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Chapter Eight Absorption and Variable Costing, and Inventory Management COPYRIGHT © 2012 Nelson Education Ltd.

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Presentation on theme: "Chapter Eight Absorption and Variable Costing, and Inventory Management COPYRIGHT © 2012 Nelson Education Ltd."— Presentation transcript:

1 Chapter Eight Absorption and Variable Costing, and Inventory Management COPYRIGHT © 2012 Nelson Education Ltd.

2 Learning Objectives 1.Explain the difference between absorption and variable costing 2.Prepare segmented income statements 3.Discuss inventory management under the economic order quantity and just-in-time (JIT) models 8-2

3 OBJECTIVE  1 1 Explain the difference between absorption and variable costing

4 COPYRIGHT © 2012 Nelson Education Ltd. Absorption Costing Income Statement Assigns all manufacturing costs to the product –direct materials –direct labour –variable overhead –fixed overhead Fixed overhead is applied to the product using a predetermined overhead rate Required by generally accepted accounting principles (GAAP) for external reporting 8-4

5 COPYRIGHT © 2012 Nelson Education Ltd. Variable Costing Income Statement Assigns only variable manufacturing costs to the product –direct materials –direct labour –variable overhead Fixed overhead is treated as a period expense 8-5

6 COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 8-1 Information: 8-6 Units in beginning inventory Units produced Units sold ($300 per unit) Variable costs per unit: Direct materials Direct labour Variable overhead Fixed costs: Fixed overhead per unit produced Fixed selling and administrative ,000 8,000 $50 $100 $50 $25 $100,000 How to Compute Inventory Cost under Absorption Costing

7 COPYRIGHT © 2012 Nelson Education Ltd. Example Required: 1.How many units are in ending inventory? 2.Using absorption costing, calculate the per- unit product cost 3.What is the value of ending inventory? 8-7

8 COPYRIGHT © 2012 Nelson Education Ltd. Example Units ending inventory Units beginning inventory Units produced Units sold = +– ,000 – 8,000 = = 2,

9 COPYRIGHT © 2012 Nelson Education Ltd. Absorption Costing Direct materials $ 50 Direct labour Variable overhead Fixed overhead Unit product cost $ Value of ending inventory =2,000 × $225 = $450,000 Per unit 8-9

10 COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 8-2 Information: Units in beginning inventory Units produced Units sold ($300 per unit) Variable costs per unit: Direct materials Direct labour Variable overhead Fixed costs: Fixed overhead per unit produced Fixed selling and administrative ,000 8,000 $50 $100 $50 $25 $100,000 How to Compute Inventory Cost under Variable Costing 8-10

11 COPYRIGHT © 2012 Nelson Education Ltd. Example Required: 1.How many units are in ending inventory? 2.Using variable costing, calculate the per- unit product cost 3.What is the value of ending inventory? 8-11

12 COPYRIGHT © 2012 Nelson Education Ltd. Example Units ending inventory Units beginning inventory Units produced Units sold = +– ,000 – 8,000 = = 2,

13 COPYRIGHT © 2012 Nelson Education Ltd. Variable Costing Direct materials Direct labour Variable overhead Unit product cost $ $200 Value of ending inventory =2,000 × $200 = $400,000 When inventory on hand exists, variable costing results in lower ending inventory than absorption costing Only variable costs 8-13

14 COPYRIGHT © 2012 Nelson Education Ltd. Absorption and Variable Costing DM DL Var OH Fixed OH DM DL Var OH Variable Costing Unit Cost Absorption Costing Unit Cost Absorption Costing includes Fixed Overhead in Unit Cost, Variable Costing does not 8-14

15 COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 8-3 Information: Units in beginning inventory Units produced Units sold ($300 per unit) Variable costs per unit: Direct materials Direct labour Variable overhead Fixed costs: Fixed overhead per unit produced Fixed selling and administrative ,000 8,000 $50 $100 $50 $25 $100,000 How to Prepare an Absorption-Costing Income Statement 8-15

16 COPYRIGHT © 2012 Nelson Education Ltd. Example Required: 1.Calculate the cost of goods sold under absorption costing 2.Prepare an income statement using absorption costing 8-16

17 COPYRIGHT © 2012 Nelson Education Ltd. Example Cost of goods sold Absorption unit product cost Units sold = × $225 = × 8,000 = $1,800,000 $50 + $100 + $50 + $

18 COPYRIGHT © 2012 Nelson Education Ltd. Fairchild Company Absorption-Costing Income Statement Sales ($300 × 8,000) Less: Cost of goods sold Gross Margin Less: Selling and administrative expenses $2,400,000 1,800,000 $ 600, ,000 Net Income$ 500,000 Fixed selling and administrative costs 8-18

19 COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 8-4 Information: Units in beginning inventory Units produced Units sold ($300 per unit) Variable costs per unit: Direct materials Direct labour Variable overhead Fixed costs: Fixed overhead per unit produced Fixed selling and administrative ,000 8,000 $50 $100 $50 $25 $100,000 How to Prepare a Variable-Costing Income Statement 8-19

20 COPYRIGHT © 2012 Nelson Education Ltd. Example Required: Calculate the cost of goods sold under variable costing 2.Prepare an income statement using variable costing

21 COPYRIGHT © 2012 Nelson Education Ltd. Example Cost of goods sold Variable unit product cost Units sold = × $200 = × 8,000 = $1,600,000 $50 + $100 + $

22 COPYRIGHT © 2012 Nelson Education Ltd. Fairchild Company Variable-Costing Income Statement Sales ($300 × 8,000) Less variable expenses: Variable cost of goods sold $2,400,000 1,600,000 Contribution margin $ 800,000 Less fixed expenses: Fixed overhead $250, ,000 Fixed selling and administrative 100,000 $ 450,000Net Income 8-22

23 COPYRIGHT © 2012 Nelson Education Ltd. Production, Sales, and Income Relationships If Production > Sales Production < Sales Production = Sales Then Absorption Income > Variable Income Absorption Income < Variable Income Absorption Income = Variable Income 8-23

24 OBJECTIVE  2 2 Prepare segmented income statements

25 COPYRIGHT © 2012 Nelson Education Ltd. Segmented Income Statements Segment is a subunit of a company –divisions –departments –product lines –customer classes Fixed expenses are broken down into two categories: –direct fixed expenses directly traceable to a segment –common fixed expenses jointly caused by two or more segments 25

26 COPYRIGHT © 2012 Nelson Education Ltd. Segment Margin Sales – Variable Cost of Goods Sold – Variable Selling Expense Contribution Margin – Direct fixed overhead – Direct selling and administrative Segment Margin 8-26

27 COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 8-5 Information: Sales Variable cost of goods sold Direct fixed overhead Sales commissions, 5% of sales Direct fixed selling and administrative expense estimated: ◦$10,000 for the MP3 line ◦$15,000 for the DVD line Common fixed overhead est., $100,000 Common selling and administrative est., $20, ,000 20,000 MP3 PlayersDVD Players $400,000$290, ,000 30,000 How to Prepare a Segmented Income Statement 8-27

28 COPYRIGHT © 2012 Nelson Education Ltd. Example Required: 28 Prepare a segmented income statement for Audiomatronics Inc. for the coming year, using variable costing

29 COPYRIGHT © 2012 Nelson Education Ltd. Audiomatronics Inc. Segmented Income Statement For the Coming Year Sales Variable cost of goods sold Variable selling expense (150,000) MP3 PlayersDVD Players $400,000$290,000 (200,000) (20,000) Total $690,000 (350,000) 5% × $290,000 (14,500) 8-29 Sales commissions = 5% of Sales 5% × $400,000

30 COPYRIGHT © 2012 Nelson Education Ltd. Audiomatronics Inc. Segmented Income Statement For the Coming Year Sales Variable cost of goods sold Variable selling expense (150,000) MP3 PlayersDVD Players $400,000$290,000 (200,000) (20,000) Total $690,000 (350,000) (14,500) Contribution Margin Less direct fixed expenses: Direct fixed overhead Direct selling & admin. (34,500) $180,000$125,500$305,500 (30,000)(20,000)(50,000) (10,000)(15,000)(25,000) $140,000$ 90,500 $230,500Segment margin Segment margin reflects only those costs directly related to the operation of the segment. Common costs are not included in the segment margin 8-30

31 COPYRIGHT © 2012 Nelson Education Ltd. Audiomatronics Inc. Segmented Income Statement For the Coming Year Sales Variable cost of goods sold Variable selling expense (150,000) MP3 PlayersDVD Players $400,000$290,000 (200,000) (20,000) Total $690,000 (350,000) (14,500) Contribution Margin Less direct fixed expenses: Direct fixed overhead Direct selling & admin. (34,500) $180,000$125,500$305,500 (30,000)(20,000)(50,000) (10,000)(15,000)(25,000) $140,000$ 90,500$230,500Segment margin Common fixed overhead Common selling & admin. Operating Income (100,000) (20,000) Less common fixed expenses: $110,

32 OBJECTIVE  3 3 Discuss inventory management under the economic order quantity and just-in-time (JIT) models

33 COPYRIGHT © 2012 Nelson Education Ltd. Ordering Costs Costs of placing and receiving an order Examples: –order processing costs –cost of insurance for shipment –unloading costs 8-33

34 COPYRIGHT © 2012 Nelson Education Ltd. Carrying Costs Costs of carrying inventory Examples: –insurance –inventory taxes –obsolescence –opportunity cost of funds ties up in inventory, handling costs, and storage space 8-34

35 COPYRIGHT © 2012 Nelson Education Ltd. Stockout Costs Occur when demand is not known Costs of not having: –product available when demanded by a customer –raw materials available when needed for production Examples: –lost sales –costs of expediting –costs of interrupted production 8-35

36 COPYRIGHT © 2012 Nelson Education Ltd. Traditional Reasons for Carrying Inventory To balance ordering or setup costs and carrying costs To satisfy customer demand To avoid shutting down manufacturing facilities because of: –Machine failure –Defective parts –Unavailable parts –Late delivery of parts To buffer against unreliable production processes To take advantage of discounts To hedge against future price increases 8-36

37 COPYRIGHT © 2012 Nelson Education Ltd. How to Calculate Ordering Cost, and Total Inventory-Related Cost Example: Cornerstone 8-6 Mall-o-Cars Inc. uses part X7B to repair water pumps –10,000 units of part X7B are used each year –currently purchased in lots of 1,000 units –cost of $25 to place an order –carrying cost is $2 per part per year Information: 8-37

38 COPYRIGHT © 2012 Nelson Education Ltd. Example 1.How many orders for Part X7B does Mall-o- Cars place per year? 2.What is the total ordering cost of Part X7B per year? 3.What is the total carrying cost of Part X7B per year? 4.What is the total cost of Mall-o-Car’s inventory policy for Part X7B per year? Required: 8-38

39 COPYRIGHT © 2012 Nelson Education Ltd. Example 1.Number of orders = Annual number of units used ÷ Number of units in an order = 10,000 / 1,000 = 10 orders per year 8-39

40 COPYRIGHT © 2012 Nelson Education Ltd. Example 2.Total ordering cost = Number of orders × Cost per order = 10 orders × $25 = $

41 COPYRIGHT © 2012 Nelson Education Ltd. Example 3.Total carrying cost Average number of units in inventory = (1,000/2) × $2 = $1,000 = × Cost of carrying one unit in inventory 8-41

42 COPYRIGHT © 2012 Nelson Education Ltd. Example 4.Total inventory-related cost Total ordering cost = $250 + $1,000 = $1,250 = + Total carrying cost 8-42

43 COPYRIGHT © 2012 Nelson Education Ltd. Economic Order Quantity (EOQ): The Traditional Inventory Model Number of units in the optimal size order Minimizes total inventory-related costs Formula: 2 × CO × D/CC Cost of placing one order Annual demand in units Cost of carrying one unit in inventory 8-43

44 COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 8-7 Mall-o-Cars Inc. uses Part X7B to repair water pumps –10,000 units of Part X7B are used each year –Currently purchased in lots of 1,000 units –Cost of $25 to place an order –Carrying cost is $2 per part per year Information: How to Calculate the EOQ 8-44

45 COPYRIGHT © 2012 Nelson Education Ltd. Example 1.What is the EOQ for Part X7B? 2.How many orders per year for Part X7B will Mall-o-Cars place under the EOQ policy? 3.What is the total annual ordering cost of Part X7B for a year under the EOQ policy? 4.What is the total annual carrying cost of Part X7B per year under the EOQ policy? 5.What is the total annual inventory-related cost for Part X7B under the EOQ? Required: 8-45

46 COPYRIGHT © 2012 Nelson Education Ltd. Example 1.Economic Order Quantity (EOQ) (2 × $25 × 10,000) /$2 = = 500,000/2 =500 units 8-46

47 COPYRIGHT © 2012 Nelson Education Ltd. Example 2.Number of orders = Annual number of units used / Number of units in an order = 10,000 / 500 = 20 orders per year 8-47

48 COPYRIGHT © 2012 Nelson Education Ltd. Example 3.Total ordering cost = Number of orders × Cost per order = 20 orders × $25 = $

49 COPYRIGHT © 2012 Nelson Education Ltd. Example 4.Total carrying cost = (500/2) × $2 = $500 Average number of units in inventory = × Cost of carrying one unit in inventory 8-49

50 COPYRIGHT © 2012 Nelson Education Ltd. Example 5.Total inventory-related cost = $500 + $500 = $1,000 Total ordering cost = + Total carrying cost 8-50

51 COPYRIGHT © 2012 Nelson Education Ltd. Reorder Point Point in time when a new order should be placed Function of: –EOQ –Lead time –Rate at which inventory is used Reorder point = Rate of usage × Lead time 8-51

52 COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 8-8 Mall-o-Cars Inc. uses Part X7B to repair water pumps –10,000 units of Part X7B are used each year –Used at a rate of 40 parts per day –Takes 5 days from time of order to arrival of order Information: HOW TO Calculate the Reorder Point Required: Calculate the reorder point 8-52

53 COPYRIGHT © 2012 Nelson Education Ltd. Example Reorder point = Daily usage × Lead time Reorder point = 40 × 5 days Reorder point =

54 COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 8-9 Mall-o-Cars Inc. uses Part X7B to repair water pumps –10,000 units of Part X7B are used each year –Used at an average rate of 40 parts per day But some days as many as 50 parts are used –Takes 5 days from the time of order to the arrival of the order Information: How to Calculate Safety Stock and the Reorder Point with Safety Stock 8-54

55 COPYRIGHT © 2012 Nelson Education Ltd. Example 1.Calculate the amount of safety stock 2.Calculate the reorder point with safety stock Required: 8-55

56 COPYRIGHT © 2012 Nelson Education Ltd. Example 1.Safety stock = (Maximum daily usage – Average daily usage) × lead time = (50 – 40) × 5 days =

57 COPYRIGHT © 2012 Nelson Education Ltd. Example 2.Reorder point = Maximum daily usage × lead time = 50 × 5 days = 250 = (Average daily usage × lead time) + Safety stock = (40 × 5 days) + 50 = 250 OR 8-57

58 COPYRIGHT © 2012 Nelson Education Ltd. Just-in-Time (JIT) Approach Goods pushed through the system by present demand rather than being pushed through on a fixed schedule based on anticipated demand Each operation produces only what is necessary to satisfy the demand of the succeeding operation Reduces all inventories to very low levels Reduces inventory carrying costs 8-58


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