1. CORNERSTONES of Managerial Accounting, 5e © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. CHAPTER 8: ABSORPTION AND VARIABLE COSTING, AND INVENTORY MANAGEMENT Cornerstones of Managerial Accounting, 5e © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Variable and Absorption Income Statements  Many companies consist of separate business units called profit centers.  It is important for these companies to determine both the overall performance of the business and the performance of the individual profit centers. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

4. Variable and Absorption Income Statements (cont.)  Therefore, it is important to develop a segmented income statement for each profit center.  Two methods of computing income have been developed:  one based on variable costing and  the other based on full or absorption costing. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

5. Absorption Costing  Absorption costing assigns all manufacturing costs to the product.  Direct materials, direct labor, variable overhead, and fixed overhead define the cost of a product.  Under this method, fixed overhead is assigned to the product through the use of a predetermined fixed overhead rate and is not expensed until the product is sold.  Fixed overhead is an inventoriable cost. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

6. Variable Costing  Variable costing stresses the difference between fixed and variable manufacturing costs.  Variable costing assigns only variable manufacturing costs to the product; these costs include direct materials, direct labor, and variable overhead. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Variable Costing (cont.)  Fixed overhead is treated as a period expense and is excluded from the product cost.  Under variable costing, fixed overhead of a period is seen as expiring that period and is charged in total against the revenues of the period. LO-1 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Comparison of Variable and Absorption Costing Methods  Generally accepted accounting principles (GAAP) require absorption costing for external reporting.  The Financial Accounting Standards Board (FASB), the Internal Revenue Service (IRS), and other regulatory bodies do not accept variable costing as a product-costing method for external reporting. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

9. Comparison of Variable and Absorption Costing Methods (cont.) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

10. Comparison of Variable and Absorption Costing Methods (cont.)  The only difference between the two approaches is the treatment of fixed factory overhead.  The unit product cost under absorption costing is always greater than the unit product cost under variable costing. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

11. Comparison of Variable and Absorption Costing Methods © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

12. Production, Sales, and Income Relationships  The relationship between variable-costing income and absorption-costing income changes as the relationship between production and sales changes. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

13. Production, Sales, and Income Relationships (cont.) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-1

14. Segmented Income Statements Using Variable Costing  Variable costing is useful in preparing segmented income statements because it gives useful information on variable and fixed expenses.  A segment is a subunit of a company of sufficient importance to warrant the production of performance reports. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-2

15. Segmented Income Statements Using Variable Costing (cont.)  Segments can be divisions, departments, product lines, customer classes, and so on.  In segmented income statements, fixed expenses are broken down into two categories:  direct fixed expenses and  common fixed expenses. LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Direct Fixed Expenses  Direct fixed expenses are fixed expenses that are directly traceable to a segment.  These are sometimes referred to as avoidable fixed expenses or traceable fixed expenses because they vanish if the segment is eliminated.  For example, if the segments were sales regions, a direct fixed expense for each region would be the rent for the sales office. LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Common Fixed Expenses  Common fixed expenses are jointly caused by two or more segments.  These expenses persist even if one of the segments to which they are common is eliminated.  Example: Depreciation on the corporate headquarters building or the salary of the CEO would be a common fixed expense for most large companies. LO-2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Decision Making for Inventory Management  Inventory can definitely affect operating income.  In addition to the product cost of inventory, there are other types of costs that relate to inventories of raw materials, work in process, and finished goods. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Inventory-Related Costs  If the inventory is a material or good purchased from an outside source, then these inventory- related costs are known as ordering costs and carrying costs. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Inventory-Related Costs (cont.)  If the material or good is produced internally, then the costs are called setup costs and carrying costs.  Ordering costs are the costs of placing and receiving an order.  Carrying costs are the costs of keeping and storing inventory.  Stockout costs are the costs of not having a product available when demanded by a customer or the cost of not having a raw material available when needed for production. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Economic Order Quantity: The Traditional Model  Once a company decides to carry inventory, two basic questions must be addressed:  How much should be ordered?  When should the order be placed?  In choosing an order quantity, managers need to be concerned only with ordering and carrying costs. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Economic Order Quantity: The Traditional Model  The formulas for calculating these are as follows: LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. The Economic Order Quantity  Maintaining an order quantity equal to the average inventory may not be the best choice. Some other order quantity may produce a lower total cost.  The objective is to find the order quantity that minimizes the total cost.  The number of units in the optimal size order quantity is called the economic order quantity (EOQ). LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. The Economic Order Quantity  Since EOQ is the quantity that minimizes total inventory-related costs, a formula for computing it is: © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-3

25. Reorder Point  Knowing when to place an order (or setup for production) is also an essential part of any inventory policy.  The reorder point is the point in time when a new order should be placed (or setup started).  It is a function of the EOQ, the lead time, and the rate at which inventory is used.  Lead time is the time required to receive the economic order quantity once an order is placed or a setup is started. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. Reorder Point (cont.)  Knowing the rate of usage and lead time allows us to compute the reorder point that accomplishes these objectives: Reorder point = Rate of usage x Lead time LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. Safety Stock  Safety stock is extra inventory carried to serve as insurance against changes in demand.  Safety stock is computed by multiplying the lead time by the difference between the maximum rate of usage and the average rate of usage: Safety stock = Maximum - Average x Lead time daily usage daily usage © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-3

28. Just-in-Time Approach to Inventory Management  The just-in-time (JIT) approach maintains that goods should be pulled through the system by present demand rather than being pushed through on a fixed schedule based on anticipated demand.  The material or subassembly arrives just in time for production to occur so that demand can be met.  Fast-food restaurants use this type of pull system. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO-3

29. Limitations of Just-in-Time Approach  JIT does have limitations.  It is often referred to as a program of simplification—yet this does not imply that JIT is simple or easy to implement.  It requires time for building sound relationships with suppliers. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. Limitations of Just-in-Time Approach (cont.)  Insisting on immediate changes in delivery times and quality may not be realistic and may cause difficult confrontations between a company and its suppliers.  Reductions in inventory buffers may cause a regimented workflow and high levels of stress among production workers.  It requires careful and thorough planning and preparation. LO-3 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.