Inventory Costing and Capacity Analysis Cost Management (Horngren) Chapter 9 Inventory Costing and Capacity Analysis Chapter 9

Cost Management (Horngren) Chapter 9 Learning Objective 1 Identify what distinguishes variable costing from absorption costing.

Inventory-Costing Methods Cost Management (Horngren) Chapter 9 Inventory-Costing Methods The difference between variable costing and absorption costing is based on the treatment of fixed manufacturing overhead.

Cost Management (Horngren) Chapter 9 Variable Costing Direct Materials Variable Factory Labor Variable Overhead Work in Process Inventory

Cost Management (Horngren) Chapter 9 Variable Costing Work in Process Inventory Finished Goods Inventory Fixed Factory Labor Cost of Goods Sold Income Summary

Cost Management (Horngren) Chapter 9 Learning Objective 2 Prepare income statements under absorption costing and variable costing.

Comparing Income Statements Cost Management (Horngren) Chapter 9 Comparing Income Statements The following data pertain to Davenport Fixtures: Year 1 Year 2 Total Beginning inventory -0- 2,000 -0- Produced 10,000 11,500 21,500 Sold 8,000 13,000 21,000 Ending inventory 2,000 500 500

Comparing Income Statements Cost Management (Horngren) Chapter 9 Comparing Income Statements The following information is on a per unit basis: Sales price: $71.00 Variable manufacturing costs: Direct materials: $ 4.00 Direct manufacturing labor: $21.00 Indirect manufacturing costs: $24.00 Fixed manufacturing costs: $ 4.50

Comparing Income Statements (Absorption Costing) Cost Management (Horngren) Chapter 9 Comparing Income Statements (Absorption Costing) Total fixed production costs are $54,000 at a normal capacity of 12,000 units. Fixed nonmanufacturing costs are $30,000 per year. Variable nonmanufacturing costs are $2.00 per unit sold.

Comparing Income Statements (Absorption Costing) Cost Management (Horngren) Chapter 9 Comparing Income Statements (Absorption Costing) Revenues $568,000 Cost of goods sold 428,000 Volume variance (U) 9,000 Gross margin $131,000 Nonmanufacturing costs 46,000 Operating income $ 85,000

Comparing Income Statements (Variable Costing) Cost Management (Horngren) Chapter 9 Comparing Income Statements (Variable Costing) Revenues for Year 1 are $568,000. What is the variable cost of goods sold? 8,000 × $49 = $392,000 What is the manufacturing contribution margin? $568,000 – $392,000 = $176,000 Net contribution margin = $160,000

Comparing Income Statements (Variable Costing) Cost Management (Horngren) Chapter 9 Comparing Income Statements (Variable Costing) Revenues $568,000 Variable cost of goods sold 392,000 Variable nonmanufacturing costs 16,000 Contribution margin $160,000 Fixed manufacturing costs 54,000 Fixed nonmanufacturing costs 30,000 Operating income $ 76,000

Cost Management (Horngren) Chapter 9 Learning Objective 3 Explain differences in operating income under absorption costing and variable costing.

Operating Income (Absorption Costing) Cost Management (Horngren) Chapter 9 Operating Income (Absorption Costing) What are revenues for Year 2? 13,000 × $71 = $923,000 What is the cost of goods sold? 13,000 × $53.50 = $695,500 Is there a volume variance? (12,000 – 11,500) × $4.50 = $2,250 underallocated fixed manufacturing costs

Operating Income (Absorption Costing) Cost Management (Horngren) Chapter 9 Operating Income (Absorption Costing) What is the gross margin? $923,000 – ($695,500 + $2,250) = $225,250 What are the nonmanufacturing costs? 13,000 units sold × $2.00 = $26,000 variable costs + $30,000 fixed costs = $56,000

Operating Income (Absorption Costing) Cost Management (Horngren) Chapter 9 Operating Income (Absorption Costing) What is the operating income before taxes? $225,250 – $56,000 = $169,250 What is the operating income for the two years combined? $85,000 + $169,250 = $254,250

Income Statements (Absorption Costing) Cost Management (Horngren) Chapter 9 Income Statements (Absorption Costing) Year 1 Year 2 Combined Revenues $568,000 $923,000 $1,491,000 Cost of goods sold 428,000 695,500 1,123,500 Volume variance (U) 9,000 2,250 11,250 Gross margin $131,000 $225,250 $ 356,250 Nonmfg. costs 46,000 56,000 102,000 Operating income $ 85,000 $169,250 $ 254,250

Operating Income (Variable Costing) Cost Management (Horngren) Chapter 9 Operating Income (Variable Costing) Revenues for Year 2 are $923,000. What is the cost of goods sold? 13,000 × $49 = $637,000 What is the manufacturing contribution margin? $923,000 – $637,000 = $286,000

Operating Income (Variable Costing) Cost Management (Horngren) Chapter 9 Operating Income (Variable Costing) What is the net contribution margin? $286,000 – $26,000 variable nonmanufacturing costs = $260,000 net contribution margin What is the operating income before taxes? $260,000 – $54,000 fixed manufacturing costs – $30,000 fixed nonmanufacturing costs = $176,000

Income Statements (Variable Costing) Cost Management (Horngren) Chapter 9 Income Statements (Variable Costing) Year 1 Year 2 Combined Revenues $568,000 $923,000 $1,491,000 Cost of goods sold 392,000 637,000 1,029,000 Mfg. contr. margin $176,000 $286,000 $ 462,000 Variable nonmfg. 16,000 26,000 42,000 Net contr. margin $160,000 $260,000 $ 420,000 Fixed mfg. costs 54,000 54,000 108,000 Fixed nonmfg. costs 30,000 30,000 60,000 Operating income $ 76,000 $176,000 $ 252,000

Comparison of Variable and Absorption Costing Cost Management (Horngren) Chapter 9 Comparison of Variable and Absorption Costing Variable costing operating income Year 1: $76,000 Absorption costing operating income Year 1: $85,000 Absorption costing operating income is $9,000 higher. Why?

Comparison of Variable and Absorption Costing Cost Management (Horngren) Chapter 9 Comparison of Variable and Absorption Costing Production exceeds sales in Year 1. The 2,000 units in ending inventory are valued as follows: Absorption costing: 2,000 × $53.50 = $107,000 Variable costing: 2,000 × $49.00 = $ 98,000 Difference: $ 9,000

Comparison of Variable and Absorption Costing Cost Management (Horngren) Chapter 9 Comparison of Variable and Absorption Costing Variable costing operating income Year 2: $176,000 Absorption costing operating income Year 2: $169,250 Variable costing operating income is $6,750 higher. Why?

Comparison of Variable and Absorption Costing Cost Management (Horngren) Chapter 9 Comparison of Variable and Absorption Costing Sales exceeded units produced in Year 2. 13,000 – 11,500 = 1,500 decrease in inventory Absorption costing: 1,500 × $53.50 = $80,250 Variable costing: 1,500 × $49.00 = $73,500 Higher cost of goods sold under absorption costing: $ 6,750

Comparison of Variable and Absorption Costing Cost Management (Horngren) Chapter 9 Comparison of Variable and Absorption Costing Variable costing combined net income: $252,000 Absorption costing combined net income: $254,250 Absorption costing is higher by $2,250 500 units in inventory × $4.50 = $2,250

Comparison of Variable and Absorption Costing Cost Management (Horngren) Chapter 9 Comparison of Variable and Absorption Costing Absorption costing operating income – Variable costing operating income EQUALS Fixed manufacturing costs in ending inventory under absorption costing – Fixed manufacturing costs in beginning inventory under absorption costing

Cost Management (Horngren) Chapter 9 Learning Objective 4 Understand how absorption costing can provide undesirable incentives for managers to build up finished goods inventory.

Cost Management (Horngren) Chapter 9 Inventory Buildup Assume that Davenport Fixtures produced 4,400 units in Year 1 and sold 4,100. What is the production volume variance? (12,000 – 4,400) × $4.50 = $34,200 U What is the net operating income or loss for the period?

Cost Management (Horngren) Chapter 9 Inventory Buildup Revenues (4,100 × $71) $291,100 Cost of goods sold (4,100 × $53.50) 219,350 Volume variance 34,200 Gross margin $ 37,550 Nonmanufacturing costs 38,200 Net loss ($ 650)

Cost Management (Horngren) Chapter 9 Inventory Buildup How many units are in ending inventory? 4,400 – 4,100 = 300 How much cost is in ending inventory? 300 × $53.50 = $16,050

Cost Management (Horngren) Chapter 9 Inventory Buildup Suppose that management decides to produce 9,000 units next year. Sales remain the same (4,100 units). What is the volume variance? (12,000 – 9,000) × $4.50 = $13,500 U What is the operating income or loss?

Cost Management (Horngren) Chapter 9 Inventory Buildup Revenues (4,100 × $71) $291,100 Cost of goods sold (4,100 × $53.50) 219,350 Volume variance 13,500 Gross margin $ 58,250 Nonmanufacturing costs 38,200 Net income $ 20,050

Cost Management (Horngren) Chapter 9 Inventory Buildup How many units are in ending inventory? 300 + 9,000 – 4,100 = 5,200 How much cost is in ending inventory? 5,200 × $53.50 = $278,200

Reducing Undesirable Effects Cost Management (Horngren) Chapter 9 Reducing Undesirable Effects Careful budgeting procedures Change in accounting system Carrying charge for inventory Longer evaluation period Nonfinancial measures of performance

Cost Management (Horngren) Chapter 9 Learning Objective 5 Differentiate throughput costing from variable costing and absorption costing.

Cost Management (Horngren) Chapter 9 Throughput Costing Revenues $568,000 Variable direct materials cost of goods sold 32,000 Throughput contribution margin $536,000 Manufacturing costs 504,000 Nonmanufacturing costs 46,000 Operating loss ($ 14,000)

Cost Management (Horngren) Chapter 9 Throughput Costing Manufacturing Costs: Labor $21.00 × 10,000 $210,000 Indirect costs $24.00 × 10,000 240,000 Fixed costs 54,000 Total manufacturing costs $504,000 What are other nonmanufacturing costs for the year?

Cost Management (Horngren) Chapter 9 Throughput Costing Nonmanufacturing Costs: Variable $2.00 × 8,000 $16,000 Fixed 30,000 Total $46,000

Cost Management (Horngren) Chapter 9 Throughput Costing Variable costing operating income: $76,000 Throughput costing operating loss: ($14,000) Difference in operating income: $90,000 How can this difference be explained?

Cost Management (Horngren) Chapter 9 Throughput Costing The 2,000 units in ending inventory are valued as follows: Variable 2,000 × $49 = $98,000 Throughput 2,000 × $4 = $8,000 $90,000 difference

Cost Management (Horngren) Chapter 9 Throughput Costing Absorption costing operating income: $85,000 Throughput costing operating loss: ($14,000) Difference in operating income: $99,000 How can this difference be explained?

Cost Management (Horngren) Chapter 9 Throughput Costing The 2,000 units in ending inventory are valued as follows: Absorption 2,000 × $53.50 = $107,000 Throughput 2,000 × $4 = $8,000 $99,000 difference

Comparison of Inventory Costing Methods Cost Management (Horngren) Chapter 9 Comparison of Inventory Costing Methods Actual Costing Variable Costing Absorption Costing Throughput Costing

Comparison of Inventory Costing Methods Cost Management (Horngren) Chapter 9 Comparison of Inventory Costing Methods Normal Costing Variable Costing Absorption Costing Throughput Costing

Comparison of Inventory Costing Methods Cost Management (Horngren) Chapter 9 Comparison of Inventory Costing Methods Standard Costing Variable Costing Absorption Costing Throughput Costing

Cost Management (Horngren) Chapter 9 Learning Objective 6 Describe the various capacity concepts that can be used in absorption costing.

Alternative Denominator-Level Concepts Cost Management (Horngren) Chapter 9 Alternative Denominator-Level Concepts Theoretical capacity Practical capacity Normal capacity Master-budget capacity

Budgeted Fixed Manufacturing Overhead Rate Cost Management (Horngren) Chapter 9 Budgeted Fixed Manufacturing Overhead Rate Lloyd’s Bicycles produces bicycle parts for domestic and foreign markets. Fixed overhead costs are $200,000 within the relevant range of the various capacity volume.

Budgeted Fixed Manufacturing Overhead Rate Cost Management (Horngren) Chapter 9 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?

Budgeted Fixed Manufacturing Overhead Rate Cost Management (Horngren) Chapter 9 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

Cost Management (Horngren) Chapter 9 Learning Objective 7 Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate.

Choosing a Capacity Level Cost Management (Horngren) Chapter 9 Choosing a Capacity Level What factors are considered in choosing a capacity level? Product costing Pricing decision Performance evaluation Financial statements Regulatory requirements Difficulty

Cost Management (Horngren) Chapter 9 Decision Making Assume that Lloyd’s Bicycles’ standard hours are 2 hours per unit. What is the budgeted fixed manufacturing overhead cost per unit?

Cost Management (Horngren) Chapter 9 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

Cost Management (Horngren) Chapter 9 Learning Objective 8 Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand.

Downward Demand Spiral Cost Management (Horngren) Chapter 9 Downward Demand Spiral The downward demand spiral is the continuing reduction in demand that occurs when the prices of competitors are not met and demand drops.

Cost Management (Horngren) Chapter 9 Learning Objective 9 Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects the production-volume variance.

Effect on Financial Statements Cost Management (Horngren) Chapter 9 Effect on Financial Statements Assume that Lloyd’s Bicycles actually used 8,400 machine-hours during the year. What is the production volume variance?

Production Volume Variance Cost Management (Horngren) Chapter 9 Production Volume Variance Production volume variance = (Denominator level – Actual level) × Budgeted fixed manufacturing overhead rate Theoretical capacity: (10,000 – 8,400) × $20.00 = $32,000 U Practical capacity: (8,500 – 8,400) × $23.53 = $2,353 U

Production Volume Variance Cost Management (Horngren) Chapter 9 Production Volume Variance Normal capacity: (7,500 – 8,400) × $26.67 = $24,003 Master-budget capacity: (6,000 – 8,400) × $33.33 = $79,992

End of Variable Costing Cost Management (Horngren) Chapter 9 End of Variable Costing