inventory costing and capacity analysis chapter 9

Inventory Costingand Capacity

Analysis

Inventory Costingand Capacity

AnalysisChapter 9

Learning Objective 1Learning Objective 1

Identify what distinguishesvariable costing from

absorption costing.

Inventory-Costing MethodsInventory-Costing Methods

The difference between variable costingand absorption costing is based on the

treatment of fixed manufacturing overhead.

Variable CostingVariable Costing

DirectMaterials

VariableFactoryLabor

VariableOverhead

Work in Process Inventory

Variable CostingVariable Costing

Work in ProcessInventory

Finished GoodsInventory

Cost of Goods Sold

Income Summary

Fixed FactoryLabor

Learning Objective 2Learning Objective 2

Prepare income statementsunder absorption costing

and variable costing.

Comparing Income StatementsComparing Income Statements

The following data pertain to Davenport Fixtures:

Year 1 Year 2 TotalBeginning inventory -0- 2,000 -0-Produced 10,000 11,500 21,500Sold 8,000 13,000 21,000Ending inventory 2,000 500 500

Comparing Income StatementsComparing Income Statements

The following information is on a per unit basis:

Sales price: $71.00

Variable manufacturing costs:Direct materials: $ 4.00Direct manufacturing labor: $21.00Indirect manufacturing costs: $24.00

Fixed manufacturing costs: $ 4.50

Comparing Income Statements(Absorption Costing)

Comparing Income Statements(Absorption Costing)

Total fixed production costs are $54,000at a normal capacity of 12,000 units.

Fixed nonmanufacturing costs are$30,000 per year.

Variable nonmanufacturing costs are$2.00 per unit sold.

Comparing Income Statements(Absorption Costing)

Comparing Income Statements(Absorption Costing)

Revenues $568,000Cost of goods sold 428,000Volume variance (U) 9,000Gross margin $131,000Nonmanufacturing costs 46,000Operating income $ 85,000

Comparing Income Statements(Variable Costing)

Comparing Income Statements(Variable Costing)

Revenues for Year 1 are $568,000.

What is the variable cost of goods sold?

8,000 × $49 = $392,000

What is the manufacturing contribution margin?

$568,000 – $392,000 = $176,000

Net contribution margin = $160,000

Comparing Income Statements (Variable Costing)

Comparing Income Statements (Variable Costing)

Revenues $568,000Variable cost of goods sold 392,000Variable nonmanufacturing costs 16,000Contribution margin $160,000Fixed manufacturing costs 54,000Fixed nonmanufacturing costs 30,000Operating income $ 76,000

Learning Objective 3Learning Objective 3

Explain differences in operatingincome under absorption

costing and variable costing.

Operating Income(Absorption Costing)

Operating Income(Absorption Costing)

What are revenues for Year 2?

13,000 × $71 = $923,000

What is the cost of goods sold?

13,000 × $53.50 = $695,500

Is there a volume variance?

(12,000 – 11,500) × $4.50 = $2,250underallocated fixed manufacturing costs

Operating Income(Absorption Costing)

Operating Income(Absorption Costing)

What is the gross margin?

$923,000 – ($695,500 + $2,250) = $225,250

What are the nonmanufacturing costs?

13,000 units sold × $2.00 = $26,000variable costs + $30,000 fixed costs = $56,000

Operating Income(Absorption Costing)

Operating Income(Absorption Costing)

What is the operating income before taxes?

$225,250 – $56,000 = $169,250

What is the operating income for thetwo years combined?

$85,000 + $169,250 = $254,250

Income Statements (Absorption Costing)Income Statements (Absorption Costing)

Year 1 Year 2 CombinedRevenues $568,000 $923,000 $1,491,000Cost of goods sold 428,000 695,500 1,123,500Volume variance (U) 9,000 2,250 11,250Gross margin $131,000 $225,250 $ 356,250Nonmfg. costs 46,000 56,000 102,000Operating income $ 85,000 $169,250 $ 254,250

Operating Income(Variable Costing)Operating Income(Variable Costing)

Revenues for Year 2 are $923,000.

What is the cost of goods sold?

13,000 × $49 = $637,000

What is the manufacturing contribution margin?

$923,000 – $637,000 = $286,000

Operating Income(Variable Costing)Operating Income(Variable Costing)

What is the net contribution margin?

$286,000 – $26,000 variable nonmanufacturing costs= $260,000 net contribution margin

What is the operating income before taxes?

$260,000 – $54,000 fixed manufacturing costs– $30,000 fixed nonmanufacturing costs = $176,000

Income Statements(Variable Costing)Income Statements(Variable Costing)

Year 1 Year 2 CombinedRevenues $568,000 $923,000 $1,491,000Cost of goods sold 392,000 637,000 1,029,000Mfg. contr. margin $176,000 $286,000 $ 462,000Variable nonmfg. 16,000 26,000 42,000Net contr. margin $160,000 $260,000 $ 420,000Fixed mfg. costs 54,000 54,000 108,000Fixed nonmfg. costs 30,000 30,000 60,000Operating income $ 76,000 $176,000 $ 252,000

Comparison of Variableand Absorption CostingComparison of Variableand Absorption Costing

Variable costing operating income Year 1: $76,000

Absorption costing operating income Year 1: $85,000

Absorption costing operating income is $9,000 higher.

Why?

Comparison of Variableand Absorption CostingComparison of Variableand Absorption Costing

Production exceeds sales in Year 1.

The 2,000 units in ending inventoryare valued as follows:

Absorption costing: 2,000 × $53.50 = $107,000

Variable costing: 2,000 × $49.00 = $ 98,000

Difference: $ 9,000

Comparison of Variableand Absorption CostingComparison of Variableand Absorption Costing

Variable costing operating income Year 2: $176,000

Absorption costing operating income Year 2: $169,250

Variable costing operating income is $6,750 higher.

Why?

Comparison of Variableand Absorption CostingComparison of Variableand Absorption Costing

Sales exceeded units produced in Year 2.

13,000 – 11,500 = 1,500 decrease in inventory

Absorption costing: 1,500 × $53.50 = $80,250

Variable costing: 1,500 × $49.00 = $73,500

Higher cost of goods sold underabsorption costing: $ 6,750

Comparison of Variableand Absorption CostingComparison of Variableand Absorption Costing

Variable costing combined net income: $252,000

Absorption costing combined net income: $254,250

Absorption costing is higher by $2,250

500 units in inventory × $4.50 = $2,250

Comparison of Variableand Absorption CostingComparison 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

–

Learning Objective 4Learning Objective 4

Understand how absorptioncosting can provide undesirable

incentives for managers tobuild up finished goods inventory.

Inventory BuildupInventory Buildup

What is the production volume variance?

(12,000 – 4,400) × $4.50 = $34,200 U

What is the net operating income or lossfor the period?

Assume that Davenport Fixtures produced4,400 units in Year 1 and sold 4,100.

Inventory BuildupInventory Buildup

Revenues (4,100 × $71) $291,100Cost of goods sold (4,100 × $53.50) 219,350Volume variance 34,200Gross margin $ 37,550Nonmanufacturing costs 38,200Net loss ($ 650)

Inventory BuildupInventory Buildup

4,400 – 4,100 = 300

How much cost is in ending inventory?

300 × $53.50 = $16,050

How many units are in ending inventory?

Inventory BuildupInventory Buildup

Sales remain the same (4,100 units).

What is the volume variance?

(12,000 – 9,000) × $4.50 = $13,500 U

Suppose that management decides toproduce 9,000 units next year.

What is the operating income or loss?

Inventory BuildupInventory Buildup

Revenues (4,100 × $71) $291,100Cost of goods sold (4,100 × $53.50) 219,350Volume variance 13,500Gross margin $ 58,250Nonmanufacturing costs 38,200Net income $ 20,050

Inventory BuildupInventory Buildup

300 + 9,000 – 4,100 = 5,200

How much cost is in ending inventory?

5,200 × $53.50 = $278,200

How many units are in ending inventory?

Reducing Undesirable EffectsReducing Undesirable Effects

Change in accounting system

Carrying charge for inventory

Longer evaluation period

Careful budgeting procedures

Nonfinancial measures of performance

Learning Objective 5Learning Objective 5

Differentiate throughputcosting from variable costing

and absorption costing.

Throughput CostingThroughput Costing

Revenues $568,000Variable direct materials cost of goods sold 32,000Throughput contribution margin $536,000Manufacturing costs 504,000Nonmanufacturing costs 46,000Operating loss ($ 14,000)

Throughput CostingThroughput Costing

Manufacturing Costs:Labor $21.00 × 10,000 $210,000Indirect costs $24.00 × 10,000 240,000Fixed costs 54,000Total manufacturing costs $504,000

What are other nonmanufacturing costs for the year?

Throughput CostingThroughput Costing

Nonmanufacturing Costs:Variable $2.00 × 8,000 $16,000Fixed 30,000Total $46,000

Throughput CostingThroughput Costing

Variable costing operating income: $76,000Throughput costing operating loss: ($14,000)

Difference in operating income: $90,000

How can this difference be explained?

Throughput CostingThroughput Costing

The 2,000 units in ending inventoryare valued as follows:

Variable2,000 × $49 = $98,000

Throughput2,000 × $4 = $8,000

$90,000 difference

Throughput CostingThroughput Costing

Absorption costing operating income: $85,000Throughput costing operating loss: ($14,000)

Difference in operating income: $99,000

How can this difference be explained?

Throughput CostingThroughput Costing

The 2,000 units in ending inventoryare valued as follows:

Absorption2,000 × $53.50 =

$107,000

Throughput2,000 × $4= $8,000

$99,000 difference

Comparison of InventoryCosting Methods

Actual CostingActual Costing

AbsorptionCosting

AbsorptionCosting

ThroughputCosting

ThroughputCosting

VariableCostingVariableCosting

Comparison of InventoryCosting Methods

Normal CostingNormal Costing

AbsorptionCosting

AbsorptionCosting

ThroughputCosting

ThroughputCosting

VariableCostingVariableCosting

Comparison of InventoryCosting Methods

Standard CostingStandard Costing

AbsorptionCosting

AbsorptionCosting

ThroughputCosting

ThroughputCosting

VariableCostingVariableCosting

Learning Objective 6Learning Objective 6

Describe the variouscapacity concepts

that can be used inabsorption costing.

Alternative Denominator-LevelConcepts

Alternative Denominator-LevelConcepts

Theoretical capacity

Practical capacity

Normal capacity

Master-budget capacity

Budgeted Fixed ManufacturingOverhead Rate

Budgeted Fixed ManufacturingOverhead 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.

Budgeted Fixed ManufacturingOverhead Rate

Budgeted Fixed ManufacturingOverhead 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?

Budgeted Fixed ManufacturingOverhead Rate

Budgeted Fixed ManufacturingOverhead 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

Learning Objective 7Learning Objective 7

Understand the major factorsmanagement considers in choosing

a capacity level to compute thebudgeted fixed overhead cost rate.

Choosing a Capacity Level Choosing a Capacity Level

What factors are consideredin choosing a capacity level?

Productcosting

Pricingdecision

Performanceevaluation

Financialstatements

Regulatoryrequirements

Difficulty

Decision MakingDecision Making

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

What is the budgeted fixed manufacturingoverhead cost per unit?

Decision MakingDecision 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

Learning Objective 8Learning Objective 8

Describe how attempts torecover fixed costs of capacity

may lead to price increasesand lower demand.

Downward Demand Spiral

The downward demand spiral is the continuingreduction in demand that occurs when the pricesof competitors are not met and demand drops.

Learning Objective 9Learning Objective 9

Explain how the capacitylevel chosen to calculate

the budgeted fixed overheadcost rate affects the

production-volume variance.

Effect on Financial StatementsEffect on Financial Statements

Assume that Lloyd’s Bicycles actually used8,400 machine-hours during the year.

What is the production volume variance?

Production Volume VarianceProduction Volume Variance

Production volume variance= (Denominator level – Actual level)

× Budgeted fixed manufacturing overhead rate

Theoretical capacity:(10,000 – 8,400) × $20.00 = $32,000 U

Practical capacity:(8,500 – 8,400) × $23.53 = $2,353 U

Production Volume VarianceProduction Volume Variance

Normal capacity:(7,500 – 8,400) × $26.67 = $24,003

Master-budget capacity:(6,000 – 8,400) × $33.33 = $79,992

End of Variable CostingEnd of Variable Costing