2009 Foster School of Business Cost Accounting L.DuCharme 1 Inventory Costing and Capacity Analysis Chapter 9

2009 Foster School of Business Cost Accounting L.DuCharme 2 OverviewChapter 9 Inventory Costing Methods Denominator Issues Example: working backwards BEPs: VC versus AC Solution to extra problem (on webpage)

2009 Foster School of Business Cost Accounting L.DuCharme 3 Absorption Costing All manufacturing cost are considered inventoriable: –All variable mfg. costs (both direct & indirect) –All fixed mfg. costs (both direct & indirect) Separates costs by business function. Other costing terms: (1)Super-full absorption costing: includes some mfg. related admin costsused for tax. (2)Full-product costing: costs from all areas of value chain are attached to product costsfor L-T pricing.

2009 Foster School of Business Cost Accounting L.DuCharme 4 Variable Costing All variable manufacturing costs are considered inventoriable. Separates costs by cost behavior. Some managers call this direct costing which is a poor choice of name. Why?

2009 Foster School of Business Cost Accounting L.DuCharme 5 Throughput Costing Also called super-variable costing. Only variable direct materials are inventoriable. Assumes that only DM are variable in the short run. Reduces incentives to build up inventories. Relatively new and not widely used.

2009 Foster School of Business Cost Accounting L.DuCharme 6 STOP! The big picture Managers make a number of accounting choices that affect income, for example: Costing Systems Fixed Mfg. Costs Flow of Costs ActualACJobFIFO NormalVCProcessLIFO StandardTputAvg. OtherSpecific I.D. Standard Retail

2009 Foster School of Business Cost Accounting L.DuCharme 7 Inventory-Costing Methods The difference between variable costing and absorption costing is based on the treatment of fixed manufacturing costs. AC includes fixed mfg. costs in cost of inventory, while VC does not. VC expenses all fixed costs as period costs.

2009 Foster School of Business Cost Accounting L.DuCharme 8 Comparing Income Statements: Absorption vs. Variable Costing The following data pertain to Davenport Pencils: Produce one product: #2 pencils. 1 box = 1 gross. Sales price = $8/box; Sold 40,000 boxes DM = $3 / box; DL = $0.50 / box VMOH = $0.25 / box FMOH = $100,000 / year Sales commission = $0.75 / box Fixed admin. expenses = $30,000 / year Budget = actual production = 50,000 boxes

2009 Foster School of Business Cost Accounting L.DuCharme 9 Comparing Income Statements What is the cost per box under VC? $ = $3.75 What is the cost per box under AC? $ * = $5.75 * Fixed mfg. OH rate = $2.00 / box = $100,000 / 50,000 boxes

2009 Foster School of Business Cost Accounting L.DuCharme 10 Comparing Income Statements Absorption Costing Revenue$320,000 CoGS230,000 GM90,000 S&A60,000 Op. Inc.$ 30,000 Variable Costing Revenue$320,000 VC180,000 CM 140,000 FC130,000 Op. Inc.$ 10,000

2009 Foster School of Business Cost Accounting L.DuCharme 11 Comparison of Variable and Absorption Costing Variable costing operating income : $10,000 Absorption costing operating income : $30,000 Absorption costing operating income is $20,000 higher. Why?

2009 Foster School of Business Cost Accounting L.DuCharme 12 Comparison of Variable and Absorption Costing Production exceeds sales. The 10,000 unit increase in ending inventory are valued as follows: Absorption costing: 10,000 × $5.75 =$ 57,500 Variable costing: 10,000 × $3.75 =$ 37,500 Difference:$ 20,000

2009 Foster School of Business Cost Accounting L.DuCharme 13 Comparison of Variable and Absorption Costing COGS Absorption costing: 40,000 X $5.75 = $230,000 Variable costing: 40,000 X $3.75 = $150,000 Plus all the fixed mfg. OH = $100,000 Lower costs recognized under absorption costing: $ 20,000

2009 Foster School of Business Cost Accounting L.DuCharme 14 Comparison of Variable and Absorption Costing Under absorption costing, each of the additional 10,000 boxes in ending inventory is storing $2/box cost that will be expensed later when sold. 10,000 units of inventory × $2.00 = $20,000

2009 Foster School of Business Cost Accounting L.DuCharme 15 Comparison of Variable and Absorption Costing Absorption costing operating income Variable costing operating income Fixed manufacturing costs in ending inventory under absorption costing Fixed manufacturing costs in beginning inventory under absorption costing – EQUALS –

2009 Foster School of Business Cost Accounting L.DuCharme 16 Absorption Costing & Inventory Buildup How might you mitigate the incentive to build up inventory? What happens over the long run?

2009 Foster School of Business Cost Accounting L.DuCharme 17 Alternative Denominator-Level Concepts Theoretical capacity Practical capacity Normal capacity Master-budget capacity

2009 Foster School of Business Cost Accounting L.DuCharme 18 Budgeted Fixed Manufacturing Overhead Rate Lloyds Bicycles produces bicycle parts for domestic and foreign markets. Fixed overhead costs are $200,000 within the relevant range of the various capacity volume.

2009 Foster School of Business Cost Accounting L.DuCharme 19 Budgeted Fixed Manufacturing Overhead Rate Assume that the theoretical capacity is 10,000 machine-hours, practical capacity is 85%, normal capacity is 75%, and master-budget capacity is 60%. What is the budgeted fixed manufacturing overhead rate at the various capacity levels?

2009 Foster School of Business Cost Accounting L.DuCharme 20 Budgeted Fixed Manufacturing Overhead Rate Theoretical 100%: $200,000 ÷ 10,000 = $20.00/machine-hour Practical 85%: $200,000 ÷ 8,500 = $23.53/machine-hour Normal 75%: $200,000 ÷ 7,500 = $26.67/machine-hour Master-budget 60%: $200,000 ÷ 6,000 = $33.33/machine-hour

2009 Foster School of Business Cost Accounting L.DuCharme 21 Effect of Denominator Level Choice The larger the denominator level, the: –Lower the budgeted FM rate. –Lower Fixed Mfg. costs in E.Inv. –Higher the unfavorable PVV for fixed OH RememberFixed mfg. are either expensed in the period or stored in E.Inv. What denominator level would you want to use for tax purposes? [practical is required for tax]

2009 Foster School of Business Cost Accounting L.DuCharme 22 Decision Making Assume that Lloyds Bicycles standard hours are 2 hours per unit. What is the budgeted fixed manufacturing overhead cost per unit?

2009 Foster School of Business Cost Accounting L.DuCharme 23 Decision Making Theoretical capacity: $20 × 2 = $40.00 Practical capacity: $23.53 × 2 = $47.06 Normal capacity: $26.67 × 2 = $53.34 Master-budget capacity: $33.33 × 2 = $66.66

2009 Foster School of Business Cost Accounting L.DuCharme 24 Exerciseworking backward QQQ Company has op. income of $120,000 under absorption costing, and op. income would be $100,000 under variable costing. FMOH = $500,000 Budgeted and actual production = 200,000 units. Did inventory increase or decrease during the period? By how much?

2009 Foster School of Business Cost Accounting L.DuCharme 25 In-class problem Answer depends on the FMOH rate for B.Inv and choice of inventory cost-flow method (FIFO, WA, LIFO, etc.). Assume no change in FMOH rate. Then choice of cost-flow method does not matter. FMOH rate = $500k / 200k = $2.50 / unit

2009 Foster School of Business Cost Accounting L.DuCharme 26 Calculation of BE points Unique solution under Variable Costing: BEPvc = Total FC / UCM Solution depends on production level under Absorption Costing: BEPac = [Total FC + (FM rate* (BEPac – Units Produced))] / UCM BEPac = [Total FC – (FMR*UP)] / (UCM – FMR) What happens to the BEP when more units are produced?