MANAGEMENT ACCOUNTING

Cheryl S. McWatters, Jerold L. Zimmerman, Dale C. Morse MANAGEMENT ACCOUNTING

Management Accounting Variable costing and capacity costs (Planning and control) Chapter 11

Objectives • Identify the problems with adsorption costing systems • Use variable costing to generate profit and loss statements and recognize their advantages and disadvantages • Identify problems in selecting the capacity of a fixed cost resource • Use the organization’s practical capacity to allocate overhead, and recognize its advantages and disadvantages • Describe trade-offs for decentralized managers to provide accurate information to make a decision on the capacity of a common resource and on the efficient use of the resource

Criticisms of Absorption Cost Systems Chapter 10 described 2 absorption cost systems, job-order costing and process costing Absorption cost systems produce misleading information Absorption cost systems create incentives that are inconsistent with maximizing the value of the firm

Variable Costs + Fixed Costs = Product Costs Number of Units Average Cost of the Product ÷ Product Costs = Result Incentive to Overproduce Absorption Cost Systems The average cost per unit decreases as more units are produced

Incentive to Overproduce Absorption Cost Systems Managers evaluated on the average cost per unit can improve their performance by just increasing the number of units produced Behavior Producing more units may not help the organization if all the units cannot be sold Problem In the short-term, cost of goods sold is lower and net income is higher because some of the fixed costs are left in the ending inventory Problem

Incentive to OverproduceNumerical Example A plant with €1 million of fixed overhead makes universal smart drives (USDs) The USDs have a variable cost of €1.00 the plant only makes USDs and allocates fixed costs by the number produced. The firm can sell 200,000 units a year for €10.00each. Handling expenses are €0.30 per unit The plant manager has the opportunity to make 200,000 units, 220,000 units or 240,000 units and wants to know which production level yields the highest reported profit for the year

Incentive to OverproduceNumerical Example

Incentive to OverproduceSolutions • Charge managers large amounts for holding inventory • Enforce a strict senior management policy against adding to or building inventories • Choose performance measures other than short-term net income • Use the just-in-time production system to reduce inventory levels • Change the costing system to a variable costing system

Variable Overhead Fixed Overhead Total Overhead + = Under-utilization of Allocation Base Used to Allocate Fixed Costs Allocated to products through an allocation base Managers who are evaluated based on product costs will use the allocation base sparingly Behaviour The organization may not benefit from reduced usage of the allocation base Problem

Under-utilization of Allocation Base Used to Allocate Fixed Costs Numerical Example The expected fixed costs of operating the IT department are £1,000,000 per year The expected variable costs are £5,000 per workstation. The number of workstations in each department is used to allocate the IT department costs. The application rate based on expected usage of 200 workstations is {£1,000,000m + (200 x £5,000)}/200 The benefits that the engineering department estimates it will gain by having workstations in the department is overleaf. The department wishes to choose the most efficient number of workstations

Under-utilization of Allocation Base Used to Allocate Fixed Costs Numerical Example The department will use only 2 workstations because the marginal benefit of a 3rd is £8,000 (less than the allocated cost) The additional benefit of the additional workstations is £14,000 the incremental cost is £10,000 therefore the net loss of not having the workstations is £4,000 To maximize profit the department should use 4 workstations as the marginal benefit is greater than the variable cost

Misleading Product Costs Occurs when an organization begins to drop products because full cost of the product is greater than its price A common result of the misuse of product costs is the death spiral which occurs when an organization drops a product because its full costs exceed its price

Misleading Product CostsNumerical Example A company makes 2 types of refrigerators. Excess capacity exists but there is no alternative use. Fixed overhead costs are allocated based on direct labour Management decides to drop the compact model because it appears to be unprofitable

Misleading Product CostsNumerical Example By dropping the compact model, all of the fixed overhead is shifted to the full-size model

Variable Costing The product cost under variable costing includes only the variable costs of making the product

Variable Costing Advantages • The variable cost per unit approximates the opportunity cost of making another unit if the organization is below capacity • Variable costing reduces the dysfunctional incentive to overproduce

Variable costs per unit are £6. The allocation base is the number of units produced. The sales price is £10 per unit. During the year the factory makes and sells 20,000 fans. In December the manager has the opportunity to make another 5,000 units but these cannot be sold in the period. The manager wishes to estimate the profit with and without the extra 5.000 units using absorption and variable costing systems Variable CostingNumerical Example A factory making electric fans has estimated and actual fixed costs of £50,000

Variable CostingNumerical Example Absorption Costing Method Application rate (without the additional 5,000 units) {£50,000 + (£6 per unit x 20,000 units}/20,000 units = £8.50 per unit Application rate (with additional 5,000 units) = {£50,000+ (£6 per unit x 25,000 units}/25,000 units = £8.00 per unit The cost of the ending inventory is £40,000

Variable CostingNumerical Example Variable Costing Method Application rate (without the additional 5,000 units) £6 per unit Application rate (with additional 5,000 units) £6.00 per unit The cost of the ending inventory is £30,000

Variable Costing Disadvantages • Variable costing may understate product costs if there is an opportunity cost of using fixed overhead resources • Managers may tend to overuse the overhead resources generating the fixed costs • If multiple allocation bases are used, the definition between variable and fixed becomes less clear

Capacity Costs Cost of toomuch capacity Cost of toolittle capacity Acquisition cost Lost sales Maintenance Overtime Security Overuse

Capacity Costs • How much capacity should be acquired? • Do fixed cost allocation alternatives influence capacity acquisition decisions? Allocate overhead based on practical capacity Allocationalternatives Allocate overhead based on capacitydecision

Allocation Based on the Capacity Decision - Numerical Example The fixed costs or operating an online retail operation result primarily from the cost of the facility The expected and actual cost of the facility is £200,000. the fixed cost of the facility of 20,000m2 allocated to marketing and inventory divisions which share the facility. Inventory division uses 10,000m2 and marketing uses 4,000m2

Allocation Based on the Capacity Decision - Numerical Example The application rate is £200,000 per 20,000 m2 = £10 per m2 The £60,000 allocated to unused capacity is a period expense

Variable Manufacturing + Overhead FixedManufacturing = Overhead TotalManufacturing Overhead Allocation Based on the Capacity Decision Partial Absorption Cost Systems Practical capacity is the maximum level of operations that can be achieved without increasing costs due to congestion

Variable Manufacturing + Overhead FixedManufacturing = Overhead TotalManufacturing Overhead Allocation Based on the Capacity Decision Partial Absorption Cost Systems Used Unused Product Costs Period Expense Only the fixed cost of overhead resources used are allocated to products

Practical Capacity of Allocation Base Expected Fixed Overhead Application Rate ÷ = Actual Usage of Allocation Base Allocated Fixed Costs Application Rate × = Allocation Based on the Capacity Decision

Allocation Based on the Capacity Decision Advantages • Costs associated with excess capacity are not allocated to products • Allocated fixed costs to products will not change much with different levels of operations • The cost of unused capacity is identified

Allocation Based on the Capacity Decision Disadvantages • It does not alleviate the incentive to overproduce • Managers may still underuse the allocation base even though only some fixed costs are being allocated

Allocation Based on the Capacity Decision Allocates fixed costs based on capacityrequested rather than the resource used Greater use of the resource than originallyrequested is charged to the managerat a much higher rate BenefitEncourages managers to better forecast and anticipate capacity needs

Management Accounting Variable costing and capacity costs (Planning and control) End of Chapter 11

MANAGEMENT ACCOUNTING