1. Inventory Costing and Capacity Analysis
CHAPTER 9
Inventory Costing
and
Capacity Analysis

2. Chapter 9 learning objectives
Identify what distinguishes variable costing from absorption costing
Compute income under variable costing and absorption costing and explain the difference in income
Understand how absorption costing can provide undesirable incentives for managers to build up inventory
Differentiate throughput costing from variable costing and absorption costing
In chapter 9, we’ll be studying inventory costing and capacity analysis concepts. Here are the first 4 of our 7 learning objectives:
Identify what distinguishes variable costing from absorption costing
Compute income under variable costing and absorption costing and explain the difference in income
Understand how absorption costing can provide undesirable incentives for managers to build up inventory
Differentiate throughput costing from variable costing and absorption costing

3. Chapter 9 learning objectives, concluded
Describe the various capacity concepts that firms can use in absorption costing
Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate
Understand other issues that play an important role in capacity planning and control
Here are the final 3 learning objectives:
Describe the various capacity concepts that firms can use in absorption costing
Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate
Understand other issues that play an important role in capacity planning and control

4. Chapter focus: inventory- denominator- costing level capacity
The inventory costing system that is chosen determines which manufacturing costs are treated as inventoriable costs.
The denominator- level capacity choice focuses on the cost allocation base used to set budgeted fixed manufacturing cost rates.
Our two major topics in this chapter include inventory costing options and capacity level issues. We’ll take a brief look at both and we’ll then look more closely first at Inventory costing options.
The inventory costing system that is chosen determines which manufacturing costs are treated as inventoriable costs.
The denominator level capacity choice focuses on the cost allocation base used to set budgeted fixed manufacturing cost rates.

5. Inventory Costing Choices: Overview
Variable costing—a method of inventory costing in which all variable manufacturing costs (direct and indirect) are included as inventoriable costs. (Also known as direct costing)
Absorption costing—a method of inventory costing in which all variable and fixed manufacturing costs are included as inventoriable costs. You can say that inventory “absorbs” all manufacturing costs.
Throughput costing—only direct materials are capitalized; all other costs are expensed.
There are three inventory costing choices. They are:
Variable costing—a method of inventory costing in which all variable manufacturing costs (direct and indirect) are included as inventoriable costs. (Also known as direct costing though that is somewhat imprecise since the method includes variable manufacturing overhead as an inventoriable cost.)
Absorption costing—a method of inventory costing in which all variable and fixed manufacturing costs are included as inventoriable costs. You can say that inventory “absorbs” all manufacturing costs.
Throughput costing—only direct materials are capitalized; all other costs are expensed.

6. Inventory costing: Differences in Income
Operating income will differ between absorption and variable costing.
The amount of the difference represents the amount of fixed manufacturing costs capitalized as inventory under absorption costing and expensed as a period cost under variable costing.
If inventory levels change, operating income will differ between the two methods because of the difference in accounting for fixed manufacturing costs.
If inventory levels change, operating income will differ between the two methods because of the difference in accounting for fixed manufacturing costs.
The amount of the difference represents the amount of fixed manufacturing costs capitalized as inventory under absorption costing, and expensed as a period costs under variable costing.

7. Comparative Income Statements
This Exhibit highlights the differences between the two methods. Panel A calculates operating income under variable costing and panel B under absorption costing.
The variable costing format uses the contribution margin format introduced in chapter 3 while the absorption-costing income statement uses the gross margin format introduced in chapter 2.
The distinction between variable costs and fixed costs is central to variable costing and is highlighted in the contribution margin format.
Similarly, the distinction between manufacturing and nonmanufacturing costs is central to absorption costing and it is highlighted by the gross-margin format. Exhibit 9-1 page 332

8. Comparing income statements for multiple years
In this exhibit, we have two years of income statements under each costing system. Panel A again showing Variable costing and Panel B Absorption costing. The values you see for 2014 are the same as the previous slide.
There is a similarity between these two years but note the following in 2015:
Fixed cost rate of $135 is based on a budgeted denominator capacity level of 8,000
In 2015, production was only 5,000 creating a production volume variance of $135 x 3000 or $405,000
Under variable costing, fixed costs are expensed as incurred and no production volume variance exists.
Exhibit 9-2 page 334

9. Comparative income effects variable and absorption costing
Here we have a summary of the comparative income effects between the two costing systems including explanatory comments. Exhibit 9-3 page 337

10. Absorption Costing and Performance measurement
Absorption costing is the required inventory method for external financial reporting in most countries. Also preferred because:
It is cost-effective and less confusing.
It can help prevent managers from taking actions that make their performance measure look good but that hurt the income they report to shareholders.
It measures the cost of all manufacturing resources (variable or fixed) necessary to produce inventory.
Absorption costing is the required inventory method for external financial reporting in most countries. Also preferred because:
It is cost-effective and less confusing
It can help prevent managers from taking actions that make their performance measure look good
It measures the cost of all manufacturing resources (variable or fixed) necessary to produce inventory

11. Absorption Costing and Performance measurement, concluded
One unfavorable attribute of absorption costing is that it enables managers to increase margins and, therefore, operating income, by producing more ending inventory.
Producing for inventory can be justified when rapid growth is forecasted, but should not be undertaken simply to boost profits.
To reduce an undesirable buildup of inventory, companies can use variable costing for internal reporting purposes including performance measurement.
One unfavorable attribute of absorption costing is that it enables managers to increase margins and, therefore, operating income, by producing more ending inventory.
Producing for inventory can be justified when rapid growth is forecasted, but should not be undertaken simply to boost profits.
To reduce an undesirable buildup of inventory, companies can use variable costing for internal reporting purposes including performance measurement.

12. Proposals for revising performance evaluation
To reduce the undesirable effects of absorption costing, management can:
Focus on careful budgeting and inventory planning.
Incorporate an internal carrying charge for inventory
Change (lengthen) the period used to evaluate performance.
Include nonfinancial as well as financial variables in the measures to evaluate performance. (compare ratio of ending/beginning inventory to ratio of units produced/sold)
To reduce the undesirable effects of absorption costing, management can:
Focus on careful budgeting and inventory planning
Incorporate an internal carrying charge for inventory
Change (lengthen) the period used to evaluate performance
Include nonfinancial as well as financial variables in the measures to evaluate performance (compare ratio of ending/beginning inventory to ratio of units produced/sold)

13. Extreme Variable Costing: Throughput Costing
Throughput costing (super-variable costing) is a method of inventory costing in which only direct material costs are included as inventory costs. All other product costs are treated as period expenses.
Throughput margin equals revenues minus all direct material cost of the goods sold.
Some managers believe that even variable costing promotes an excessive amount of costs being inventoried.
Throughput costing (super-variable costing) is a method of inventory costing in which only direct material costs are included as inventory costs. All other product costs are treated as period expenses.
Throughput margin equals revenues minus all direct material cost of the goods sold

14. Throughput Costing Illustrated
Here we see an income statement using throughput costing.
As is shown, only direct materials are subtracted from revenues to calculate throughput margin. All other costs (variable or fixed) are subtracted to obtain operating income. Exhibit 9-5 page 341

15. Costing Systems Compared
In this slide, we have a comparison of variable and absorption costing as would be calculated under the actual costing, normal costing or standard costing systems.
As a result, we have a combination of six alternative inventory-costing systems.
Accountants, and others, disagree about which costs should be expensed and which inventoried.
For external reporting to shareholders, companies around the globe tend to follow the generally accepted accounting principle that all manufacturing costs are inventoriable. Exhibit 9-6 page 342

16. Concludes inventory costing; begin capacity concepts
We have concluded the discussion of inventory costing and will begin capacity analysis. Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit?
We have concluded the discussion of inventory costing and will begin capacity analysis.
Recall from an earlier slide that the key question regarding capacity concepts is: Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit?

17. Denominator level capacity-overview
Spending on fixed manufacturing costs enables firms to obtain the scale or capacity needed to satisfy the expected market demand from customers. Determining the “right” amount of spending, or the appropriate level of capacity, is one of the most strategic and most difficult decisions managers face.
The key question regarding denominator level capacity is this:
Given a firm’s level of spending on fixed manufacturing costs, what capacity level should managers and accountants use to compute the fixed manufacturing cost per unit?

18. Denominator level capacity concepts
Spending on fixed manufacturing costs enables firms to obtain the scale or capacity needed to satisfy the expected market demand from customers. Determining the “right” amount of spending, or the appropriate level of capacity, is one of the most strategic and most difficult decisions managers face. Too much capacity means firms will incur the cost of unused capacity; having too little means that demand from some customers may be unfulfilled.
Spending on fixed manufacturing costs enables firms to obtain the scale or capacity needed to satisfy the expected market demand from customers. Determining the “right” amount of spending, or the appropriate level of capacity, is one of the most strategic and most difficult decisions managers face.
Too much capacity means firms will incur the cost of unused capacity; having too little means that demand from some customers may be unfulfilled.

19. Capacity levels
The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly affect operating income.
Four different capacity levels can be used as the denominator to compute the budgeted fixed manufacturing cost rate:
Theoretical capacity
Practical capacity
Normal capacity utilization
Master-budget capacity utilization
The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly affect operating income.
Four different capacity levels can be used as the denominator to compute the budgeted fixed manufacturing cost rate:
Theoretical capacity
Practical capacity
Normal capacity utilization
Master-budget capacity utilization

20. Theoretical capacity
Theoretical capacity is the level of capacity based on producing at full efficiency all the time.
It is theoretical in the sense that it does not allow for any slowdowns due to plant maintenance, shutdown periods or interruptions because of downtime.
In the real world, theoretical capacity levels are unattainable but they represent the ideal goal of capacity utilization a company can aspire to.
Theoretical capacity is the level of capacity based on producing at full efficiency all the time.
It is theoretical in the sense that it does not allow for any slowdowns due to plant maintenance, shutdown periods or interruptions because of downtime.
In the real world, theoretical capacity levels are unattainable but they represent the ideal goal of capacity utilization a company can aspire to.

21. Practical capacity
Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions like maintenance and holiday shutdowns. Engineering and human resource factors are important when estimating theoretical or practical capacity.
Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions like maintenance and holiday shutdowns.
Engineering and human resource factors are important when estimating theoretical or practical capacity.

22. Measures of capacity: supply or demand
Both theoretical and practical capacity measure capacity levels in terms of what a plant can supply. Normal Capacity Utilization and Master-Budget Capacity Utilization, in contrast, measure capacity levels in terms of demand for the output of the plant. It is possible and even likely that budgeted demand will be below production capacity levels.
Capacity can be measured in terms of output capable of being supplied or in terms of demand on the product.
Both theoretical and practical capacity measure capacity levels in terms of what a plant can supply.
Normal Capacity Utilization and Master-Budget Capacity Utilization, in contrast, measure capacity levels in terms of demand for the output of the plant.

23. Normal capacity utilization & master-budget capacity utilization
Normal capacity utilization is the level of capacity utilization that satisfies average customer demand over a period that is long enough to consider seasonal, cyclical and trend factors.
Master-budget capacity utilization is the level of capacity utilization that managers expect for the current budget period which is typically one year.
Turning now to the next two types of capacity:
Normal capacity utilization is the level of capacity utilization that satisfies average customer demand over a period that is long enough to consider seasonal, cyclical and trend factors.
Master-budget capacity utilization is the level of capacity utilization that managers expect for the current budget period which is typically one year.
These two capacity-utilization levels can differ significantly in industries that face cyclical demand patterns.

24. Effect of choice of capacity on the budgeted fixed manufacturing cost rate
The choice of capacity level can have a huge impact on budgeted fixed manufacturing cost per unit as shown here:
As you can see on this chart, choosing between the capacity levels for the denominator in the calculation of the budgeted fixed manufacturing cost rate has a tremendous impact on the overall fixed manufacturing cost per unit – in this example, from $60 per unit to $135 per unit.
Remember too, that you’ll be adding this cost per unit to the variable manufacturing cost per unit to obtain total budgeted manufacturing cost per unit. How should a company choose the capacity level to use?
From page 345.

25. Choosing a capacity level
The choice of denominator-level capacity to use may differ based on the purpose for which the choice is being made. Some of those purposes include:
Product costing and capacity management
Pricing
Performance evaluation
External reporting
Tax requirements
Having discussed the various capacity levels, we now turn to a discussion of how to choose the appropriate level for a particular purpose. We’ll review the process for 5 different purposes, including:
Product costing and capacity management
Pricing
Performance evaluation
External reporting
Tax requirements

26. Product costing & capacity management
For product costing and capacity management, using practical capacity as the denominator level sets the cost of capacity at the cost of supplying the capacity, regardless of demand for the capacity.
Highlighting the cost of capacity acquired but not used directs managers’ attention toward managing unused capacity.
In contrast, using either of the capacity levels based on demand hides the amount of unused capacity.
For product costing and capacity management, using practical capacity as the denominator level sets the cost of capacity at the cost of supplying the capacity, regardless of demand for the capacity.
Highlighting the cost of capacity acquired but not used directs managers’ attention toward managing unused capacity.
In contrast, using either of the capacity levels based on demand hides the amount of unused capacity.

27. Pricing decisions
To understand the best choice for pricing decisions, let’s look first at the downward demand spiral for a company. It is the continuing reduction in the demand for its products that occurs when competitor prices are not met, demand drops further and the fixed costs are spread over fewer units, resulting in greater and greater costs per unit.
Practical capacity, by contrast, is a more stable measure. It calculates the fixed cost rate based on capacity available rather than capacity used to meet demand.
The downward demand spiral for a company is important to understand before determining the best capacity level for pricing decisions. It is the continuing reduction in the demand for its products that occurs when competitor prices are not met, demand drops further and the fixed costs are spread over fewer units, resulting in greater and greater costs per unit.
Practical capacity, by contrast, is a more stable measure. It calculates the fixed cost rate based on capacity available rather than capacity used to meet demand.

28. Performance evaluation
Unused capacity adds costs to products.
Mid-level managers have no control over those costs but do have control over prices.
Should the marketing managers be held accountable for the manufacturing overhead costs unrelated to their potential customer base? (practical capacity vs master-budget capacity utilization)
Where there are large differences between practical capacity and master-budget capacity utilization, that difference is often classified as planned unused capacity.
For performance evaluations, it is often best to use master-budget capacity utilization since that most closely holds managers accountable for what they have control over.
In this case, where there are large differences between practical capacity and master-budget capacity utilization, that difference is often classified as planned unused capacity and is shown as a separate cost on the financial statements.

29. External reporting
The magnitude of the favorable/unfavorable production-volume variance under absorption costing is affected by the choice of the denominator level used to calculate the budgeted fixed manufacturing cost per unit.
Recall from Chapter 4 that the production- volume variance can be disposed of three ways:
Adjusted allocation-rate approach (recalculate at year end)
Proration approach (spread to Work-In-Process, Finished Goods and Cost of Goods Sold)
Write-off to Cost of Goods Sold.
The production-volume variance will be affected by the choice of denominator level used to calculate the budgeted fixed manufacturing cost per unit. Recall from Chapter 4 that the production volume variance can be disposed of three ways:
Adjusted allocation-rate approach (recalculate at year end)
Proration approach (spread to Work-In-Process, Finished Goods and Cost of Goods Sold)
Write-off to Cost of Goods Sold

30. External reporting, concluded
The objective in choosing the method to dispose of the production-volume variance is to write-off the portion of the variance that represents the cost of capacity not used to support the production of output during the period. That objective is also helpful in determining which capacity should be used to develop the budgeted fixed manufacturing cost per unit.
The objective to choosing the method to write-off the production-volume variance is to write-off the portion of that variance that represents the cost of capacity not used during the period to support production of output. That objective should also influence the capacity that is used to develop the budgeted fixed manufacturing cost per unit.

31. Tax requirements
The IRS permits the use of practical capacity to calculate budgeted fixed manufacturing costs per unit AND allows for the write-off of the production-volume variance generated this way.
The tax benefit can be significant
The IRS permits the use of practical capacity to calculate budgeted fixed manufacturing costs per unit AND allows for the write-off of the production-volume variance generated this way.
The tax benefit can be significant.

32. Planning & control of capacity costs: other issues
A few other factors should be taken into account when planning capacity levels and in deciding how best to control and assign capacity costs. They are:
Difficulty of obtaining demand-side denominator-level concepts
Difficulty of forecasting fixed manufacturing costs
Capacity issues for nonmanufacturing parts of the value chain
In ABC Costing, a capacity level must be chosen for each cost driver
A few other factors should be taken into account when planning capacity levels and in deciding how best to control and assign capacity costs. They are:
Difficulty of obtaining demand-side denominator-level concepts
Difficulty of forecasting fixed manufacturing costs
Capacity issues for nonmanufacturing parts of the value chain
In ABC Costing, a capacity level must be chosen for each cost driver

33. Terms to learn TERMS TO LEARN PAGE NUMBER REFERENCE Absorption costing
Direct costing
Page 329
Downward demand spiral
Page 346
Master-budget capacity utilization
Page 344
Normal capacity utilization
Practical capacity
Super-variable costing
Page 341
Theoretical capacity
Page 343
Throughput costing
Variable costing