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

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

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

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

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

Example: Cornerstone 8-1
How to Compute Inventory Cost under Absorption Costing Information: Units in beginning inventory ---- Units produced 10,000 Units sold (\$300 per unit) 8,000 Variable costs per unit: Direct materials \$50 Direct labour \$100 Variable overhead \$50 Fixed costs: Fixed overhead per unit produced \$25 Fixed selling and administrative \$100,000

Example How many units are in ending inventory?
Required: How many units are in ending inventory? Using absorption costing, calculate the per-unit product cost What is the value of ending inventory?

Example 10,000 8,000 2,000 Units beginning inventory
Units ending inventory Units produced Units sold = + 10,000 = + 8,000 2,000 =

Absorption Costing Direct materials \$ 50 Direct labour 100
Per unit Direct materials \$ 50 Direct labour 100 Variable overhead 50 Fixed overhead 25 Unit product cost \$225 Value of ending inventory = 2,000 × \$225 = \$450,000

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

Example How many units are in ending inventory?
Required: How many units are in ending inventory? Using variable costing, calculate the per-unit product cost What is the value of ending inventory?

Example 10,000 8,000 2,000 Units beginning inventory
Units ending inventory Units produced Units sold = + 10,000 = + 8,000 = 2,000

Variable Costing Direct materials \$ 50 Direct labour 100
\$ 50 Direct labour 100 Only variable costs Variable overhead 50 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

Absorption and Variable Costing
DM DM Variable Costing Unit Cost DL DL Absorption Costing Unit Cost Var OH Var OH Fixed OH Absorption Costing includes Fixed Overhead in Unit Cost, Variable Costing does not

Example: Cornerstone 8-3
How to Prepare an Absorption-Costing Income Statement Information: Units in beginning inventory ---- Units produced 10,000 Units sold (\$300 per unit) 8,000 Variable costs per unit: Direct materials \$50 Direct labour \$100 Variable overhead \$50 Fixed costs: Fixed overhead per unit produced \$25 Fixed selling and administrative \$100,000

Example Calculate the cost of goods sold under absorption costing
Required: Calculate the cost of goods sold under absorption costing Prepare an income statement using absorption costing

Absorption unit product cost
Example Absorption unit product cost Cost of goods sold = × Units sold = \$225 × 8,000 \$50 + \$100 + \$50 + \$25 \$1,800,000 =

Fairchild Company Absorption-Costing Income Statement
Sales (\$300 × 8,000) \$2,400,000 Less: Cost of goods sold 1,800,000 Gross Margin \$ 600,000 Less: Selling and administrative expenses 100,000 Net Income \$ 500,000 Fixed selling and administrative costs

Example: Cornerstone 8-4
How to Prepare a Variable-Costing Income Statement Information: Units in beginning inventory ---- Units produced 10,000 Units sold (\$300 per unit) 8,000 Variable costs per unit: Direct materials \$50 Direct labour \$100 Variable overhead \$50 Fixed costs: Fixed overhead per unit produced \$25 Fixed selling and administrative \$100,000

Example Calculate the cost of goods sold under variable costing
Required: Calculate the cost of goods sold under variable costing Prepare an income statement using variable costing

Variable unit product cost
Example Cost of goods sold Variable unit product cost = × Units sold = \$200 × 8,000 \$50 + \$100 + \$50 = \$1,600,000

Fairchild Company Variable-Costing Income Statement
Sales (\$300 × 8,000) \$2,400,000 Less variable expenses: Variable cost of goods sold 1,600,000 Contribution margin \$ 800,000 Less fixed expenses: Fixed overhead \$250,000 \$800,000: Only variable costs are subtracted. Subtotal is called Contribution Margin instead of Gross Margin \$250,000: \$25 x 10,000 Fixed overhead for all the units produced. None of the fixed overhead is carried in inventory Fixed selling and administrative 100,000 350,000 Net Income \$ 450,000

Production, Sales, and Income Relationships
If Then 1. Production > Sales Absorption Income > Variable Income 2. Production < Sales Absorption Income < Variable Income 3. Production = Sales Absorption Income = Variable Income

Prepare segmented income statements
OBJECTIVE  2 Prepare segmented income statements

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

Segment Margin Sales – Variable Cost of Goods Sold
– Variable Selling Expense Contribution Margin – Direct fixed overhead – Direct selling and administrative Segment Margin

Example: Cornerstone 8-5
How to Prepare a Segmented Income Statement Information: MP3 Players DVD Players Sales \$400,000 \$290,000 Variable cost of goods sold 200,000 150,000 Direct fixed overhead 30,000 20,000 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

Example Required: Prepare a segmented income statement for Audiomatronics Inc. for the coming year, using variable costing

Audiomatronics Inc. Segmented Income Statement For the Coming Year
MP3 Players DVD Players Total Sales \$400,000 \$290,000 \$690,000 Variable cost of goods sold (200,000) (150,000) (350,000) Variable selling expense (20,000) (14,500) 5% × \$290,000 Sales commissions = 5% of Sales 5% × \$400,000

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

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

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

Ordering Costs Costs of placing and receiving an order Examples:

Carrying Costs Costs of carrying inventory Examples: insurance
inventory taxes obsolescence opportunity cost of funds ties up in inventory, handling costs, and storage space

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

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

Example: Cornerstone 8-6
How to Calculate Ordering Cost, and Total Inventory-Related Cost Information: 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

Example How many orders for Part X7B does Mall-o-Cars place per year?
Required: How many orders for Part X7B does Mall-o-Cars place per year? What is the total ordering cost of Part X7B per year? What is the total carrying cost of Part X7B per year? What is the total cost of Mall-o-Car’s inventory policy for Part X7B per year?

= Annual number of units used ÷ Number of units in an order
Example Number of orders = Annual number of units used ÷ Number of units in an order = 10,000 / 1,000 = 10 orders per year

= Number of orders × Cost per order
Example Total ordering cost = Number of orders × Cost per order = 10 orders × \$25 = \$250

Example = Total carrying cost × Cost of carrying one unit in inventory
Average number of units in inventory = × = (1,000/2) × \$2 = \$1,000

Example Total inventory-related cost = Total ordering cost +
Total carrying cost = \$250 + \$1,000 = \$1,250

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

Example: Cornerstone 8-7
How to Calculate the EOQ Information: 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

Example Required: What is the EOQ for Part X7B?
How many orders per year for Part X7B will Mall-o-Cars place under the EOQ policy? What is the total annual ordering cost of Part X7B for a year under the EOQ policy? What is the total annual carrying cost of Part X7B per year under the EOQ policy? What is the total annual inventory-related cost for Part X7B under the EOQ?

Example Economic Order Quantity (EOQ) (2 × \$25 × 10,000) /\$2 500,000/2
= 500,000/2 = = 500 units

= Annual number of units used / Number of units in an order
Example Number of orders = Annual number of units used / Number of units in an order = 10,000 / 500 = 20 orders per year

= Number of orders × Cost per order
Example Total ordering cost = Number of orders × Cost per order = 20 orders × \$25 = \$500

Example Total carrying cost Cost of carrying one unit in inventory
Average number of units in inventory = × = (500/2) × \$2 = \$500

Example Total inventory-related cost = Total ordering cost +
Total carrying cost = \$ \$500 = \$1,000

Reorder point = Rate of usage × Lead time
Point in time when a new order should be placed Function of: EOQ Lead time Rate at which inventory is used Lead time: Time required to received the economic order quantity once an order is place or a setup is started Reorder point = Rate of usage × Lead time

Example: Cornerstone 8-8
HOW TO Calculate the Reorder Point Information: 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 Required: Calculate the reorder point

Reorder point = Daily usage × Lead time
Example Reorder point = Daily usage × Lead time Reorder point = 40 × 5 days Reorder point = 200

Example: Cornerstone 8-9
How to Calculate Safety Stock and the Reorder Point with Safety Stock Information: 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

Example Calculate the amount of safety stock
Required: Calculate the amount of safety stock Calculate the reorder point with safety stock

= (Maximum daily usage – Average daily usage)
Example Safety stock = (Maximum daily usage – Average daily usage) × lead time = (50 – 40) × 5 days = 50

Example Reorder point = Maximum daily usage × lead time = 50 × 5 days
= 250 = (Average daily usage × lead time) + Safety stock = (40 × 5 days) + 50 = 250

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