1. © Pearson Education Limited 2008 MANAGEMENT ACCOUNTING Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse

2. © Pearson Education Limited 2008 11-2 Management Accounting McWatters, Zimmerman, Morse Management Accounting Variable costing and capacity costs (Planning and control) Chapter 11

3. © Pearson Education Limited 2008 11-3 Management Accounting McWatters, Zimmerman, Morse Objectives Identify the problems with adsorption costing systems Use variable costing to generate profit and loss statements and recognize their advantages and disadvantages Identify problems in selecting the capacity of a fixed cost resource Use the organizations practical capacity to allocate overhead, and recognize its advantages and disadvantages Describe trade-offs for decentralized managers to provide accurate information to make a decision on the capacity of a common resource and on the efficient use of the resource

4. © Pearson Education Limited 2008 11-4 Management Accounting McWatters, Zimmerman, Morse Criticisms of Absorption Cost Systems Absorption cost systems produce misleading information Absorption cost systems create incentives that are inconsistent with maximizing the value of the firm Chapter 10 described 2 absorption cost systems, job-order costing and process costing

5. © Pearson Education Limited 2008 11-5 Management Accounting McWatters, Zimmerman, Morse Absorption Cost Systems Variable CostsFixed CostsProduct Costs + = Number of Units Average Cost of the Product ÷ = Incentive to Overproduce The average cost per unit decreases as more units are produced Result

6. © Pearson Education Limited 2008 11-6 Management Accounting McWatters, Zimmerman, Morse Absorption Cost Systems Incentive to Overproduce Managers evaluated on the average cost per unit can improve their performance by just increasing the number of units produced Behavior Producing more units may not help the organization if all the units cannot be sold Problem In the short-term, cost of goods sold is lower and net income is higher because some of the fixed costs are left in the ending inventory Problem

7. © Pearson Education Limited 2008 11-7 Management Accounting McWatters, Zimmerman, Morse A plant with 1 million of fixed overhead makes universal smart drives (USDs) Incentive to Overproduce Numerical Example The USDs have a variable cost of 1.00 the plant only makes USDs and allocates fixed costs by the number produced. The firm can sell 200,000 units a year for 10.00 each. Handling expenses are 0.30 per unit The plant manager has the opportunity to make 200,000 units, 220,000 units or 240,000 units and wants to know which production level yields the highest reported profit for the year

8. © Pearson Education Limited 2008 11-8 Management Accounting McWatters, Zimmerman, Morse Production levels 200,000220,000240,000 Fixed costs1,000,000 Variable costs (1 per unit) 200,000 220,000 240,000 Total Costs1,200,0001,220,0001,240,000 Average cost per USD6 per unit5.55 per unit5.17 per unit Revenues (200,00 USDs x 10 per unit)2,000,002,000,000 Cost of goods sold (200,00 USDs x 6 per unit)(1,200,000) (200,00 USDs x 5.55 per unit)(1,110,000) (200,00 USDs x 5.17 per unit)(1,034,000) Excess inventory handling costs0 (220,000 – 200,000) x 0.30 per unit(6,000) (240,000 – 200,000) x 0.30 per unit(12,000) Net Profit800,000884,000954,000 Incentive to Overproduce Numerical Example

9. © Pearson Education Limited 2008 11-9 Management Accounting McWatters, Zimmerman, Morse Charge managers large amounts for holding inventory Enforce a strict senior management policy against adding to or building inventories Choose performance measures other than short- term net income Use the just-in-time production system to reduce inventory levels Change the costing system to a variable costing system Charge managers large amounts for holding inventory Enforce a strict senior management policy against adding to or building inventories Choose performance measures other than short- term net income Use the just-in-time production system to reduce inventory levels Change the costing system to a variable costing system Incentive to Overproduce Solutions

10. © Pearson Education Limited 2008 11-10 Management Accounting McWatters, Zimmerman, Morse Problem The organization may not benefit from reduced usage of the allocation base Variable Overhead Total Overhead += Fixed Overhead Allocated to products through an allocation base Behaviour Managers who are evaluated based on product costs will use the allocation base sparingly Under-utilization of Allocation Base Used to Allocate Fixed Costs

11. © Pearson Education Limited 2008 11-11 Management Accounting McWatters, Zimmerman, Morse The expected fixed costs of operating the IT department are £1,000,000 per year Under-utilization of Allocation Base Used to Allocate Fixed Costs Numerical Example The benefits that the engineering department estimates it will gain by having workstations in the department is overleaf. The department wishes to choose the most efficient number of workstations The expected variable costs are £5,000 per workstation. The number of workstations in each department is used to allocate the IT department costs. The application rate based on expected usage of 200 workstations is {£1,000,000m + (200 x £5,000)}/200 The expected variable costs are £5,000 per workstation. The number of workstations in each department is used to allocate the IT department costs. The application rate based on expected usage of 200 workstations is {£1,000,000m + (200 x £5,000)}/200

12. © Pearson Education Limited 2008 11-12 Management Accounting McWatters, Zimmerman, Morse Number of workstationsExpected benefits (£)Marginal benefits (£) 115,000 227,00012,000 335,0008,000 441,0006,000 544,0003,0000 Under-utilization of Allocation Base Used to Allocate Fixed Costs Numerical Example The department will use only 2 workstations because the marginal benefit of a 3 rd is £8,000 (less than the allocated cost) To maximize profit the department should use 4 workstations as the marginal benefit is greater than the variable cost The additional benefit of the additional workstations is £14,000 the incremental cost is £10,000 therefore the net loss of not having the workstations is £4,000

13. © Pearson Education Limited 2008 11-13 Management Accounting McWatters, Zimmerman, Morse Occurs when an organization begins to drop products because full cost of the product is greater than its price Misleading Product Costs A common result of the misuse of product costs is the death spiral which occurs when an organization drops a product because its full costs exceed its price

14. © Pearson Education Limited 2008 11-14 Management Accounting McWatters, Zimmerman, Morse A company makes 2 types of refrigerators. Excess capacity exists but there is no alternative use. Fixed overhead costs are allocated based on direct labour Misleading Product Costs Numerical Example Compact (£)Full-size (£) Revenues500,0001,000,000 Direct costs(300,000)(450,000) Allocated fixed costs(240,000)(360,000) Profit(40,000)190,000 Management decides to drop the compact model because it appears to be unprofitable

15. © Pearson Education Limited 2008 11-15 Management Accounting McWatters, Zimmerman, Morse By dropping the compact model, all of the fixed overhead is shifted to the full-size model Misleading Product Costs Numerical Example Full-size (£) Revenues1,000,000 Direct costs(450,000) Allocated fixed costs(600,000) Profit(50,000)

16. © Pearson Education Limited 2008 11-16 Management Accounting McWatters, Zimmerman, Morse Variable Costing The product cost under variable costing includes only the variable costs of making the product

17. © Pearson Education Limited 2008 11-17 Management Accounting McWatters, Zimmerman, Morse Advantages The variable cost per unit approximates the opportunity cost of making another unit if the organization is below capacity Variable costing reduces the dysfunctional incentive to overproduce Advantages The variable cost per unit approximates the opportunity cost of making another unit if the organization is below capacity Variable costing reduces the dysfunctional incentive to overproduce Variable Costing

18. © Pearson Education Limited 2008 11-18 Management Accounting McWatters, Zimmerman, Morse Variable costs per unit are £6. The allocation base is the number of units produced. The sales price is £10 per unit. During the year the factory makes and sells 20,000 fans. In December the manager has the opportunity to make another 5,000 units but these cannot be sold in the period. The manager wishes to estimate the profit with and without the extra 5.000 units using absorption and variable costing systems Variable Costing Numerical Example A factory making electric fans has estimated and actual fixed costs of £50,000

19. © Pearson Education Limited 2008 11-19 Management Accounting McWatters, Zimmerman, Morse Variable Costing Numerical Example £ Sales200,000 Cost of goods sold (£8.50 x 20,000 units) (170,000) Profit30,000 Absorption Costing Method Application rate (without the additional 5,000 units) {£50,000 + (£6 per unit x 20,000 units}/20,000 units = £8.50 per unit Application rate (with additional 5,000 units) = {£50,000+ (£6 per unit x 25,000 units}/25,000 units = £8.00 per unit £ Sales200,000 Cost of goods sold (£8.00 x 20,000 units) (160,000) Profit40,000 The cost of the ending inventory is £40,000

20. © Pearson Education Limited 2008 11-20 Management Accounting McWatters, Zimmerman, Morse Variable Costing Numerical Example £ Sales (£10/unit x 20,000 units)200,000 Cost of goods sold (£6 x 20,000 units) (120,000) Fixed costs(50,000) Profit30,000 Variable Costing Method Application rate (without the additional 5,000 units) £6 per unit Application rate (with additional 5,000 units) £6.00 per unit £ Sales (£10/unit x 20,000 units) 200,000 Cost of goods sold (£6 x 20,000 units) (120,000) Fixed costs(50,000) Profit30,000 The cost of the ending inventory is £30,000

21. © Pearson Education Limited 2008 11-21 Management Accounting McWatters, Zimmerman, Morse Disadvantages Variable costing may understate product costs if there is an opportunity cost of using fixed overhead resources Managers may tend to overuse the overhead resources generating the fixed costs If multiple allocation bases are used, the definition between variable and fixed becomes less clear Disadvantages Variable costing may understate product costs if there is an opportunity cost of using fixed overhead resources Managers may tend to overuse the overhead resources generating the fixed costs If multiple allocation bases are used, the definition between variable and fixed becomes less clear Variable Costing

22. © Pearson Education Limited 2008 11-22 Management Accounting McWatters, Zimmerman, Morse Capacity Costs Cost of too much capacity Cost of too little capacity Overtime Acquisition cost Lost sales Maintenance Overuse Security

23. © Pearson Education Limited 2008 11-23 Management Accounting McWatters, Zimmerman, Morse Capacity Costs How much capacity should be acquired? Do fixed cost allocation alternatives influence capacity acquisition decisions? How much capacity should be acquired? Do fixed cost allocation alternatives influence capacity acquisition decisions? Allocation alternatives Allocate overhead based on practical capacity Allocate overhead based on capacity decision

24. © Pearson Education Limited 2008 11-24 Management Accounting McWatters, Zimmerman, Morse The fixed costs or operating an online retail operation result primarily from the cost of the facility The expected and actual cost of the facility is £200,000. the fixed cost of the facility of 20,000m 2 allocated to marketing and inventory divisions which share the facility. Inventory division uses 10,000m 2 and marketing uses 4,000m 2 Allocation Based on the Capacity Decision - Numerical Example

25. © Pearson Education Limited 2008 11-25 Management Accounting McWatters, Zimmerman, Morse The application rate is £200,000 per 20,000 m 2 = £10 per m 2 The application rate is £200,000 per 20,000 m 2 = £10 per m 2 Allocation Based on the Capacity Decision - Numerical Example Cost objectUsage m 2 Application rate per m 2 (£) Allocation (£) Inventory10,00010100,000 Marketing4,0001040,000 Excess capacity6,0001060,000 Totals20,000200,000 The £60,000 allocated to unused capacity is a period expense

26. © Pearson Education Limited 2008 11-26 Management Accounting McWatters, Zimmerman, Morse Allocation Based on the Capacity Decision Partial Absorption Cost Systems Variable Manufacturing + Overhead Total Manufacturing Overhead Fixed Manufacturing = Overhead Practical capacity is the maximum level of operations that can be achieved without increasing costs due to congestion

27. © Pearson Education Limited 2008 11-27 Management Accounting McWatters, Zimmerman, Morse Allocation Based on the Capacity Decision Partial Absorption Cost Systems Only the fixed cost of overhead resources used are allocated to products Product Costs Used Period Expense Unused Variable Manufacturing + Overhead Total Manufacturing Overhead Fixed Manufacturing = Overhead

28. © Pearson Education Limited 2008 11-28 Management Accounting McWatters, Zimmerman, Morse Allocation Based on the Capacity Decision Application Rate Expected Fixed Overhead Practical Capacity of Allocation Base ÷= Application Rate Actual Usage of Allocation Base Allocated Fixed Costs ×=

29. © Pearson Education Limited 2008 11-29 Management Accounting McWatters, Zimmerman, Morse Allocation Based on the Capacity Decision Advantages Costs associated with excess capacity are not allocated to products Allocated fixed costs to products will not change much with different levels of operations The cost of unused capacity is identified Advantages Costs associated with excess capacity are not allocated to products Allocated fixed costs to products will not change much with different levels of operations The cost of unused capacity is identified

30. © Pearson Education Limited 2008 11-30 Management Accounting McWatters, Zimmerman, Morse Allocation Based on the Capacity Decision Disadvantages It does not alleviate the incentive to overproduce Managers may still underuse the allocation base even though only some fixed costs are being allocated Disadvantages It does not alleviate the incentive to overproduce Managers may still underuse the allocation base even though only some fixed costs are being allocated

31. © Pearson Education Limited 2008 11-31 Management Accounting McWatters, Zimmerman, Morse Allocation Based on the Capacity Decision Allocates fixed costs based on capacity requested rather than the resource used Greater use of the resource than originally requested is charged to the manager at a much higher rate Benefit Encourages managers to better forecast and anticipate capacity needs

32. © Pearson Education Limited 2008 11-32 Management Accounting McWatters, Zimmerman, Morse Management Accounting Variable costing and capacity costs (Planning and control) End of Chapter 11