Absorption Costing and GAAP

1. Absorption Costing and GAAP

2. Variable Costing a.k.a. direct costing Fixed Mfg O/H is a Period Cost Focus is on Contri-bution Margin This isn’t G.A.A.P. Absorption Costing a.k.a. full costing Fixed Mfg O/H is an Inventoriable Cost Focus is on Gross Margin This is G.A.A.P. Two Ways To Treat Fixed Manufacturing Overhead

3. What Costs Are Included In Inventory? Non-manufacturing costs (e.g. selling, general & admin.) Variable manufac- turing costs (& any direct, fixed costs) Variable Costing Absorption Costing Fixed Manufacturing Overhead

4. Accounting Research Bulletins • Issued by the Committee on Accounting Procedure • In 1953, ARB 43 revised and/or restated all previous bulletins. • Bulletins 44 through 51 were issued subsequently. • In 1959, the newly-formed Accounting Principles Board passed a resolution establishing the continuing authority of the ARBs, until such time as the APB issued new rules replacing specific provisions.

5. ARB Chapter 4, Inventory PricingStatement 2 “A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.”

6. ARB Chapter 4, Inventory PricingDiscussion of Statement 2 “In accounting for the goods in the inventory at any point of time, the major objective is the matching of appropriate costs against revenues in order that there may be a proper determination of the realized income. Thus, the inventory at any given date is the balance of costs applicable to goods on hand remaining after the matching of absorbed costs with concurrent revenues.”

7. ARB Chapter 4, Inventory PricingStatement 3 “The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.”

8. ARB Chapter 4, inventory pricingDiscussion of Statement 3 “The definition of cost as applied to inventories is understood to mean acquisition and production cost, and its determination involves many problems. … Under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges rather than as a portion of the inventory cost. Also, general and administrative expenses should be included as period charges, except for the portion of such expenses that may be clearly related to production and thus constitute a part of inventory costs ….”

9. ARB Chapter 4, inventory pricingDiscussion of Statement 3 “It should also be recognized that the exclusion of all overhead from inventory costs does not constitute an accepted accounting procedure.”

10. Cost Allocations to InventorySteve Landekich - An article reporting the results of a survey. - The article appeared in the magazine Management Accounting. - March 1973.

11. Cost Allocations to InventorySteve Landekich - The principal survey question was: “do you allocate (at least on a broad- brush basis) all expenditures that are indirectly related to production?” - The question was asked separately for annual financial reporting and for management (internal) reporting. - 1,200 usable responses were received.

12. Cost Allocations to InventorySteve Landekich

13. Cost Allocations to InventorySteve Landekich For the firms that do not allocate all expenses, here is the percentage of those firms that do not allocate each type of expense: Service department costs: 23 – 69% General and administrative: 75 – 87% Depreciation: 24% Property taxes: 28% Repairs and maintenance: 17% Fire and casualty insurance: 26%

14. Cost Allocations to InventorySteve Landekich For the firms that do not allocate all expenses, here are the reasons given, in decreasing order of frequency: 1. Method of allocation would be too arbitrary 2. The result would be misleading 3. Amount is not significant 4. Not considered inventory costs 5. Considered period costs

15. SFAS 151, Inventory CostsAn amendment to ARB No. 43 “Under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges rather than as a portion of the inventory cost.” This statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities.

16. SFAS 151 • Purpose: to improve comparability of cross-border financial reporting; to align with the International Accounting Standards Board (IAS #2). • ARB 43 did not define “so abnormal.” • SFAS 151 was approved unanimously by the FASB in 2004, and applies to inventory costs incurred during fiscal years beginning after June 15, 2005.

17. SFAS 151 Variable production overheads are allocated to each unit of production on the basis of the actual use of the production facilities. However, the allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities.

18. SFAS 151 Normal capacity refers to a range of production levels. Normal capacity is the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. Some variation in production levels from period to period is expected and establishes the range of normal capacity.

19. SFAS 151 The range of normal capacity will vary based on business- and industry-specific factors. Judgment is required to determine when a production level is abnormally low (that is, outside the range of expected variation in production). Examples of factors that might be anticipated to cause an abnormally low production level include significantly reduced demand, labor and materials shortages, and unplanned facility or equipment downtime.

20. SFAS 151 The actual level of production may be used if it approximates normal capacity. In periods of abnormally high production, the amount of fixed overhead allocated to each unit of production is decreased to that inventories are not measured above cost. The amount of fixed overhead allocated to each unit of production is not increased as a consequence of abnormally low production or idle plant.

21. SFAS 151 Unallocated overheads are recognized as an expense in the period in which they are incurred. Other items such as abnormal freight, handling costs, and amounts of wasted materials (spoilage) require treatment as current period charges rather than as a portion of the inventory cost.

22. SFAS 151 Also, under most circumstances, general and administrative expenses should be included as period charges, except for the portion of such expenses that may be clearly related to production and thus constitute a part of inventory costs (product charges). Selling expenses constitute no part of inventory costs.

23. SFAS 151 Many respondents to the Exposure Draft … noted that incorporating the guidance from IAS 2 that states that fixed production overhead costs should be allocated to inventory based on the “normal capacity” of the production facility would result in recognition of all unfavorable volume variances as a period expense, while favorable variances that are normal would be recognized in inventory. Those respondents noted that under ARB 43, Chapter 4, volume variances are recognized as a period cost only when the “so abnormal” criterion is met.

24. SFAS 151 … to address respondents’ concerns, the Board decided that the amendment should include guidance slightly more detailed than that in IAS 2 regarding normal capacity. In particular, the Board decided to add guidance clarifying that normal capacity refers to a range of production levels within which ordinary variations in production levels are expected. The Board believes the amendment to ARB 43, Chapter 4, as modified, will not lead to significant changes in inventory accounting practice.