CHAPTER 9
INVENTORY COSTING AND CAPACITY ANALYSIS
LEARNING OBJECTIVES
1. Identify what distinguishes variable costing from absorption costing
2. Prepare income statements under absorption costing and variable costing
3. Explain differences in operating income under absorption costing and variable costing
4. Understand how absorption costing can provide undesirable incentives for managers to build up finished goods inventory
5. Differentiate throughput costing from variable costing and absorption costing
6. Describe the various capacity concepts that can be used in absorption costing
7. Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate
8. Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand
9. Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects the production-volume variance
CHAPTER OVERVIEW
Chapter 9 is about fixed manufacturing costs. As a manufacturing cost, the issue of inventory costing and its effect on operating income under different costing systems exists. As a fixed cost, the issue of rate calculations and choice of a denominator exists. These issues can be studied separately through the structure of the chapter though both have the common characteristic of how best to determine the cost of manufacturing a product when that cost changes upon being applied as a cost per unit of product.
For external reporting all usual and reasonable manufacturing costs are considered as costs of the product using absorption costing. Managers, however, often find the behavior aspect of costs, rather than the function of those costs, to be most helpful in making decisions about volume and profit and use variable costing for internal reports. These two costing approaches yield different operating income amounts when production and sales differ.
The investment base for a manufacturing-sector company is usually the source for most of the fixed manufacturing costs and with the emphasis on technology, many companies have more fixed manufacturing costs than variable manufacturing costs. Managers must wrestle with how much capacity as well as how to cost their products so as to recover those costs with a competitive selling price. Assigning responsibility for fixed or capacity costs presents interesting challenges also. The guideline of different costs for different purposes is highlighted throughout the chapter.
The calculation of breakeven point using absorption costing is illustrated in the appendix to the chapter.
CHAPTER OUTLINE
I. Fixed manufacturing costs – the difference in inventory costing systems
Learning Objective 1:
Identify what distinguishes variable costing from absorption costing
A. Classification issue
1. Methods of inventory costing
a. Variable costing of inventory
i. All variable manufacturing costs included as inventoriable costs—assets initially
ii. All fixed manufacturing costs excluded from inventoriable costs because charged to income as incurred—expenses
b. Absorption costing of inventory: required method under GAAP for external reporting and tax reporting in most countries
i. All variable manufacturing costs included as inventoriable costs—assets initially
ii. All fixed manufacturing costs included as inventoriable costs—assets initially
2. All nonmanufacturing costs in the value chain, whether variable or fixed, charged to income as incurred within the accounting period
Do multiple choice 1. Assignments start with L. O. 3.
Learning Objective 2:
Prepare income statements under absorption costing and variable costing
B. Income statement presentation [Exhibit 9-1]
1. Highlighted by format indicating cost classification
a. Variable costing – contribution-margin format
i. Costs categorized by variable or fixed—only variable manufacturing costs inventoriable
ii. Fixed costs expensed in total
b. Absorption costing – gross-margin format
i. Costs categorized by manufacturing or nonmanufacturing—all manufacturing costs inventoriable
ii. Fixed manufacturing costs expensed per unit in cost of goods sold
2. Direct costing: not accurate term to describe variable costing
a. Variable costing does not include all direct costs as inventoriable (only direct variable manufacturing costs—direct fixed manufacturing and direct nonmanufacturing excluded)
b. Variable costing includes direct and some indirect variable manufacturing costs as inventoriable
c. Not all variable costs are inventoriable costs—must be manufacturing variable costs
Do multiple choice 2 and 3. Assignments start with L.O. 3.
C. Operating income differences [Exhibit 9-2]
Learning Objective 3:
Explain differences in operating income under absorption costing and variable costing
1. Goods sold versus goods produced [Exhibit 9-3]
a. Variable costing: quantity sold drives cost and income
b. Absorption costing: quantity sold and produced drives cost and income
i. Inventory increase from beginning to end: less fixed costs expensed
ii. Inventory decrease from beginning to end: more fixed costs expensed
c. Low levels of inventory have less effect (less “material” in amount)
Do multiple choice 4. Assign Exercises 9-16, 9-18, 9-20, and 9-21.
2. Income manipulation—undesirable buildup of inventories [Exhibit 9-4]
a. Using reported income based on absorption costing to increase operating income by increasing production (even if no increase in customer demand)
Learning Objective 4:
Understand how absorption costing can provide undesirable incentives for managers to build up finished goods inventory
i. Switch to manufacturing products that absorb highest amounts of fixed manufacturing costs and delaying those that absorb the least or lower fixed manufacturing costs
ii Accept orders to increase production at one plant rather than produce at a better suited plant
iii. Defer maintenance beyond current accounting period
iv. Increase amount of inventory units each year
b. Revising performance evaluation—reducing undesirable effects of absorption costing
i. Careful budgeting and inventory planning to reduce management freedom to build up excess inventory
ii. Change the accounting system from absorption costing to variable costing for internal reporting
iii. Incorporate a carrying charge for inventory in the internal accounting system
iv. Change to a longer time period to evaluate performance
v. Include nonfinancial as well as financial variable in measures for performance evaluation [Concepts in Action]
Do multiple choice 5. Assign Exercise 9-23, Problems 9-30 and 9-33.
Learning Objective 5:
Differentiate throughput costing from variable costing and absorption costing
D. Another costing method – throughput costing (also called super-variable costing)
1. Method of inventory costing in which only direct material costs are inventoriable costs; all other costs are costs of the period in which incurred
2. Reporting includes throughput contribution: revenues minus all direct material costs of goods sold [Exhibit 9-5]
3. Advocates say it provides less incentive to produce for inventory than other methods
E. Comparison of inventory costing methods [Exhibit 9-6] [Surveys of Company Practice]
Do multiple choice 6. Assign Exercises 9-17 and 9-19.
II. Fixed manufacturing cost capacity analysis and denominator-level capacity concepts
Learning Objective 6:
Describe the various capacity concepts that can be used in absorption costing
A. Choices for denominator-level capacity (absorption costing issue)
1. Supply–based choices (available from the plant—upper limit or constraint)
a. Theoretical capacity: producing at full efficiency all the time: largest denominator/smallest rate
b. Practical capacity: reduces theoretical capacity by unavoidable operating interruptions: somewhat smaller than theoretical denominator/larger rate
2. Demand-based choices (demand for product is constraint)
a. Normal capacity utilization: satisfies average customer demand over several periods: typically lesser than practical denominator/larger rate
b. Master-budget capacity utilization: expected level of capacity utilization for the next budget period: usually smallest denominator/largest rate
Do multiple choice 7. Assign Exercise 9-24 and Problem 9-34.
B. Choices for capacity level to compute budgeted fixed overhead cost rate
1. Different costs for different purposes
Learning Objective 7:
Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate
2. Effect on product costing and capacity management
a. Highlighting the cost of capacity acquired but not used by use of practical capacity level
b. Managing unused capacity (practical capacity level) by designing new products, leasing to others, eliminating excess capacity
Do multiple choice 8. Assign Exercise 9-25.
Learning Objective 8:
Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand
3. Effect on pricing decisions
a. Customers willing to pay price that covers cost of capacity actually used but not willing to bear cost of unused capacity—use of practical capacity
b. Using smaller denominator of supply-based capacity levels with unused capacity means larger cost per unit
c. Continuing reduction in demand for product when not meeting competitors’ prices may result in downward demand spiral resulting in higher and higher units costs and more reluctance to meet competitors’ prices
d. Using practical capacity level avoids recalculation of rate—use of capacity available rather than capacity used to meet demand
Do multiple choice 9. Assign Problems 9-36, 9-39, and 9-40.
4. Effect on performance evaluation
a. Use of appropriate capacity level for time-span of performance period: if current year is evaluation period, use short-term measure such as master-budget capacity utilization (the principal short-run planning and control tool)
b. Use of responsibility accounting to classify part of difference between practical capacity level and master-budget capacity utilization as planned unused capacity
Learning Objective 9:
Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects the production-volume variance.
5. Effect on financial statements
a. Magnitude of favorable/unfavorable production-volume variance affected by choice of denominator used to calculate the rate (absorption costing)
b. Method of handling end-of-period variances results in different effect on financial statements [Refer to Chapter 4]
a. Adjusted allocation-rate approach—effectively changes to actual costing so denominator choice has no effect on end-of-period financial statements
b. Proration approach—denominator choice has no effect on end-of-period financial statements as underallocated or overallocated is spread among ending balances of work-in-process inventory, finished goods inventory, and cost of goods sold
c. Immediate write-off to cost of goods sold approach—denominator choice has an effect on end-of-period financial statements [Exhibit 9-7]
6. Regulatory requirements: IRS requires use of practical capacity level to calculate the rate and proration for tax reporting
7. Difficulties in forecasting chosen denominator-level capacity
a. Practical capacity (supply concept) provides more reliable estimate
b. Normal capacity utilization (demand concept) more difficult to estimate but shorter time span for master-budget capacity utilization more reliably estimated
8. Other issues
a. Managers use range of activity due to uncertainty about the future: denominator-level concept (normal or standard costing) use a single amount of activity—unused capacity allows gain from meeting sudden demand surges
b. Events affect amount of fixed costs used in numerator of rate calculation
c. Capacity as a total concept for an organization with parts of value chain having individual capacity concerns
Do multiple choice 10. Assign any of Exercises 9-22, 27, 28 or 29 and Problems 9-35, 37, 38.
III. Breakeven point with absorption costing
Do multiple choice 11 and 12. Assign Exercise 9-26, Problems 9-31 and 9-32.
Chapter Quiz Solutions: 1.c 2.d 3.c 4.b 5.a 6.d 7.c 8.a 9.b 10.d 11.c 12.a
CHAPTER QUIZ
1. The main difference between variable costing and absorption costing is
a. the treatment of nonman ufacturing costs.
b. the accounting for variable manufacturing costs.
c. the accounting for fixed manufacturing costs.
d. their value for decision makers.
The following data apply to questions 2 and 3.
Alvin Inc. planned and actually manufactured 200,000 units of its single product in 2001, its first year of operations. Variable manufacturing costs were $30 per unit of product. Planned and actual fixed manufacturing costs were $600,000, and marketing and administrative costs totaled $400,000 in 2001. Alvin sold 120,000 units of product in 2001 at a selling price of $40 per unit.
2. [CMA Adapted] Alvin’s 2001 operating income using variable costing is
a. $800,000. b. $600,000. c. $440,000. d. $200,000.
3. [CMA Adapted] Alvin’s 2001 operating income using absorption costing is
a. $840,000. b. $800,000. c. $440,000. d. $200,000.
4. [CPA Adapted] Operating income using variable costing as compared to absorption costing would be higher
a. when the quantity of beginning inventory equals the quantity of ending inventory.
b. when the quantity of beginning inventory is more than the quantity of ending inventory.
c. when the quantity of beginning inventory is less than the quantity of ending inventory.
d. under no circumstances.
5. Absorption costing enables managers to increase operating income in the short run by changing production schedules. Which statement is true regarding such action?
a. The reason for increased operating income is the deferral of fixed manufacturing overhead contained in unsold inventory.
b. A desirable effect of these changes in production is “cherry picking” the production line.
c. This is done through decreases in the production schedule as customer demand for product falls.
d. None of the above statements are true regarding manager’s action to increase operating income through changes in the production schedule.
6. The proponents of throughput costing
a. maintain that variable costing undervalues inventories.
b. maintain that it provides more incentive to produce for inventory than do either variable or absorption costing.
c. argue that only direct materials and direct labor are “truly variable” and all indirect manufacturing costs be written off in the period in which they are incurred.
d. treat all costs except those related to variable direct materials as costs of the period in which they are incurred.
7. The absolute minimum absorption-inventory cost that would be reported under the best conceivable operating conditions is a description of which type of denominator-level concept cost?
a. Master-budget utilization
b. Practical capacity
c. Theoretical capacity
d. Normal utilization
8. Use of capacity levels based on demand
a. hides the amount of unused capacity.
b. highlights the cost of capacity acquired but not used.
c. yields a cost rate that does not include a charge for unused capacity.
d. results in a price that covers the cost of capacity customers expect to pay.
9. A company may experience the downward demand spiral when
a. the use of theoretical capacity as a denominator-level has contributed to budgets that project sales to be higher than actually attainable.