C 8 hapter Inventory Valuation Approaches and Just-in-Time Inventory Management Prepared by Douglas Cloud Pepperdine University 1 1 1 1

After studying this chapter, you should be able to: Objectives 1. Explain the primary characteristics of the absorption costing and variable costing inventory valuation methods. 2. Prepare absorption costing and variable costing income statements. 3. Evaluate the benefits and limitations of variable costing. After studying this chapter, you should be able to: Continued

Objectives 4. Describe just-in-time (JIT) inventory management and discuss how it is used to reduce raw materials, work-in-process, and finished goods inventories. 5. Explain the change required in performance evaluation and record keeping when an organization adopts the JIT approach to inventory management.

A Comparison of Absorption and Variable Costing Absorption Costing Product Costs Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead

A Comparison of Absorption and Variable Costing Product Costs Direct materials Direct labor Variable manufacturing overhead

A Comparison of Absorption and Variable Costing Absorption Costing Period Costs Variable selling and administrative Fixed selling and administrative

A Comparison of Absorption and Variable Costing Period Costs Variable selling and administrative Fixed selling and administrative Fixed manufacturing overhead

Basic Concepts Absorption costing treats fixed manufacturing overhead as product cost...

Basic Concepts …whereas, variable costing treats fixed manufacturing overhead as a period cost.

Inventory Valuations Nutech Company manufactured 4,000 units. Cost per Unit Using Variable Costing Direct materials $ 7 Direct labor 5 Variable manufacturing overhead 4 Total unit cost $16

Inventory Valuations Nutech Company manufactured 4,000 units. Cost per Unit Using Absorption Costing Direct materials $ 7 Direct labor 5 Variable manufacturing overhead 4 Fixed manufacturing overhead ($8,000 ÷ 4,000 units) 2 Total unit cost $18

Contribution Format Sales $000 Less variable expenses: Cost of goods sold (000 Selling (000 Administrative (000 Contribution margin $000 Less fixed expenses: Manufacturing (000 Selling (000 Net income $000 )

Functional Format Sales $000 Less cost of goods sold (000 ) Gross profit $000 Less operating expenses: Selling (000 Administrative (000 Net income $000 )

Comparison (Production Constant) Absorption Costing--Production Equals Sales Sales (4,000 @ $30) $120,000 Less cost of goods sold (at $18/unit) - 72,000 Gross profit $ 48,000 Selling and administrative expenses: Variable (at $3 per unit) $ 12,000 Administrative 10,000 Total - 22,000 Net income $ 26,000 June

Comparison (Production Constant) Variable Costing--Production Equals Sales Sales (4,000 @ $30 per unit) $120,000 Variable expenses: Cost of goods sold (@ $16 per unit) $ 64,000 Selling and administrative (@ $3/unit) 12,000 Total - 76,000 Contribution margin $ 44,000 Fixed expenses: Manufacturing overhead $ 8,000 Selling and administrative 10,000 Total - 18,000 Net income $ 26,000 June

Comparison (Production Constant) Absorption Costing--Production Exceeds Sales Sales (2,500 @ $30 per unit) $75,000 Less cost of goods sold (at $18/unit) -45,000 Gross profit $30,000 Selling and administrative expenses: Variable (at $3 per unit) $ 7,500 Administrative 10,000 Total -17,500 Net income $12,500 July

Comparison (Production Constant) Variable Costing--Production Exceeds Sales Sales (2,500 @ $30 per unit) $ 75,000 Variable expenses: Cost of goods sold (@ $16 per unit) $ 40,000 Selling and administrative (@ $3/unit) 7,500 Total -47,500 Contribution margin $ 27,500 Fixed expenses: Manufacturing overhead $ 8,000 Selling and administrative 10,000 Total - 18,000 Net income $ 9,500 July

Reconciliation of Income Differences + Increase (or minus decrease) in inventoried fixed manufacturing overhead $3,000 Variable costing net income $9,500 = Absorption costing net income $12,500 1,500 units x $2 per unit July

Comparison (Production Constant) Absorption Costing--Sales Exceed Production Sales (5,500 @ $30/unit) $165,000 Less cost of goods sold (at $18/unit) - 99,000 Gross profit $ 66,000 Selling and administrative expenses: Variable (at $3 per unit) $ 16,500 Administrative 10,000 Total - 26,500 Net income $ 39,500 August

Comparison (Production Constant) Variable Costing--Sales Exceed Production Sales (5,500 @ $30 per unit) $165,000 Variable expenses: Cost of goods sold (@ $16 per unit) $ 88,000 Selling and administrative (@ $3/unit) 16,500 Total -104,500 Contribution margin $ 60,500 Fixed expenses: Manufacturing overhead $ 8,000 Selling and administrative 10,000 Total - 18,000 Net income $ 42,500 August

Reconciliation of Income Differences + Decrease (or minus increase) in inventoried fixed manufacturing overhead Absorption costing net income = Variable costing net income $39,500 + $3,000 = $42,500 1,500 units x $2 per unit Beginning inventory August

Comparison (Sales Constant) Absorption Costing--Production Equals Sales Sales (4,000 @ $30) $120,000 Beginning inventory $ -0- Variable manufacturing costs 64,000 Fixed manufacturing costs 8,000 Cost of goods available $ 72,000 Less ending inventory -0- Cost of goods sold - 72,000 Gross profit $ 48,000 Continued next slide October

Comparison (Sales Constant) Absorption Costing--Production Equals Sales Gross profit $ 48,000 Selling and administrative expenses: Variable (at $3 per unit) $ 12,000 Fixed 10,000 Total - 22,000 Net income $ 26,000 October

Comparison (Sales Constant) Variable Costing--Production Equals Sales Sales (4,000 @ $30 per unit) $120,000 Variable expenses: Cost of goods sold (@ $16 per unit) $ 64,000 Selling and administrative (@ $3/unit) 12,000 Total - 76,000 Contribution margin $ 44,000 Fixed expenses: Manufacturing overhead $ 8,000 Selling and administrative 10,000 Total - 18,000 Net income $ 26,000 October

Comparison (Sales Constant) Absorption Costing--Production Exceeds Sales Sales (4,000 @ $30) $120,000 Beginning inventory $ -0- Variable manufacturing costs 80,000 Fixed manufacturing costs 8,000 Cost of goods available $ 88,000 Less ending inventory 17,600 Cost of goods sold - 70,400 Gross profit $ 49,600 Continued next slide November

Comparison (Sales Constant) Absorption Costing--Production Exceeds Sales Gross profit $ 49,600 Selling and administrative expenses: Variable (at $3 per unit) $ 12,000 Fixed 10,000 Total - 22,000 Net income $ 27,600 November

Comparison (Sales Constant) Variable Costing--Production Exceeds Sales Sales (4,000 @ $30 per unit) $120,000 Variable expenses: Cost of goods sold (@ $16 per unit) $ 64,000 Selling and administrative (@ $3/unit) 12,000 Total - 76,000 Contribution margin $ 44,000 Fixed expenses: Manufacturing overhead $ 8,000 Selling and administrative 10,000 Total - 18,000 Net income $ 26,000 November

Reconciling of Income Differences + Decrease (or minus increase) in inventoried fixed manufacturing overhead Absorption costing net income = Variable costing net income $26,000 + $1,600 = $27,600 1,000 units x $1.60 per unit Ending inventory November

Comparison (Sales Constant) Absorption Costing--Sales Exceed Production Sales (4,000 @ $30) $120,000 Beginning inventory $ 17,600 Variable manufacturing costs 51,200 Fixed manufacturing costs 8,000 Cost of goods available $ 76,800 Less ending inventory 3,700 Cost of goods sold - 73,100 Gross profit $ 46,900 Continued next slide December

Comparison (Sales Constant) Absorption Costing--Sales Exceed Production Gross profit $ 46,900 Selling and administrative expenses: Variable (at $3 per unit) $ 12,000 Fixed 10,000 Total - 22,000 Net income $ 24,900 December

Comparison (Sales Constant) Variable Costing--Sales Exceed Production Sales (4,000 @ $30 per unit) $120,000 Variable expenses: Cost of goods sold (@ $16 per unit) $ 64,000 Selling and administrative (@ $3/unit) 12,000 Total - 76,000 Contribution margin $ 44,000 Fixed expenses: Manufacturing overhead $ 8,000 Selling and administrative 10,000 Total - 18,000 Net income $ 26,000 December

Reconciling of Income Differences + Decrease (or minus increase) in inventoried fixed manufacturing overhead Absorption costing net income = Variable costing net income $24,900 + $1,600 – $500 = $26,000 1,000 units x $1.60 per unit Beginning inventory 200 units x $2.50 per unit Beginning inventory December

Proponents of Variable Costing Inventories have value only to the extent that they avoid the necessity of incurring costs in the future. Another advantage is that variable costing matches revenue with the direct cost of producing those revenues. Proponents of Variable Costing

Proponents of Absorption Costing By omitting fixed costs from inventory, variable costing understates long-run variable costs and misleads decision makers into underestimating true production costs. Fixed manufacturing costs are incurred for only one purpose, namely to manufacture the product. Proponents of Absorption Costing

Theory of Constraints Emphasis on: Product cost components: Throughput Direct materials

Variable Costing Emphasis on: Product cost components: Direct labor Contribution margin Product cost components: Direct materials Direct labor Variable manufacturing overhead

Traditional Absorption Costing Emphasis on: Gross profit Product cost components: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing

ABC Absorption Costing Emphasis on: Gross profit Product cost components: Direct materials Direct labor Manufacturing overhead Unit level Batch level Product level Facility level

Full ABC Emphasis on: Product cost components: Direct labor Net income Product cost components: Direct materials Direct labor Unit level costs Batch level costs Product level costs Order level costs Customer level costs Market segment level costs Facility levels costs

Just-in-Time (JIT) JIT is a comprehensive inventory management philosophy that stresses policies, procedures, and attitudes by managers and other workers that result in the efficient production of high quality goods while maintaining the minimum level of inventories.

Just-in-Time (JIT) The JIT approach to reducing raw materials includes: 1. Developing long-term relationships with a limited number of vendors. 2. Selecting vendors on the basis of service and material quality, as well as price. 3. Establishing procedures for employees to order materials for current needs directly from approved vendors. 4. Accepting vendor deliveries directly to the shop floor or department store.

Dysfunctional Effects of Traditional Performance Measures To achieve quantity discounts and favorable prices, a purchasing agent may order excessive inventory, thereby increasing subsequent storage, obsolescence, and handling. To obtain a low price, a purchasing agent may order from a supplier whose not been certified as meeting quality specifications. Continued

Dysfunctional Effects of Traditional Performance Measures To avoid having idle employees and equipment, a supervisor may refuse to halt production to determine the quality problem, thereby increasing inspection, rework, and spoiled costs. To obtain low fixed costs per unit under absorption costing, a supervisor may produce in excess of current needs, thereby causing subsequent increase in storage, obsolescence, and handling costs.

Performance Evaluation When applied to a specific item of raw materials or finished goods inventory turnover is computed as follows: Inventory turnover = Annual demand in units Average inventory (in units)

Performance Evaluation When stated in dollars, inventory turnover can be used as a measure of the overall success of the organization in reducing inventory. Inventory turnover = Cost of goods sold Average inventory (in dollars)

Performance Evaluation + Inspec-tion Time + Move-ment Time + Wait-ing Time + Proc-essing Time Cycle Time = Setup Time Cycle efficiency = Processing time Cycle time

Product Costing Also, many of the distinctions and arguments regarding absorption versus variable costing are moot. Another advantage of JIT is that it reduces the amount of detailed bookkeeping.

C 8 hapter The End