacity: production volume variance: $20 000 (F)