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Ch09 Inventory Costing And Capacity Analysis
Sciences Economiques et Gestion
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CHAPTER 9
INVENTORY COSTING AND CAPACITY ANALYSIS
LEARNING OBJECTIVES
Identify what distinguishes variable costing from absorption costing
Prepare income statements under absorption costing and variable costing
Explain differences in operating income under absorption costing and variable costing
Understand how absorption costing can provide undesirable incentives for managers to build up finished goods inventory
Differentiate throughput costing from variable costing and absorption costing
Describe the various capacity concepts that can be used in absorption costing
Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate
Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand
Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects the production-volume variance
CHAPTER OVERVIEW
Chapter 9 is about fixed manufacturing costs. As a manufacturing cost, the issue of inventory costing and its effect on operating income under different costing systems exists. As a fixed cost, the issue of rate calculations and choice of a denominator exists. These issues can be studied separately through the structure of the chapter though both have the common characteristic of how best to determine the cost of manufacturing a product when that cost changes upon being applied as a cost per unit of product.
For external reporting all usual and reasonable manufacturing costs are considered as costs of the product using absorption costing. Managers, however, often find the behavior aspect of costs, rather than the function of those costs, to be most helpful in making decisions about volume and profit and use variable costing for internal reports. These two costing approaches yield different operating income amounts when production and sales differ.
The investment base for a manufacturing-sector company is usually the source for most of the fixed manufacturing costs and with the emphasis on technology, many companies have more fixed manufacturing costs than variable manufacturing costs. Managers must wrestle with how much capacity as well as how to cost their products so as to recover those costs with a competitive selling price. Assigning responsibility for fixed or capacity costs presents interesting challenges also. The guideline of different costs for different purposes is highlighted throughout the chapter.
The calculation of breakeven point using absorption costing is illustrated in the appendix to the chapter.
CHAPTER OUTLINE
I. Fixed manufacturing costs – the difference in inventory costing systems
Learning Objective 1: Identify what distinguishes variable costing from absorption costing
A. Classification issue
- Methods of inventory costing
a. Variable costing of inventory
i. All variable manufacturing costs included as inventoriable costs—assets initially
ii. All fixed manufacturing costs excluded from inventoriable costs because charged to income as incurred—expenses
b. Absorption costing of inventory: required method under GAAP for external reporting and tax reporting in most countries
i. All variable manufacturing costs included as inventoriable costs—assets initially
ii. All fixed manufacturing costs included as inventoriable costs—assets initially
- All nonmanufacturing costs in the value chain, whether variable or fixed, charged to income as incurred within the accounting period
Do multiple choice 1. Assignments start with L. O. 3.
Learning Objective 2: Prepare income statements under absorption costing and variable costing
B. Income statement presentation [Exhibit 9-1]
- Highlighted by format indicating cost classification
a. Variable costing – contribution-margin format
i. Costs categorized by variable or fixed—only variable manufacturing costs inventoriable
ii. Fixed costs expensed in total
b. Absorption costing – gross-margin format
i. Costs categorized by manufacturing or nonmanufacturing—all manufacturing costs inventoriable
ii. Fixed manufacturing costs expensed per unit in cost of goods sold
- Direct costing: not accurate term to describe variable costing
i. Careful budgeting and inventory planning to reduce management freedom to build up excess inventory
ii. Change the accounting system from absorption costing to variable costing for internal reporting
iii. Incorporate a carrying charge for inventory in the internal accounting system
iv. Change to a longer time period to evaluate performance
v. Include nonfinancial as well as financial variable in measures for performance evaluation [Concepts in Action]
Do multiple choice 5. Assign Exercise 9-23, Problems 9-30 and 9-33.
Learning Objective 5: Differentiate throughput costing from variable costing and absorption costing
D. Another costing method – throughput costing (also called super-variable costing)
Method of inventory costing in which only direct material costs are inventoriable costs; all other costs are costs of the period in which incurred
Reporting includes throughput contribution: revenues minus all direct material costs of goods sold [Exhibit 9-5]
Advocates say it provides less incentive to produce for inventory than other methods
E. Comparison of inventory costing methods [Exhibit 9-6] [Surveys of Company Practice]
Do multiple choice 6. Assign Exercises 9-17 and 9-19.
II. Fixed manufacturing cost capacity analysis and denominator-level capacity concepts
Learning Objective 6: Describe the various capacity concepts that can be used in absorption costing
A. Choices for denominator-level capacity (absorption costing issue)
- Supply–based choices (available from the plant—upper limit or constraint)
a. Theoretical capacity: producing at full efficiency all the time: largest denominator/smallest rate
b. Practical capacity: reduces theoretical capacity by unavoidable operating interruptions: somewhat smaller than theoretical denominator/larger rate
- Demand-based choices (demand for product is constraint)
a. Normal capacity utilization: satisfies average customer demand over several periods: typically lesser than practical denominator/larger rate
b. Master-budget capacity utilization: expected level of capacity utilization for the next budget period: usually smallest denominator/largest rate
Do multiple choice 7. Assign Exercise 9-24 and Problem 9-34.
B. Choices for capacity level to compute budgeted fixed overhead cost rate
- Different costs for different purposes
Learning Objective 7: Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate
- Effect on product costing and capacity management
a. Highlighting the cost of capacity acquired but not used by use of practical capacity level
b. Managing unused capacity (practical capacity level) by designing new products, leasing to others, eliminating excess capacity
Do multiple choice 8. Assign Exercise 9-25.
Learning Objective 8: Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand
- Effect on pricing decisions
a. Customers willing to pay price that covers cost of capacity actually used but not willing to bear cost of unused capacity—use of practical capacity
b. Using smaller denominator of supply-based capacity levels with unused capacity means larger cost per unit
c. Continuing reduction in demand for product when not meeting competitors’ prices may result in downward demand spiral resulting in higher and higher units costs and more reluctance to meet competitors’ prices
d. Using practical capacity level avoids recalculation of rate—use of capacity available rather than capacity used to meet demand
Do multiple choice 9. Assign Problems 9-36, 9-39, and 9-40.
- Effect on performance evaluation
a. Use of appropriate capacity level for time-span of performance period: if current year is evaluation period, use short-term measure such as master-budget capacity utilization (the principal short-run planning and control tool)
b. Use of responsibility accounting to classify part of difference between practical capacity level and master-budget capacity utilization as planned unused capacity
- The main difference between variable costing and absorption costing is
a. the treatment of nonmanufacturing costs. b. the accounting for variable manufacturing costs. c. the accounting for fixed manufacturing costs. d. their value for decision makers.
The following data apply to questions 2 and 3.
Alvin Inc. planned and actually manufactured 200,000 units of its single product in 2001, its first year of operations. Variable manufacturing costs were $30 per unit of product. Planned and actual fixed manufacturing costs were $600,000, and marketing and administrative costs totaled $400,000 in 2001. Alvin sold 120,000 units of product in 2001 at a selling price of $40 per unit.
- [CMA Adapted] Alvin’s 2001 operating income using variable costing is
a. $800,000. b. $600,000. c. $440,000. d. $200,000.
- [CMA Adapted] Alvin’s 2001 operating income using absorption costing is
a. $840,000. b. $800,000. c. $440,000. d. $200,000.
- [CPA Adapted] Operating income using variable costing as compared to absorption costing would be higher
a. when the quantity of beginning inventory equals the quantity of ending inventory. b. when the quantity of beginning inventory is more than the quantity of ending inventory. c. when the quantity of beginning inventory is less than the quantity of ending inventory. d. under no circumstances.
- Absorption costing enables managers to increase operating income in the short run by changing production schedules. Which statement is true regarding such action?
a. The reason for increased operating income is the deferral of fixed manufacturing overhead contained in unsold inventory. b. A desirable effect of these changes in production is “cherry picking” the production line. c. This is done through decreases in the production schedule as customer demand for product falls. d. None of the above statements are true regarding manager’s action to increase operating income through changes in the production schedule.
- The proponents of throughput costing
a. maintain that variable costing undervalues inventories. b. maintain that it provides more incentive to produce for inventory than do either variable or absorption costing. c. argue that only direct materials and direct labor are “truly variable” and all indirect manufacturing costs be written off in the period in which they are incurred. d. treat all costs except those related to variable direct materials as costs of the period in which they are incurred.
- The absolute minimum absorption-inventory cost that would be reported under the best conceivable operating conditions is a description of which type of denominator-level concept cost?
a. Master-budget utilization b. Practical capacity c. Theoretical capacity d. Normal utilization
- Use of capacity levels based on demand
a. hides the amount of unused capacity. b. highlights the cost of capacity acquired but not used. c. yields a cost rate that does not include a charge for unused capacity. d. results in a price that covers the cost of capacity customers expect to pay.
- A company may experience the downward demand spiral when
a. the use of theoretical capacity as a denominator-level has contributed to budgets that project sales to be higher than actually attainable. b. spreading capacity costs over a small number of units and setting selling prices even higher to recover those costs. c. engaged in a cyclical business and after experiencing an upturn. d. the production-volume variance is unfavorable each time period during a year.
- The manner in which a company deals with end-of-period variances will determine the effect production- volume variances have on the company’s end-of-period operating income. When the chosen capacity level exceeds the actual production level, which approach to end-of-period variances results in an unfavorable production-volume variance affect on that period’s operating income?
a. Proration approach b. Adjusted allocation-rate approach c. Theoretical approach d. Write-off variances to cost of goods sold approach
- Under a variable costing system, the breakeven point is a function of
Sales Volume Production Volume a. Yes Yes b. No Yes c. No No d. Yes No
- Under an absorption costing system, the breakeven point is a function of
Sales Volume Production Volume a. Yes Yes b. No Yes c. Yes No d. No No
Discuss the importance of setting appropriate performance criteria for managers. As illustrated in the text, the criterion of operating income for evaluating managers can lead to the undesirable buildup of inventory when the absorption costing method is used to measure operating income. The phenomenon of “unintended consequences” can be used to describe the intention of increasing operating income by setting that as a performance measure but having the consequence of inventory buildup because that is a method of increasing operating income – though that method was not the one meant to be used. Another example is as follows:
The old Soviet Union provides many cases where overstress on one or two aspects of the measurement system may lead to uneconomical behavior that focuses on a subgoal without considering overall organizational goals. To illustrate, taxi drivers were put on a bonus system based on mileage. Soon the Moscow suburbs were full of empty taxis barreling down the boulevards to fatten their bonuses. In response to bonuses based on tonnage norms, a Moscow chandelier factory produced heavier and heavier chandeliers until they started pulling ceilings down.
- Differentiate throughput costing from variable costing and absorption costing
Throughput costing would seem best suited to what time frame? Throughput costing considers all manufacturing costs but direct materials to be expenses of the time period. In the short-run perspective most costs are fixed and this would fit with variable costing—fixed costs expensed when incurred. Over the long-run time frame, most costs are variable. Throughput costing then would seem to be especially useful for short-run concepts as costs which cannot be changed quickly are deemed to be “fixed” and expensed as incurred.
- Describe the various capacity concepts that can be used in absorption costing
The authors note that “engineering and human resource factors are both important when estimating theoretical or practical capacity.” How can managers discern human resource factors in estimating supply-based capacity? The authors note the increased injury risk when the line operates at faster speeds as a human-safety factor. Management-by-observation during times of different levels of production could inform the manager of potential problems. Manufacturers of equipment used and materials processed provide labels and/or warnings about the use of their products. Regulatory agencies of various oversight groups and governments issue occupational guidelines. The company’s medical team and/or medical insurance provider would also be sources of information. The cost of human injury could far exceed the benefit of extracting a bit more capacity in most cases.
- Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate
Do companies have varying levels of capacity at any one time? How flexible is capacity that is defined in the text as a “constraint” or “upper limit”? In today’s market, most companies must be able to adapt readily to changes in customer demands and in technology. A company can develop various options for its “capacity.” One method might be to have relationships with other companies that could be used when demand exceeded “in-house capacity” through outsourcing. Companies to momentarily increase their capacity to meet sudden surges in demand could use short-term rentals or leases. Changes in design could also be used in some situations to change a process allowing more product to flow through. If “excess capacity” is the problem, the company could rent out space or processing facilities until such time as needed in-house. A company would not want to be handicapped by only enough capacity to meet regular demand, balancing capacity with demand. Most companies need “wiggle room” in calculating capacity. 8. Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand
Discuss the value of creating “capacity” in smaller increments as opposed to one super- sized unit. Sometimes a company has the choice of investing in many smaller sized pieces of equipment or one expensive “efficient” super-sized piece of equipment. The large piece of equipment may seem most economical for capacity demands but could prove inflexible if demand decreases – and may not be suitable for other production processes if demand switches to a different type of product.
The choice of how to develop capacity is tied to a company’s strategy. If a company is pursuing a cost leadership strategy, the equipment that can produce large quantities for the lowest price is a better choice. Equipment that could be adapted for changing product features would be better for a company pursuing a product differentiation strategy.
- Explain how the choice of the denominator level affects the production-volume variance
Apply the saying that “inside the solution to one problem are other problems just waiting to get out” to the choice of a denominator-level capacity concept. Selecting a denominator-level capacity is necessary in using absorption costing under a normal or standard costing basis. Several good purposes are served by choosing a specific denominator-level amount. The ability to prepare external reports and to provide information on a timely basis through the use of a predetermined rate are two benefits of using specific denominator levels. The choice of one number as the denominator, however, creates the problems described in the text as to pricing, dealing with uncertainty, and performance evaluation, for example.
(From earlier edition of textbook)
- Depending on the business outlook, I would object strenuously because the $1,400,000 profit is represented by $1,400,000 share of fixed production costs (5/30 x $8,400,000). The $1,400,000 which was plowed into inventory is an asset only if it represents a future cost saving in the form of the lost profits on added sales that would otherwise be lost of increases in future production costs.
Income statement recast using variable costing: Sales, 25,000,000 x $2 $50,000, Variable costs: Variable production, 25,000,000 x $1 $25,000, Variable nonproduction, 25,000,000 x $0 12,500, Total variable costs 37,500, Contribution margin $12,500, Fixed costs: Fixed production $ 8,400, Fixed nonproduction 4,100,000 12,500, Operating income $ 0
The conventional statement as shown in the problem generally is not a proper basis for declaring bonuses. It does not seem right that we should be making profits by producing for inventory. Not only have we really made zero profits; we also must fork out a $140,000 bonus and pay income taxes. So this arrangement has resulted in a real loss instead of a profit.
a. No. As long as the company can meet its sales needs out of current production the fixed costs do not represent assets because no future savings are forthcoming. The loss situation will continue. b. No, for the same reason as (a). c. No, unless the present inventory really represents future cost savings which may offset the danger of increases in variable costs through time or of a permanent loss of sales. d. If the fixed costs continue and selling prices remain the same, the answer would be “no.” If the fixed costs do not continue and the regular selling price can be attained, the answer would be “yes.” e. Yes. If the 5,000,000 units were not held in stock, the future sales would be only 40,000,000 units. Therefore, the case for recognizing fixed costs as an asset is strong.
No. Tie bonus in with more factors, not conventional income alone. If I could not get the other board members to accept direct costing, I would try to hinge the bonus on board-approved budgeted figures.
If the board decided to continue with the same basic bonus arrangement, I would insist on having a maximum inventory level determinant so that fixed overhead related to production in excess of the maximum would be deducted from conventional net operating profit in bonus computations.
A discussion of incentive and risk considerations may also be desirable. The present bonus scheme encourages the executive to take heavy risks by building up inventories because the bonus is a direct function of reported income.
In contrast, an incentive (bonus) system tied directly to budgeted income would dampen the executive’s tendency to not abide by the directors’ wishes.
If absorption income for a one-year contract is used, the bonus formula could include an adjustment factor for inventory effects.
Ch09 Inventory Costing And Capacity Analysis
Course: Sciences Economiques et Gestion
University: Université Sidi Mohamed Ben Abdellah de Fès
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