1. © 2012 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. Chapter 8: Absorption and Variable Costing, and Inventory Management Cornerstones of Managerial Accounting, 4e

2. © 2012 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. Measuring the Performance of Profit Centers by Using 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. ► 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. 1

3. © 2012 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. 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. ► In other words, fixed overhead is an inventoriable cost. 1

4. © 2012 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. 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. ► 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. 1

5. © 2012 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. Comparison of Variable and Absorption Costing Methods 1 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.

6. © 2012 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. Comparison of Variable and Absorption Costing Methods 1 The only difference between the two approaches is the treatment of fixed factory overhead. As a result, the unit product cost under absorption costing is always greater than the unit product cost under variable costing.

7. © 2012 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. Production, Sales, and Income Relationships 1 The relationship between variable-costing income and absorption-costing income changes as the relationship between production and sales changes.

8. © 2012 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. 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. ► 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. 2

9. © 2012 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. 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. 2

10. © 2012 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. 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. ► For example, depreciation on the corporate headquarters building or the salary of the CEO would be a common fixed expense for most large companies. 2

11. © 2012 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. 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. 3

12. © 2012 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. 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. ► 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. 3

13. © 2012 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. Economic Order Quantity: The Traditional Model ► Once a company decides to carry inventory, two basic questions must be addressed: 1.How much should be ordered? 2.When should the order be placed? ► In choosing an order quantity, managers need to be concerned only with ordering and carrying costs. ► The formulas for calculating these are as follows: 3

14. © 2012 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. 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). 3

15. © 2012 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. The Economic Order Quantity ► Since EOQ is the quantity that minimizes total inventory-related costs, a formula for computing it is: 3

16. © 2012 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. 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. ► 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 3

17. © 2012 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. 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 3 -

18. © 2012 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. 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. 3

19. © 2012 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. 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. ► 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. 3