2009 Foster School of Business Cost Accounting L.DuCharme 1

Inventory Costingand Capacity

Analysis

Chapter 9

2009 Foster School of Business Cost Accounting L.DuCharme 2

Overview—Chapter 9

• Inventory Costing Methods

• Denominator Issues

• Example: working backwards

• BEPs: VC versus AC

• Solution to extra problem (on webpage)

2009 Foster School of Business Cost Accounting L.DuCharme 3

Absorption Costing

• All manufacturing cost are considered inventoriable:

– All variable mfg. costs (both direct & indirect)– All fixed mfg. costs (both direct & indirect)

• Separates costs by business function.• Other costing terms:

(1) Super-full absorption costing: includes some mfg. related admin costs—used for tax.

(2) Full-product costing: costs from all areas of value chain are attached to product costs—for L-T pricing.

2009 Foster School of Business Cost Accounting L.DuCharme 4

Variable Costing

• All variable manufacturing costs are considered inventoriable.

• Separates costs by cost behavior.

• Some managers call this direct costing which is a poor choice of name. Why?

2009 Foster School of Business Cost Accounting L.DuCharme 5

Throughput Costing

• Also called super-variable costing.

• Only variable direct materials are inventoriable. Assumes that only DM are variable in the short run.

• Reduces incentives to build up inventories.

• Relatively new and not widely used.

2009 Foster School of Business Cost Accounting L.DuCharme 6

STOP! The big picture

• Managers make a number of accounting choices that affect income, for example:

Costing

Systems

Fixed Mfg. Costs

Flow of Costs

Actual AC Job FIFO

Normal VC Process LIFO

Standard Tput Avg.

Other Specific I.D.

Standard

Retail

2009 Foster School of Business Cost Accounting L.DuCharme 7

Inventory-Costing Methods

The difference between variable costingand absorption costing is based on the

treatment of fixed manufacturing costs.

AC includes fixed mfg. costs in cost of inventory, while VC does not. VC expenses all fixed costs as period costs.

2009 Foster School of Business Cost Accounting L.DuCharme 8

Comparing Income Statements:Absorption vs. Variable Costing

The following data pertain to Davenport Pencils:

Produce one product: #2 pencils. 1 box = 1 gross.Sales price = $8/box; Sold 40,000 boxesDM = $3 / box; DL = $0.50 / boxVMOH = $0.25 / boxFMOH = $100,000 / yearSales commission = $0.75 / boxFixed admin. expenses = $30,000 / yearBudget = actual production = 50,000 boxes

2009 Foster School of Business Cost Accounting L.DuCharme 9

Comparing Income Statements

What is the cost per box under VC?

$3.00 + 0.50 + 0.25 = $3.75

What is the cost per box under AC?

$3.00 + 0.50 + 0.25 + 2.00* = $5.75

* Fixed mfg. OH rate = $2.00 / box = $100,000 / 50,000 boxes

2009 Foster School of Business Cost Accounting L.DuCharme 10

Comparing Income Statements

Absorption Costing

Revenue $320,000CoGS 230,000 GM 90,000S&A 60,000Op. Inc. $ 30,000

Variable Costing

Revenue $320,000 VC 180,000 CM 140,000FC 130,000Op. Inc. $ 10,000

2009 Foster School of Business Cost Accounting L.DuCharme 11

Comparison of Variableand Absorption Costing

Variable costing operating income : $10,000

Absorption costing operating income : $30,000

Absorption costing operating income is $20,000 higher.

Why?

2009 Foster School of Business Cost Accounting L.DuCharme 12

Comparison of Variableand Absorption Costing

Production exceeds sales.

The 10,000 unit increase in ending inventoryare valued as follows:

Absorption costing: 10,000 × $5.75 = $ 57,500

Variable costing: 10,000 × $3.75 = $ 37,500

Difference: $ 20,000

2009 Foster School of Business Cost Accounting L.DuCharme 13

Comparison of Variableand Absorption Costing

COGS

Absorption costing: 40,000 X $5.75 = $230,000

Variable costing: 40,000 X $3.75 = $150,000Plus all the fixed mfg. OH = $100,000

Lower costs recognized underabsorption costing: $ 20,000

2009 Foster School of Business Cost Accounting L.DuCharme 14

Comparison of Variableand Absorption Costing

Under absorption costing, each of the additional 10,000 boxes in ending inventory is storing $2/box cost that will be expensed later

when sold.

10,000 units of inventory × $2.00 = $20,000

2009 Foster School of Business Cost Accounting L.DuCharme 15

Comparison of Variableand Absorption Costing

Absorption costingoperating income

Variable costingoperating income

Fixed manufacturingcosts in endinginventory under

absorption costing

Fixed manufacturingcosts in beginninginventory under

absorption costing

–

EQUALS

–

2009 Foster School of Business Cost Accounting L.DuCharme 16

Absorption Costing & Inventory Buildup

How might you mitigate the incentive to build up inventory?

What happens over the long run?

2009 Foster School of Business Cost Accounting L.DuCharme 17

Alternative Denominator-LevelConcepts

Theoretical capacity

Practical capacity

Normal capacity

Master-budget capacity

2009 Foster School of Business Cost Accounting L.DuCharme 18

Budgeted Fixed Manufacturing Overhead Rate

Lloyd’s Bicycles produces bicycle partsfor domestic and foreign markets.

Fixed overhead costs are $200,000 within therelevant range of the various capacity volume.

2009 Foster School of Business Cost Accounting L.DuCharme 19

Budgeted Fixed Manufacturing Overhead Rate

Assume that the theoretical capacity is10,000 machine-hours, practical capacity

is 85%, normal capacity is 75%, andmaster-budget capacity is 60%.

What is the budgeted fixed manufacturingoverhead rate at the various capacity levels?

2009 Foster School of Business Cost Accounting L.DuCharme 20

Budgeted Fixed Manufacturing Overhead Rate

Theoretical 100%:$200,000 ÷ 10,000 = $20.00/machine-hour

Practical 85%:$200,000 ÷ 8,500 = $23.53/machine-hour

Normal 75%:$200,000 ÷ 7,500 = $26.67/machine-hour

Master-budget 60%:$200,000 ÷ 6,000 = $33.33/machine-hour

2009 Foster School of Business Cost Accounting L.DuCharme 21

Effect of Denominator Level Choice

• The larger the denominator level, the:– Lower the budgeted FM rate.– Lower Fixed Mfg. costs in E.Inv.– Higher the unfavorable PVV for fixed OH

Remember—Fixed mfg. are either expensed in the period or stored in E.Inv.

What denominator level would you want to use for tax purposes? [practical is required for tax]

2009 Foster School of Business Cost Accounting L.DuCharme 22

Decision Making

Assume that Lloyd’s Bicycles’ standardhours are 2 hours per unit.

What is the budgeted fixed manufacturingoverhead cost per unit?

2009 Foster School of Business Cost Accounting L.DuCharme 23

Decision Making

Theoretical capacity: $20 × 2 = $40.00

Practical capacity: $23.53 × 2 = $47.06

Normal capacity: $26.67 × 2 = $53.34

Master-budget capacity: $33.33 × 2 = $66.66

2009 Foster School of Business Cost Accounting L.DuCharme 24

Exercise—working backward

QQQ Company has op. income of $120,000 under absorption costing, and op. income would be $100,000 under variable costing.

FMOH = $500,000

Budgeted and actual production = 200,000 units.Did inventory increase or decrease during the period? By how much?

2009 Foster School of Business Cost Accounting L.DuCharme 25

In-class problem

• Answer depends on the FMOH rate for B.Inv and choice of inventory cost-flow method (FIFO, WA, LIFO, etc.).

• Assume no change in FMOH rate. Then choice of cost-flow method does not matter.

• FMOH rate = $500k / 200k = $2.50 / unit

2009 Foster School of Business Cost Accounting L.DuCharme 26

Calculation of BE points

• Unique solution under Variable Costing:BEPvc = Total FC / UCM

• Solution depends on production level under Absorption Costing:BEPac = [Total FC + (FM rate* (BEPac – Units

Produced))] / UCMBEPac = [Total FC – (FMR*UP)] / (UCM – FMR)

What happens to the BEP when more units are produced?