Inventory costing and Capacity analysis

1. Inventory costing and Capacity analysis

2. Class Announcements • Assignment #5 due October 21st • Assignment #6 due October 31st • Midterm: Thursday October 24th (in-class) • Final Exam: 7:00pm Friday December 6th • Not responsible for the appendix or production volume variance

3. Midterm • Worth: 30% • When: Thursday (24th) in-class • Coverage: • Management Accounting (Chapter 1) • Costs (Chapter 2) • CVP (Chapter 3) • Job Costing (Chapter 4) • ABC and ABM (Chapter 5) • Inventory Costing and Capacity Analysis (Chapter 9) • Format: • short answer with multiple parts; • choice of 3 out of 4; • no journal entries; no ethics; no decision making model

4. Class Objectives • Three costing choices for inventory • Comparison of the three costing approaches • Manipulation of inventory costing choices for opportunistic purposes • Videos: • Absorption vs Variable Costing • The problem with absorption costing

5. Inventory Costing Choices: Overview • Absorption costing—product costs are capitalized; period costs are expensed. • Variable costing—variable product costs are capitalized; fixed product and period costs are expensed. • Throughput costing—only direct materials are capitalized; all other costs are expensed.

6. Inventory Costing Choices: Comparison • Variable costing is a method of inventory costing in which only variable manufacturing costs are included as inventoriable costs. • Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs. • 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 operating expenses.

7. Absorption Costing vs. Variable Costing • The product costing method used can significantly affect reported income.

8. Inventory Costing Choices: Comparison • Operating income will differ between absorption, variable and throughput costing. • The amount of the difference represents the amount of fixed product costs capitalized as inventory under absorption costing, and expensed as a period costs under variable costing.

9. Variable versus Absorption Costing

10. VariableCosting AbsorptionCosting Variable versus Absorption Costing • All manufacturingcosts must be assignedto products to properlymatch revenues andcosts. • Depreciation,taxes, insurance andsalaries are just asessential to productsas variable costs. • They are the numbers that appear on our external reports. • Only period costs are S&A • Highlights separation between fixed & variable • Fixed costs arenot really the costsof any particularproduct. • These are capacitycosts and will beincurred even if nothingis produced. • Absorption costing product costs are misleading for decision making.

11. Inventory Costing Choices: Performance Issues • Manipulation schemes: • Overproduction of inventory • Deciding to manufacture products that absorb the highest amount of fixed costs, regardless of demand (“cherry-picking”) • Accepting an order to increase production, even though another plant in the same firm is better suited to handle that order • Deferring maintenance

12. Inventory Costing Choices: Performance Issues – Overproduction of inventory • Under absorption costing (GAAP), managers may seek to manipulate income by producing too many units. • Production beyond demand : • will increase the amount of inventory on hand. • will result in more fixed costs being capitalized as inventory. • will leave a smaller amount of fixed costs to be expensed during the period. • profit increases, and potentially, so does a manager’s bonus. • Prevention: base manager’s bonuses on profit calculated using variable costing.

13. Inventory Costing Choices: Performance Issues – Addressing Manipulation • 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

14. Egg Production: Industry • http://www.eggs.ca/onthefarm/ • Canada has approximately 1,100 registered egg farms. • The average egg farm has 10,000 to 20,000 hens, although Canadian egg farms can range from a few hundred to more than 400,000 hens. • In Canada, a total of 25 million hens (including unregistered hens) produce about 500 million dozen eggs per year – that's 6 billion eggs! • The egg industry contributes about $500 million to the Canadian economy.

15. Nova Scotia Egg Producers • The Nova Scotia Egg Producers (NSEP) is incorporated under the Natural Products Act for Nova Scotia. The act provides the NSEP the authority to carry out its mandate of effective promotion, control and regulation of eggs and pullets in Nova Scotia. • The NSEP is governed by an eight person Board of Directors consisting of seven members who represent egg producers in geographic zones throughout the province and one who represents the pullet sector. • NSEP uses a supply management system to provide a stable supply of eggs to consumers at fair prices and a fair return to producers.