Chapter 9 Income Effects of Alternative Inventory Costing Models

1. Chapter 9Income Effects of Alternative Inventory Costing Models

2. Absorption Costing Absorption costing income statement • also called full costing • classify costs based on functions • inventory composed of variable and fixed production costs • net income is function of sales and production Revenue Manufacturing costs Contribution margin Marketing costs Operating income Pages 313 - 316

3. Variable Costing Variable costing income statement • also called direct costing • classify costs based on behaviour • inventory composed of variable production costs only • net income is a function of sales Revenue Variable costs Contribution margin Fixed costs Operating income Pages 313 - 316

4. Comparing the Two Income Statements • Difference in net income between a variable costing income statement and an absorption costing income statement is due to the treatment of fixed manufacturing costs • Fixed manufacturing costs are treated as a period cost under variable costing • Fixed manufacturing costs are treated as an inventoriable (product) cost under absorption costing Pages 316 - 318

5. Fixed Manufacturing Overhead Costs How the Two Income Statements Differ Variable Absorption Revenue Variable costs Contribution margin Fixed costs Operating income Revenue Manufacturing costs Gross margin Marketing costs Operating income Pages 316 - 318

6. Converting Between the Two Statements Direct operating income - absorption operating income = Fixed manufacturing costs in ending inventory - fixed manufacturing costs in beginning inventory = (200 x $16) - (0 x $16) = $3,200 or = (Units produced - units sold) x fixed manufacturing cost rate = (600 - 400) x $16 = $3,200 or = (Ending inventory units - Beginning inventory units) x fixed manufacturing cost rate = (200 units - 0 units) x $16 = $3,200 Pages 319 - 321

7. Performance Evaluation – Absorption • One of the problems with absorption costing that managers can increase operating income in the short run by increasing production independent of sales • The additional units produced absorb some of the fixed costs which are carried forward on the balance sheet rather than being expensed on the income statement • Therefore • carefully monitor inventory levels • consider a charge for the amount of inventory carried (1% x value of inventory on hand) • evaluate performance over longer periods Pages 321 - 324

8. Throughput Costing • Throughput costing (or super-variable costing) treats all costs except those related to variable direct materials as costs of the period in which they were incurred • only variable direct material costs are inventoriable • since all other production-related costs are expensed on the income statement, management is less motivated to increase inventories (shifting costs from the income statement to the balance sheet) • reducing inventory levels means less funds are tied up in inventory Pages 325 - 326

9. Capacity Concepts • Many different numbers can be used as “capacity” under absorption costing Theoretical capacity – ideal situation with 100% efficiency Practical capacity – recognize that some downtime is unavoidable Normal capacity – the average output level over a 2-3 year period Budgeted capacity – expected output for the next year 1,152,000 bottles 800,000 bottles 500,000 bottles 400,000 bottles Pages 328 - 333

10. Capacity and Absorption Costing • Using theoretical capacity or practical capacity as the denominator reduces the amount of fixed manufacturing overhead assigned to inventory and increases the production volume variance • Canada Customs and Revenue Agency (CCRA) does not allow the use of theoretical or practical capacity in determining taxable income • When considering which denominator to use keep in mind that the resultant cost information will be used for product costing and capacity management, pricing, performance evaluation, and forecasting Pages 328 - 333