1. COPYRIGHT © 2012 Nelson Education Ltd.
Chapter Eight Absorption and Variable Costing, and Inventory Management
COPYRIGHT © 2012 Nelson Education Ltd.

2. Learning Objectives
Explain the difference between absorption and variable costing
Prepare segmented income statements
Discuss inventory management under the economic order quantity and just-in-time (JIT) models

3. Explain the difference between absorption and variable costing
OBJECTIVE  1
Explain the difference between absorption and variable costing

4. Absorption Costing Income Statement
Assigns all manufacturing costs to the product
direct materials
direct labour
variable overhead
fixed overhead
Fixed overhead is applied to the product using a predetermined overhead rate
Required by generally accepted accounting principles (GAAP) for external reporting

5. Variable Costing Income Statement
Assigns only variable manufacturing costs to the product
direct materials
direct labour
variable overhead
Fixed overhead is treated as a period expense

6. Example: Cornerstone 8-1
How to Compute Inventory Cost under Absorption Costing
Information:
Units in beginning inventory
----
Units produced
10,000
Units sold ($300 per unit)
8,000
Variable costs per unit:
Direct materials
$50
Direct labour
$100
Variable overhead
$50
Fixed costs:
Fixed overhead per unit produced
$25
Fixed selling and administrative
$100,000

7. Example How many units are in ending inventory?
Required:
How many units are in ending inventory?
Using absorption costing, calculate the per-unit product cost
What is the value of ending inventory?

8. Example 10,000 8,000 2,000 Units beginning inventory
Units ending inventory
Units produced
Units sold = + –
10,000 = + –
8,000
2,000 =

9. Absorption Costing Direct materials $ 50 Direct labour 100
Per unit
Direct materials
$ 50
Direct labour
100
Variable overhead 50
Fixed overhead 25
Unit product cost
$225
Value of ending inventory =
2,000 × $225 = $450,000

10. Example: Cornerstone 8-2
How to Compute Inventory Cost under Variable Costing
Information:
Units in beginning inventory
----
Units produced
10,000
Units sold ($300 per unit)
8,000
Variable costs per unit:
Direct materials
$50
Direct labour
$100
Variable overhead
$50
Fixed costs:
Fixed overhead per unit produced
$25
Fixed selling and administrative
$100,000

11. Example How many units are in ending inventory?
Required:
How many units are in ending inventory?
Using variable costing, calculate the per-unit product cost
What is the value of ending inventory?

12. Example 10,000 8,000 2,000 Units beginning inventory
Units ending inventory
Units produced
Units sold = + –
10,000 = + –
8,000 =
2,000

13. Variable Costing Direct materials $ 50 Direct labour 100
$ 50
Direct labour
100
Only variable costs
Variable overhead 50
Unit product cost
$200
Value of ending inventory =
2,000 × $200 = $400,000
When inventory on hand exists, variable costing results in lower ending inventory than absorption costing

14. Absorption and Variable CostingDM DM
Variable Costing Unit Cost DL DL
Absorption Costing Unit Cost
Var OH
Var OH
Fixed OH
Absorption Costing includes Fixed Overhead in Unit Cost, Variable Costing does not

15. Example: Cornerstone 8-3
How to Prepare an Absorption-Costing Income Statement
Information:
Units in beginning inventory
----
Units produced
10,000
Units sold ($300 per unit)
8,000
Variable costs per unit:
Direct materials
$50
Direct labour
$100
Variable overhead
$50
Fixed costs:
Fixed overhead per unit produced
$25
Fixed selling and administrative
$100,000

16. Example Calculate the cost of goods sold under absorption costing
Required:
Calculate the cost of goods sold under absorption costing
Prepare an income statement using absorption costing

17. Absorption unit product cost
Example
Absorption unit product cost
Cost of goods sold = ×
Units sold =
$225 ×
8,000
$50 + $100 + $50 + $25
$1,800,000 =

18. Fairchild Company Absorption-Costing Income Statement
Sales ($300 × 8,000)
$2,400,000
Less: Cost of goods sold
1,800,000
Gross Margin
$ 600,000
Less: Selling and administrative expenses
100,000
Net Income
$ 500,000
Fixed selling and administrative costs

19. Example: Cornerstone 8-4
How to Prepare a Variable-Costing Income Statement
Information:
Units in beginning inventory
----
Units produced
10,000
Units sold ($300 per unit)
8,000
Variable costs per unit:
Direct materials
$50
Direct labour
$100
Variable overhead
$50
Fixed costs:
Fixed overhead per unit produced
$25
Fixed selling and administrative
$100,000

20. Example Calculate the cost of goods sold under variable costing
Required:
Calculate the cost of goods sold under variable costing
Prepare an income statement using variable costing

21. Variable unit product cost
Example
Cost of goods sold
Variable unit product cost = ×
Units sold =
$200 ×
8,000
$50 + $100 + $50 =
$1,600,000

22. Fairchild Company Variable-Costing Income Statement
Sales ($300 × 8,000)
$2,400,000
Less variable expenses:
Variable cost of goods sold
1,600,000
Contribution margin
$ 800,000
Less fixed expenses:
Fixed overhead
$250,000
$800,000: Only variable costs are subtracted. Subtotal is called Contribution Margin instead of Gross Margin
$250,000: $25 x 10,000 Fixed overhead for all the units produced. None of the fixed overhead is carried in inventory
Fixed selling and administrative
100,000
350,000
Net Income
$ 450,000

23. Production, Sales, and Income RelationshipsIf
Then 1.
Production > Sales
Absorption Income > Variable Income 2.
Production < Sales
Absorption Income < Variable Income 3.
Production = Sales
Absorption Income = Variable Income

24. Prepare segmented income statements
OBJECTIVE  2
Prepare segmented income statements

25. Segmented Income Statements
Segment is a subunit of a company
divisions
departments
product lines
customer classes
Fixed expenses are broken down into two categories:
direct fixed expenses
directly traceable to a segment
common fixed expenses
jointly caused by two or more segments

26. Segment Margin Sales – Variable Cost of Goods Sold
– Variable Selling Expense
Contribution Margin
– Direct fixed overhead
– Direct selling and administrative
Segment Margin

27. Example: Cornerstone 8-5
How to Prepare a Segmented Income Statement
Information:
MP3 Players
DVD Players
Sales
$400,000
$290,000
Variable cost of goods sold
200,000
150,000
Direct fixed overhead
30,000
20,000
Sales commissions, 5% of sales
Direct fixed selling and administrative expense estimated:
$10,000 for the MP3 line
$15,000 for the DVD line
Common fixed overhead est., $100,000
Common selling and administrative est., $20,000

28. Example
Required:
Prepare a segmented income statement for Audiomatronics Inc. for the coming year, using variable costing

29. Audiomatronics Inc. Segmented Income Statement For the Coming Year
MP3 Players
DVD Players
Total
Sales
$400,000
$290,000
$690,000
Variable cost of goods sold
(200,000)
(150,000)
(350,000)
Variable selling expense
(20,000)
(14,500)
5% × $290,000
Sales commissions = 5% of Sales
5% × $400,000

30. Audiomatronics Inc. Segmented Income Statement For the Coming Year
MP3 Players
DVD Players
Total
Sales
$400,000
$290,000
$690,000
Variable cost of goods sold
(200,000)
(150,000)
(350,000)
Variable selling expense
(20,000)
(14,500)
(34,500)
Contribution Margin
$180,000
$125,500
$305,500
Less direct fixed expenses:
Direct fixed overhead
(30,000)
(20,000)
(50,000)
Direct selling & admin.
(10,000)
(15,000)
(25,000)
Segment margin
$140,000
$ 90,500
$230,500
Segment margin reflects only those costs directly related to the operation of the segment. Common costs are not included in the segment margin

31. Audiomatronics Inc. Segmented Income Statement For the Coming Year
MP3 Players
DVD Players
Total
Sales
$400,000
$290,000
$690,000
Variable cost of goods sold
(200,000)
(150,000)
(350,000)
Variable selling expense
(20,000)
(14,500)
(34,500)
Contribution Margin
$180,000
$125,500
$305,500
Less direct fixed expenses:
Direct fixed overhead
(30,000)
(20,000)
(50,000)
Direct selling & admin.
(10,000)
(15,000)
(25,000)
Segment margin
$140,000
$ 90,500
$230,500
Less common fixed expenses:
Common fixed overhead
(100,000)
Common selling & admin.
(20,000)
Operating Income
$110,500

32. OBJECTIVE  3
Discuss inventory management under the economic order quantity and just-in-time (JIT) models

33. Ordering Costs Costs of placing and receiving an order Examples:
order processing costs
cost of insurance for shipment
unloading costs

34. Carrying Costs Costs of carrying inventory Examples: insurance
inventory taxes
obsolescence
opportunity cost of funds ties up in inventory, handling costs, and storage space

35. Stockout Costs Occur when demand is not known Costs of not having:
product available when demanded by a customer
raw materials available when needed for production
Examples:
lost sales
costs of expediting
costs of interrupted production

36. Traditional Reasons for Carrying Inventory
To balance ordering or setup costs and carrying costs
To satisfy customer demand
To avoid shutting down manufacturing facilities because of:
Machine failure
Defective parts
Unavailable parts
Late delivery of parts
To buffer against unreliable production processes
To take advantage of discounts
To hedge against future price increases

37. Example: Cornerstone 8-6
How to Calculate Ordering Cost,
and Total Inventory-Related Cost
Information:
Mall-o-Cars Inc. uses part X7B to repair water pumps
10,000 units of part X7B are used each year
currently purchased in lots of 1,000 units
cost of $25 to place an order
carrying cost is $2 per part per year

38. Example How many orders for Part X7B does Mall-o-Cars place per year?
Required:
How many orders for Part X7B does Mall-o-Cars place per year?
What is the total ordering cost of Part X7B per year?
What is the total carrying cost of Part X7B per year?
What is the total cost of Mall-o-Car’s inventory policy for Part X7B per year?

39. = Annual number of units used ÷ Number of units in an order
Example
Number of orders
= Annual number of units used ÷ Number of units in an order
= 10,000 / 1,000
= 10 orders per year

40. = Number of orders × Cost per order
Example
Total ordering cost
= Number of orders × Cost per order
= 10 orders × $25
= $250

41. Example = Total carrying cost × Cost of carrying one unit in inventory
Average number of units in inventory = ×
= (1,000/2) × $2
= $1,000

42. Example Total inventory-related cost = Total ordering cost +
Total carrying cost
= $250 + $1,000
= $1,250

43. Economic Order Quantity (EOQ): The Traditional Inventory Model
Number of units in the optimal size order
Minimizes total inventory-related costs
Formula:
2 × CO × D/CC
Cost of placing one order
Annual demand in units
Cost of carrying one unit in inventory

44. Example: Cornerstone 8-7
How to Calculate the EOQ
Information:
Mall-o-Cars Inc. uses Part X7B to repair water pumps
10,000 units of Part X7B are used each year
Currently purchased in lots of 1,000 units
Cost of $25 to place an order
Carrying cost is $2 per part per year

45. Example Required: What is the EOQ for Part X7B?
How many orders per year for Part X7B will Mall-o-Cars place under the EOQ policy?
What is the total annual ordering cost of Part X7B for a year under the EOQ policy?
What is the total annual carrying cost of Part X7B per year under the EOQ policy?
What is the total annual inventory-related cost for Part X7B under the EOQ?

46. Example Economic Order Quantity (EOQ) (2 × $25 × 10,000) /$2 500,000/2=
500,000/2 = =
500 units

47. = Annual number of units used / Number of units in an order
Example
Number of orders
= Annual number of units used / Number of units in an order
= 10,000 / 500
= 20 orders per year

48. = Number of orders × Cost per order
Example
Total ordering cost
= Number of orders × Cost per order
= 20 orders × $25
= $500

49. Example Total carrying cost Cost of carrying one unit in inventory
Average number of units in inventory = ×
= (500/2) × $2
= $500

50. Example Total inventory-related cost = Total ordering cost +
Total carrying cost
= $ $500
= $1,000

51. Reorder point = Rate of usage × Lead time
Point in time when a new order should be placed
Function of:
EOQ
Lead time
Rate at which inventory is used
Lead time: Time required to received the economic order quantity once an order is place or a setup is started
Reorder point = Rate of usage × Lead time

52. Example: Cornerstone 8-8
HOW TO Calculate the Reorder Point
Information:
Mall-o-Cars Inc. uses Part X7B to repair water pumps
10,000 units of Part X7B are used each year
Used at a rate of 40 parts per day
Takes 5 days from time of order to arrival of order
Required:
Calculate the reorder point

53. Reorder point = Daily usage × Lead time
Example
Reorder point = Daily usage × Lead time
Reorder point = 40 × 5 days
Reorder point = 200

54. Example: Cornerstone 8-9
How to Calculate Safety Stock and
the Reorder Point with Safety Stock
Information:
Mall-o-Cars Inc. uses Part X7B to repair water pumps
10,000 units of Part X7B are used each year
Used at an average rate of 40 parts per day
But some days as many as 50 parts are used
Takes 5 days from the time of order to the arrival of the order

55. Example Calculate the amount of safety stock
Required:
Calculate the amount of safety stock
Calculate the reorder point with safety stock

56. = (Maximum daily usage – Average daily usage)
Example
Safety stock
= (Maximum daily usage – Average daily usage)
× lead time
= (50 – 40) × 5 days
= 50

57. Example Reorder point = Maximum daily usage × lead time = 50 × 5 days
= 250
= (Average daily usage × lead time) + Safety stock
= (40 × 5 days) + 50
= 250

58. Just-in-Time (JIT) Approach
Goods pushed through the system by present demand rather than being pushed through on a fixed schedule based on anticipated demand
Each operation produces only what is necessary to satisfy the demand of the succeeding operation
Reduces all inventories to very low levels
Reduces inventory carrying costs