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

2. 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

3. 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.

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

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

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

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

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

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

10. 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

11. 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

12. 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 )

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

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

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

16. Comparison (Production Constant)
Absorption Costing--Production Exceeds Sales
Sales $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

17. 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) ,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

18. 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

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

20. 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) ,500
Total -104,500
Contribution margin $ 60,500
Fixed expenses:
Manufacturing overhead $ 8,000
Selling and administrative ,000
Total ,000
Net income $ 42,500
August

21. 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

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

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

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

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

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

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

28. 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

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

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

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

32. 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

33. 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

34. 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

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

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

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

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

39. 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

40. 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.

41. 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.

42. 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

43. 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.

44. 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)

45. 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)

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

47. 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.

48. C 8
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The End