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Chapter Nine

Inventory Costing and Capacity Analysis

Learning Objectives
Define Absorption and Variable Costing

Understand the purpose of each method


Compute income using Variable and Absorption Costing Choosing the appropriate capacity level for the budgeted

fixed manufacturing cost rate

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Variable Costs
Total Cost
$6,600 $6,500

Total Cost

Total Variable Cost


$3,000 3,500 3,600

Units of the Cost Driver

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Fixed Costs
Total Cost
$6,600 $6,500 $3,000

Total Fixed Cost


3,500 3,600

Units of the Cost Driver

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Direct and Indirect Costs


Direct Costs
Costs that can be easily traced to a product or department Example: cost of paint in the paint department of an automobile assembly

Indirect Costs
Costs that must be allocated in order to be assigned to a product or department Example: cost of national advertising for an airline

plant

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Product Costs

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Manufacturing OH Costs
Fixed Overhead Factory managers salaries Plant and equipment depreciation Plant security guards Insurance and property taxes for factory building and equipment

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Variable Overhead

Energy costs Indirect materials Indirect labor Equipment repair and maintenance

Period Costs

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Inventory Costing Choices: Overview


Absorption costing
Capitalize product costs (inventory) Expense period costs

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Inventory Costing Choices: Overview


Variable costing
Capitalize variable product costs Expense all fixed costs (product and period) Expense variable period costs

Throughput costing (special case of variable costing)


Capitalize only direct materials; all other costs are

expensed

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In Other Words
Variable costing only applies variable manufacturing OH to

inventory
Absorption costing applies all manufacturing OH costs, both

fixed and variable, to inventory


DM and DL allocation is the same for both methods

Result in different income reporting, product pricing, and decision making

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Differences in Income Reporting


Operating income will differ between the methods
The amount of the difference are the fixed costs Capitalized under absorption costing and expensed

under variable costing


Variable costing reports lower net income
Reduce taxes

Companies using absorption costing will not incur lower net income until they sell goods

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Example Income Statements

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Other Potential Impacts


Product costing
Variable costing under-costs manufactured goods Absorption costing better defines production costs

Pricing
Variable costing may result in lower pricing, due to lower

imputed costs
This is misleading since fixed manufacturing OH remains a

period cost on the income statement

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When are they Used?


External Accounting
GAAP requires Absorption Costing for external reporting

purposes Taxes
The IRS requires Absorption Costing for tax reporting

purposes Where does Variable Costing fit in?


As an internal management accounting - tool
More closely reflects what a manager can control
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Cost Allocation Systems


1. 2.

The cost accumulation method Process Costing or Job Costing The cost measurement method Actual, normal or standard

3.

The overhead assignment method


Volume based or Activity based

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Costing Systems
Job costing
Account for distinct cost objects called jobs. Each

job may be unique and consumes different resources


Wedding announcements, aircraft, advertising

Process costing
Account for mass production of identical or similar

products
Oil refining, orange juice, soda pop

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Inventory Costing Systems


Variable Direct Manufacturing Cost (e.g. raw materials)

Actual Costing
Actual price X Actual quantity of inputs used

Normal Costing Standard Costing


Actual price X Actual quantity of inputs used Standard price X Standard quantity of inputs allowed for actual output achieved

Inventory Costing Systems


Fixed Direct Manufacturing Cost (e.g., machine rental)

Actual Costing
Actual price X Actual quantity of inputs used

Normal Costing Standard Costing


Actual price X Actual quantity of inputs used Standard price X Standard quantity of inputs allowed for actual output achieved

Manufacturing Indirect (OH) Costs


Fixed Overhead Factory managers salaries Plant and equipment depreciation Plant security guards Insurance and property taxes for factory building and equipment

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Variable Overhead

Energy costs Indirect materials Indirect labor Equipment repair and maintenance

Inventory Costing Systems


Variable Indirect Manufacturing Cost (e.g., electricity)

Actual Costing
Actual variable indirect rate X Actual quantity of cost allocation bases used

Normal Costing Standard Costing


Budgeted variable indirect rate X Actual quantity of cost allocation bases used
Standard variable indirect rate X Standard quantity of cost-allocation bases allowed for actual output achieved

Inventory Costing Systems


Fixed Indirect Manufacturing Cost (e.g., security guard)

Actual Costing
Actual fixed indirect rate X Actual quantity of cost allocation bases used

Normal Costing Standard Costing


Budgeted fixed indirect rate X Actual quantity of cost allocation bases used Standard fixed indirect rate X Standard quantity of cost allocation bases allowed for actual output achieved

Absorbing Fixed Manufacturing OH


Standard Costing Systems record budget and variance

journal entries
GAAP demands that fixed OH be allocated on a per unit

basis to calculate the full cost of the product


Absorption costing - absorbing the fixed costs The variance between the budgeted and the actual fixed

costs is the amount over- or under-applied

Therefore variance analysis of OH is necessary for


product costing in a standard costing environment
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Defining the Standard Fixed OH Rate


Determine the total budgeted fixed factory OH costs for

the period
Select an activity variable for applying fixed factory OH to

outputs (e.g., machine hours or direct labor hours)


Choose a denominator volume level for the selected activity

variable (e.g., practical capacity)


Divide the amount in Step 1 by the amount in Step 3 to

determine the standard fixed factory OH rate


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Choosing a Capacity Level


Theoretical (or Ideal) Capacity Practical Capacity Normal Capacity Master Budget Capacity

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Calculating Fixed OH Variances


Schmidt Co.s budgeted fixed manufacturing OH at $120,000 for October 2010 The budgeted activity measure for the month is 1,000 units @ 5 DLHs/unit (assume practical capacity) Actual production is 780 units and actual fixed OH is $130,650 for the month Compute the fixed OH spending and production volume variances

$120,000 budgeted fixed overhead FR = = $24.00/DLH 5,000 DLHs


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Fixed OH Production Volume Variance


Fixed OH Production Volume Variance = Standard Fixed OH Application Rate x (Actual Units Produced Denominator Volume, in units) = $120.00/unit x (780 1,000) units = $26,400 U (i.e., under-applied fixed OH)

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Calculating Fixed OH Variances

Given

Given

Underapplied

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Fixed OH Variance: Now You Do It!


A company has the following Fixed OH Data:

The applied amount is $123,000


The budgeted amount is $120,000 The actual overhead incurred is $140,000

Calculate the :
Total Fixed OH Variance Fixed OH Production Volume Variance (under/over

applied)
Fixed OH Spending Variance

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Interpretation of Fixed OH Variances


Spending (Budget) Variance
Results from spending more or less than expected for fixed OH items

Production Volume Variance


Results from operating at a level other than the

denominator volume level


Important for product

costing purpose, not for


control purposes

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Effects of Denominator Level Choice for Allocating Fixed OH


Management can manage earnings Changing the denominator volume level results in a different OH application rate Resulting in different product costs, and ultimately in a different production volume variance Management can allocate between inventory and COGS

or write off completely to COGS

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Comparative Income Effects


Variable Costing Absorption Costing Yes

Are fixed product


costs inventoried? Is there a No

production volume
variance? Are classifications

No

Yes

between variable and


fixed costs routinely made?
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Yes

Infrequently

Comparative Income Effects


Variable Costing How do changes in unit inventory cost affect operating Absorption Costing

income if?
Production = Sales Production > Sales Production < Sales Equal Lower Higher Equal Higher Lower

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Comparative Income Effects


Variable Costing
What are the effects on C-V-P for
1.

Absorption Costing
Driven by: Unit level of

a given level of
fixed costs and a given contribution margin per unit?

Driven by:
unit level of sales
2.

sales
Unit level of production
3.

Chosen
denominator level
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Downward Demand Cycle


If pricing based on absorption costs and use master budget

for the denominator level


As demand decreases, each unit will absorb more fixed

costs
Resulting in a higher absorbed cost basis and desire to

increase costs
Although the business climate demands otherwise

Use Practical Capacity as your denominator basis to avoid this situation


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Income Manipulation
Produce extra units
Production beyond demand will increase the amount of

inventory on hand
This will result in more fixed costs being capitalized,

leaving a smaller amount to be expensed


Profits will increase, and potentially, so will a managers

bonus
base managers bonuses on profit calculated using variable

costing
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Other Manipulations
Manufacture products that absorb the highest amount of

fixed costs, regardless of demand (cherry-picking)


Accept an order to increase production, even though

another plant may be better suited to handle that order


Defer maintenance

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Management Countermeasures
Careful budgeting and inventory planning Incorporate an internal carrying charge for inventory Lengthen the period used to evaluate performance

Include non-financial as well as financial variables to

evaluate performance
Balanced Scorecard

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Summary Analysis Variable vs. Absorption Costing


Variable costing separates variable and fixed costs on the

income statement
Absorption costing includes fixed manufacturing cost as part

of product cost
Required by GAAP for financial reporting and by the IRS for

computing taxable income


Variable costing meets the three objectives of management

control systems

MotivateIncent.Reward
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Standard Costing in Service Organizations


Service organization costs tend to be fixed in the short to medium term Professional service firms (accountancy) Direct labor is fixed since employees are salaried Other significant costs are related to brick-andmortar (buildings and equipment) Predominant costs are fixed assets Airlines/Shipping/Telecommunications Industries

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