Inventory Costing

and
Capacity Analysis

1.
2.

3.

4.

Identify what distinguishes variable costing

from absorption costing
Compute income under variable costing and
absorption costing and explain the
difference in income
Understand how absorption costing can
provide undesirable incentives for
managers to build up inventory
Differentiate throughput costing from
variable costing and absorption costing
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5.
6.

7.

Describe the various capacity concepts that

firms can use in absorption costing
Examine the key factors managers use to
choose a capacity level to compute the
budgeted fixed manufacturing cost rate
Understand other issues that play an
important role in capacity planning and
control

9-3

The inventory
costing system that
is chosen determines
which manufacturing
costs are treated as
inventoriable costs.

The denominatorlevel capacity

choice focuses on
the cost allocation
base used to set
budgeted fixed
manufacturing cost
rates.

9-4

Variable costinga method of inventory

costing in which all variable manufacturing
costs (direct and indirect) are included as
inventoriable costs. (Also known as direct
costing)
Absorption costinga method of inventory
costing in which all variable and fixed
manufacturing costs are included as
inventoriable costs. You can say that
inventory absorbs all manufacturing costs.
Throughput costingonly direct materials are
capitalized; all other costs are expensed.
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Operating income will differ between absorption

and variable costing.
The amount of the difference represents the
amount of fixed manufacturing costs capitalized
as inventory under absorption costing and
expensed as a period cost under variable costing.
If inventory levels change, operating income will
differ between the two methods because of the
difference in accounting for fixed manufacturing
costs.

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9-7

9-8

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Absorption costing is the required inventory

method for external financial reporting in
most countries. Also preferred because:
It is cost-effective and less confusing.
It can help prevent managers from taking
actions that make their performance
measure look good but that hurt the income
they report to shareholders.
It measures the cost of all manufacturing
resources (variable or fixed) necessary to
produce inventory.
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One unfavorable attribute of absorption

costing is that it enables managers to
increase margins and, therefore, operating
income, by producing more ending
inventory.
Producing for inventory can be justified
when rapid growth is forecasted, but
should not be undertaken simply to boost
profits.
To reduce an undesirable buildup of
inventory, companies can use variable
costing for internal reporting purposes
including performance measurement.
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To reduce the undesirable effects of absorption

costing, management can:
Focus on careful budgeting and inventory planning.
Incorporate an internal carrying charge for
inventory
Change (lengthen) the period used to evaluate
performance.
Include nonfinancial as well as financial variables
in the measures to evaluate performance.
(compare ratio of ending/beginning inventory to
ratio of units produced/sold)

9-12

Throughput costing (super-variable costing) is a

method of inventory costing in which only direct
material costs are included as inventory costs.
All other product costs are treated as period
expenses.
Throughput Margin = Revenues minus all Direct
material cost of the goods sold.

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9-14

9-15

We have concluded the discussion of inventory

costing and will begin capacity analysis.
Given a firms level of spending on fixed
manufacturing costs, what capacity level
should managers and accountants use to
compute the fixed manufacturing cost per
unit?

9-16

Spending on fixed manufacturing costs enables

firms to obtain the scale or capacity needed to
satisfy the expected market demand from
customers. Determining the right amount of
spending, or the appropriate level of capacity, is
one of the most strategic and most difficult
decisions managers face.

9-17

Spending on fixed manufacturing costs enables

firms to obtain the scale or capacity needed to
satisfy the expected market demand from
customers. Determining the right amount of
spending, or the appropriate level of capacity, is
one of the most strategic and most difficult
decisions managers face.
Too much capacity means firms will incur the
cost of unused capacity; having too little means
that demand from some customers may be
unfulfilled.
9-18

The choice of the capacity level used to

allocate budgeted fixed manufacturing costs
to products can greatly affect operating
income.
Four different capacity levels can be used as
the denominator to compute the budgeted
fixed manufacturing cost rate:
1.
2.
3.
4.

Theoretical capacity
Practical capacity
Normal capacity utilization
Master-budget capacity utilization
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Theoretical capacity is the level of capacity

based on producing at full efficiency all the
time.
It is theoretical in the sense that it does not
allow for any slowdowns due to plant
maintenance, shutdown periods or
interruptions because of downtime.
In the real world, theoretical capacity levels
are unattainable but they represent the ideal
goal of capacity utilization a company can
aspire to.
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Practical capacity is the level of capacity that

reduces theoretical capacity by considering
unavoidable operating interruptions like
maintenance and holiday shutdowns.
Engineering and human resource factors are
important when estimating theoretical or
practical capacity.

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Both theoretical and practical capacity

measure capacity levels in terms of what a
plant can supply.
Normal Capacity Utilization and Master-Budget
Capacity Utilization, in contrast, measure
capacity levels in terms of demand for the
output of the plant.
It is possible and even likely that budgeted
demand will be below production capacity
levels.

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Normal capacity utilization is the level of

capacity utilization that satisfies average
customer demand over a period that is long
enough to consider seasonal, cyclical and
trend factors.
Master-budget capacity utilization is the
level of capacity utilization that managers
expect for the current budget period which is
typically one year.

9-23

The choice of capacity level can have a huge

impact on budgeted fixed manufacturing cost
per unit as shown here:

9-24

The choice of denominator-level capacity to

use may differ based on the purpose for which
the choice is being made. Some of those
purposes include:
1.Product costing and capacity management
2.Pricing
3.Performance evaluation
4.External reporting
5.Tax requirements

9-25

For product costing and capacity

management, using practical capacity as the
denominator level sets the cost of capacity
at the cost of supplying the capacity,
regardless of demand for the capacity.
Highlighting the cost of capacity acquired
but not used directs managers attention
toward managing unused capacity.
In contrast, using either of the capacity
levels based on demand hides the amount of
unused capacity.
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To understand the best choice for pricing

decisions, lets look first at the downward
demand spiral for a company. It is the
continuing reduction in the demand for its
products that occurs when competitor prices
are not met, demand drops further and the
fixed costs are spread over fewer units,
resulting in greater and greater costs per
unit.
Practical capacity, by contrast, is a more
stable measure as it calculates the fixed cost
rate based on capacity available rather than
capacity used to meet demand.
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Unused capacity adds costs to products.

Mid-level managers have no control over
those costs but do have control over prices.
Should the marketing managers be held
accountable for the manufacturing overhead
costs unrelated to their potential customer
base? (practical capacity vs master-budget
capacity utilization)
Where there are large differences between
practical capacity and master-budget
capacity utilization, that difference is often
classified as planned unused capacity.
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The magnitude of the favorable/unfavorable

production-volume variance under absorption
costing is affected by the choice of the
denominator level used to calculate the
budgeted fixed manufacturing cost per unit.
Recall from Chapter 4 that the productionvolume variance can be disposed of three
ways:
Adjusted

allocation-rate approach (recalculate at

year end)
Proration approach (spread to Work-In-Process,
Finished Goods and Cost of Goods Sold)
Write-off to Cost of Goods Sold.
9-29

The objective in choosing the method to

dispose of the production-volume variance is
to write-off the portion of the variance that
represents the cost of capacity not used to
support the production of output during the
period.
That objective is also helpful in determining
which capacity should be used to develop the
budgeted fixed manufacturing cost per unit.

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The IRS permits the use of practical capacity

to calculate budgeted fixed manufacturing
costs per unit AND allows for the write-off of
the production-volume variance generated
this way.
The tax benefit can be significant.

9-31

A few other factors should be taken into

account when planning capacity levels and in
deciding how best to control and assign
capacity costs. They are:
1.Difficulty of obtaining demand-side
denominator-level concepts
2.Difficulty of forecasting fixed manufacturing
costs
3.Capacity issues for nonmanufacturing parts of
the value chain
4.In ABC Costing, a capacity level must be
chosen for each cost driver
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TERMS TO LEARN

PAGE NUMBER REFERENCE

Absorption costing

Page 330

Direct costing

Page 329

Downward demand spiral

Page 346

Master-budget capacity
utilization

Page 344

Normal capacity utilization

Page 344

Practical capacity

Page 344

Super-variable costing

Page 341

Theoretical capacity

Page 343

Throughput costing

Page 341

Variable costing

Page 329

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