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  • EXHIBIT 9-6 Comparison of Alternative Inventory-Costing Systems



    Actual Costing Normal Costing Standard Costing

    Variable Actual prices x Actual Actual prices x Actual Standard prices x StandardDirect quantity of inputs quantity of inputs quantity of inputs

    '" Manufacturing used used allowed for actuale.'" Cost output achieved~"u Variable Actual variable overhead Budgeted variable Standard variable overhead":c Manufacturing fates x Actual overhead rates x rates x Standard

    '".~ Overhead quantity of cost- Actual quantity of quantity of cost-e m.'" > Costs allocation bases used cost-allocation bases allocation bases allowed~

    " used for actual output achievedue,~ Fixed Direct Actual prices x Actual Actual prices x Actual Standard prices x Standard"- Manufacturing quantity of inputs quantity of inputs quantity of inputs

  • SOLUTION1. Budgetedfixed ..

    f . Budgeted fixed manufacturing costsmanu actunng =cost per unit Budgeted production units


    ~ $1.50per unit

    2lAbSofPtion ~costing variable-c,asting] l Fixe.d ma~ufa.cturing Fixed manufactunng costS]operating - operating = costs In ending Inventory In beginning Inventoryincome income under absorption costing under absorption costing2006: $16,800 $16,500 = ($1.50per unit x 200unitsl-I$1.50 per unit x 0 units)

    $300 = $300

    2007: $18,650 $18,875 = 1$1.50per unit x 50units) -1$1.50 per unit x 200unitsl-$225 ~ -$225

    2008: $24,000 $23,625 = 1$1.50per unit x 300units) - IS1.50per unit x 50units)

    $375 = $375

    3. Subcontracting a large part of manufacturing has greatly reduced the magnitude of fixed man-ufacturing costs. This reduction, in turn, means differences between absorption costing andvariable costing are much smaller than in Exhibit 9-2.

    PART TWO: DENOMINATOR-LEVEL CAPACITYCONCEPTS AND FIXED-COST CAPACITY ANALYSISDetermining the "right" level of capacity is one of the most strategic and most difficult deci-sionsmanagers face. I-laving too much capacity to produce relative to capacity needed to meetdemand means incurring some costs of unused capacity. Having too little capacity to producemeans that demand from some customers may be unfilled. These customers may go to othersourcesof supply and never return. \Ve 110\,\, consider issues that arise vvith capacity costs.

    Alternative Denominator-Level Capacity Conceptsfor Absorption CostingEarlierchapters, especially Chapters 4,5, and 8, have highlighted how normal costing andstandard costing report costs in an ongoing timely manner throughout a fiscal year. Thechoice of the capacity level used to allocate budgeted fixed manufacturing costs to prod-uctscan greatly affect the operating income reported under normal costing or standardcostingand the product-cost information available to managers.

    Consider Bushells Company, which produces 12-ounce bottles of iced tea at its Sydneybottling plant. The annual fixed manufacturing costs of the bottling plant are $5,400,000.Bushellscurrently uses absorption costing with standard costs for external reporting purposes,andit calculates its budgeted fixed manufacturing rate on a per-case basis (one case is twenty-four12-ounce bottles of iced tea). We will now examine four different capacity levels used asthedenominator to compute the budgeted fixed manufacturing cost rate: theoretical capacity,praaical capacity, normal capacity utilization, and master-budget capacity utilization.

    Theoretical Capacity and Practical Capacity]n business and accounting, capacity ordinarily means a "constraint," an "upper limit."Theoretical capacity is the level of capacity based on producing at full efficiency all thetime. Bushells can produce 10,000 cases of iced tea per shift when the bottling lines areoperating at maximum speed. If we assume 360 days per year, the theoretical annualcapacity for three 8-hour shifts per day is:

    10,000cases per shift x 3 shifts per day x 360days = 10,800,000cases

    Describe the variouscapacity concepts thatcan be used inabsorption costing

    ., . theoretical capacity,practical capacity, normalcapaciw utilization, andmaster-budget capacityutilization


  • 310

    ~,. Choosing a denominatorai!llevel arises onlv underAG. Both VC and throughputcosting expense the lump-sumFMOH costs in the periodincurred.

    Theoretical capacity is theoretical in the sense that it does not allow for any plant main-tenance, interruptions because of boule breakage on the filling lines, or any other factorTheoretical capacity represents an ideal goal of capacity utilization. Theoretical capacitylevels are unattainable in the real world, but they provide a benchmark for a company toaspire lo.

    Practical capacity is the level of capacity that reduces theoretical capacity by consid-ering unavoidable operating interruptions, such as scheduled maintenance time, shut-downs for holidays, and so on. Assume that practical capacity is the practical produaionrate of 8,000 cases per shift (as opposed to 10,000 cases per shift under theoretical capac-ity) for three shifts per day for 300 days a year (as distinguished from 360 days a yearunder theoretical capacity). The practical annual capacity is:

    8,000cases per shift x 3 shifts per day x 300days = 7,200,000cases

    Engineering and human resource factors are both important when estimating theoreticalor practical capacity. Engineers at the Bushells plant can provide input on the technicalcapabilities of machines for filling bottles. Human-safety faclOrs, such as increased injuryrisk \vhen the line operates at faster speeds, are also necessary considerations in estimat-ing practical capacity.

    Normal Capacity Utilization and Master-BUdgetCapacity utilizationBoth theoretical capacity and practical capacity measure capacity levels in terms of 'whata plant can supply-available capacity. In contrast, normal capacity utilization and master-budget capacity utilization measure capacity levels in terms of demand for the output ofthe plant-the amount of the available capacity that the plant expects to use based on thedemand for its products. In many cases, budgeted demand is well below productioncapacity available.

    Normal capacity utilization is the level of capacity utilization that satisfies averagecustomer demand over a period (say, two to three years) that includes seasonal, cyclical,and trend factors. Master-budget capacity utilization is the level of capacity utilizationthat managers expect for the current budget period, which is typically one year. These twocapacity-utilization levels can differ-for example, when an industry, such as automobilesor semiconductors, has cyclical periods of high and low demand or when managementbelieves that budgeted production for the coming period is not representative of long-rundemand.

    Consider Bushells' master budget for 2007, based on demand for and production of4,000,000 cases of tea per year.' Despite using this master-budget capacity-utilization levelof 4,000,000 cases for 2007, top management believes that over the next three years thenormal (average) annual production level will be 5,000,000 cases. They view 2007's bud-geted production level of 4,000,000 cases to be "abnormally" low. That's because a majorcompetitor (Tea-Mania) has been sharply reducing its selling price and spending largeamounts on advertising. Bushells expects that the competitor's lower price and advertisingblitz will not be a long-run phenomenon and that, in 2008, Bushells' production andsales will be higher.

    Effect on Budgeted Fixed ManUfacturing Cost RateWe now illustrate how each of these four denominator levels affects the budgeted Axedmanufaauring cost rate. Bushells has budgeted (standard) ftxed manufacturing costs (allof whicll are overhead costs) of $5,400,000 for 2007. This lump-sum amount is incurredto provide the capacity to bottle iced tea. This lump sum includes, among other costs,leasing costs for bottling equipment and the compensation of the plant manager. The

    'Management plans 10 run one shift for 300 days in 1007 at a speed of 8,000 cases per shift. A second shiflwill run for 100 days (in the warmer months) at the same speed of 8,000 cases per shift. Thus, budgeted production for 1007 is (300 days x 8,000 cases/day) + (100 days x 8,000 cases/day) '" 4,000,000 cases.

  • budgeted fixed manufacturing cost rates for 2007 for each of the four capacity-level con-cepts are:

    1 D IBudgered Fi>edManufuturingCost per Case(4) = (2)+ (3)



    Capadty Level(in Casel)


    B IBudgered Fi>edManufuturingCosu per Year


    A 1rJ:.-f.2 Dell1lminator-LeveI

    3 Capadty Concept4 (I)

    .~ Theoretical capacity"~ Pl3Cticalcapacityi--~Normal capacity utilizationJ... Master.budget capacity utilization

    The significant difference in cost rates (from $0.50 to $1.35) arises because of large dif-ferences in budgeted capacity levels under the different capacity concepts.

    Budgeted (standard) variable manufacturing cost is $5.20 per case. The total bud-geted (standard) manufacturing cost per case for alternative capacity-level concepts is:

    1112 Denominator-Level13 Capadty Concept14 (I)15 Theoretical capocity16. Pl3Cticalcapacity17 Normal capacity utilization18 Master-budget capacity utilization

    Budgered VariableManufuturingCost per Case


    BudgeredFixed Budgered TotalManufuturing ManufuturingCOlt per Case Co.tper Cue

    (3) (4)=(2)+(3)$0.50 $5.70$0.75 $5.95$108 $6..28$135 $6.55

    Because different denominator-level capacity concepts yield different budgeted fixedmanufacturing costs per case, Bushells must decide which capacity level to use. There isno requirement that Bushells us


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