Inventory Costing and Capacity Analysis

1. Inventory Costingand Capacity Analysis Chapter 9

2. Overview—Chapter 9 • Inventory Costing Methods • Denominator Issues • Example: working backwards • BEPs: VC versus AC • Solution to extra problem (on webpage)

3. Absorption Costing • All manufacturing cost are considered inventoriable: • All variable mfg. costs (both direct & indirect) • All fixed mfg. costs (both direct & indirect) • Separates costs by business function. • Other costing terms: • Super-full absorption costing: includes some mfg. related admin costs—used for tax. • Full-product costing: costs from all areas of value chain are attached to product costs—for L-T pricing.

4. Variable Costing • All variable manufacturing costs are considered inventoriable. • Separates costs by cost behavior. • Some managers call this direct costing which is a poor choice of name. Why?

5. Throughput Costing • Also called super-variable costing. • Only variable direct materials are inventoriable. Assumes that only DM are variable in the short run. • Reduces incentives to build up inventories. • Relatively new and not widely used.

6. STOP! The big picture • Managers make a number of accounting choices that affect income, for example:

7. Inventory-Costing Methods The difference between variable costing and absorption costing is based on the treatment of fixed manufacturing costs. AC includes fixed mfg. costs in cost of inventory, while VC does not. VC expenses all fixed costs as period costs.

8. Comparing Income Statements:Absorption vs. Variable Costing The following data pertain to Davenport Pencils: Produce one product: #2 pencils. 1 box = 1 gross. Sales price = $8/box; Sold 40,000 boxes DM = $3 / box; DL = $0.50 / box VMOH = $0.25 / box FMOH = $100,000 / year Sales commission = $0.75 / box Fixed admin. expenses = $30,000 / year Budget = actual production = 50,000 boxes

9. Comparing Income Statements What is the cost per box under VC? $3.00 + 0.50 + 0.25 = $3.75 What is the cost per box under AC? $3.00 + 0.50 + 0.25 + 2.00* = $5.75 * Fixed mfg. OH rate = $2.00 / box = $100,000 / 50,000 boxes

10. Comparing Income Statements Absorption Costing Revenue $320,000 CoGS 230,000 GM 90,000 S&A 60,000 Op. Inc. $ 30,000 Variable Costing Revenue $320,000 VC 180,000 CM 140,000 FC 130,000 Op. Inc. $ 10,000

11. Comparison of Variableand Absorption Costing Variable costing operating income : $10,000 Absorption costing operating income : $30,000 Absorption costing operating income is $20,000 higher. Why?

12. Comparison of Variableand Absorption Costing Production exceeds sales. The 10,000 unit increase in ending inventory are valued as follows: Absorption costing: 10,000 × $5.75 = $ 57,500 Variable costing: 10,000 × $3.75 = $ 37,500 Difference: $ 20,000

13. Comparison of Variableand Absorption Costing COGS Absorption costing: 40,000 X $5.75 = $230,000 Variable costing: 40,000 X $3.75 = $150,000 Plus all the fixed mfg. OH = $100,000 Lower costs recognized under absorption costing: $ 20,000

14. Comparison of Variableand Absorption Costing Under absorption costing, each of the additional 10,000 boxes in ending inventory is storing $2/box cost that will be expensed later when sold. 10,000 units of inventory × $2.00 = $20,000

15. Comparison of Variableand Absorption Costing Absorption costing operating income – Variable costing operating income EQUALS Fixed manufacturing costs in ending inventory under absorption costing – Fixed manufacturing costs in beginning inventory under absorption costing

16. Absorption Costing & Inventory Buildup What happens over the long run? How might you mitigate the incentive to build up inventory?

17. Alternative Denominator-LevelConcepts Theoretical capacity Practical capacity Normal capacity Master-budget capacity

18. Budgeted Fixed Manufacturing Overhead Rate Lloyd’s Bicycles produces bicycle parts for domestic and foreign markets. Fixed overhead costs are $200,000 within the relevant range of the various capacity volume.

19. Budgeted Fixed Manufacturing Overhead Rate Assume that the theoretical capacity is 10,000 machine-hours, practical capacity is 85%, normal capacity is 75%, and master-budget capacity is 60%. What is the budgeted fixed manufacturing overhead rate at the various capacity levels?

20. Budgeted Fixed Manufacturing Overhead Rate Theoretical 100%: $200,000 ÷ 10,000 = $20.00/machine-hour Practical 85%: $200,000 ÷ 8,500 = $23.53/machine-hour Normal 75%: $200,000 ÷ 7,500 = $26.67/machine-hour Master-budget 60%: $200,000 ÷ 6,000 = $33.33/machine-hour

21. Effect of Denominator Level Choice • The larger the denominator level, the: • Lower the budgeted FM rate. • Lower Fixed Mfg. costs in E.Inv. • Higher the unfavorable PVV for fixed OH Remember—Fixed mfg. are either expensed in the period or stored in E.Inv. What denominator level would you want to use for tax purposes? [practical is required for tax]

22. Decision Making Assume that Lloyd’s Bicycles’ standard hours are 2 hours per unit. What is the budgeted fixed manufacturing overhead cost per unit?

23. Decision Making Theoretical capacity: $20 × 2 = $40.00 Practical capacity: $23.53 × 2 = $47.06 Normal capacity: $26.67 × 2 = $53.34 Master-budget capacity: $33.33 × 2 = $66.66

24. Exercise—working backward QQQ Company has op. income of $120,000 under absorption costing, and op. income would be $100,000 under variable costing. FMOH = $500,000 Budgeted and actual production = 200,000 units. Did inventory increase or decrease during the period? By how much?

25. In-class problem • Answer depends on the FMOH rate for B.Inv and choice of inventory cost-flow method (FIFO, WA, LIFO, etc.). • Assume no change in FMOH rate. Then choice of cost-flow method does not matter. • FMOH rate = $500k / 200k = $2.50 / unit

26. Calculation of BE points • Unique solution under Variable Costing: • BEPvc = Total FC / UCM • Solution depends on production level under Absorption Costing: • BEPac = [Total FC + (FM rate* (BEPac – Units Produced))] / UCM • BEPac = [Total FC – (FMR*UP)] / (UCM – FMR) What happens to the BEP when more units are produced?