Chapter 9
Inventory Costing and Capacity
Analysis
Overview of Absorption and Variable Costing
Absorption
Costing
Variable
Costing
Direct Materials
Product
Costs
Direct Labor
Product
Costs
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Period
Costs
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Period
Costs
Manufacturing Cost Flows
Costs
Balance Sheet
Inventories
Material Purchases
Raw Materials
Income
Statement
Expenses
Direct Labor
Variable
Manufacturing
Overhead
Fixed
Manufacturing
Overhead
Selling and
Administrative
Work in
Process
Finished
Goods
Period Costs
Cost of
Goods
Sold
Selling and
Administrative
Data for Stassen Company for 2009
• Stassen uses standard costing
• Stassen’s management wants to
prepare an income statement for
2009 (the fiscal year just ended)
to evaluate the performance of
the telescope product line
Data for Stassen Company for 2009 (Cont)
• The operating information for the year is:
Units
Beginning Inventory
0
Production
8,000
Sales
6,000
Ending Inventory
2,000
Data for Stassen Company for 2009 (Cont)
• Actual price and cost data for 2009 are:
Selling Price
$1,000
Variable Manufacturing cost per unit
Direct material cost per unit
Direct manufacturing labor cost per unit
$110
40
Manufacturing overhead cost per unit
Total variable manufacturing cost per unit
Variable marketing cost per unit sold
50
$200
$185
Fixed manufacturing costs (all indirect)
Fixed marketing costs (all indirect)
$1,080,000
$1,380,000
Data for Stassen Company for 2009 (Cont)
• Stassen incurs manufacturing and marketing
costs only
the cost driver for all variable manufacturing
costs is units produced
the cost driver for variable marketing costs is
units sold
• There are no price variances, efficiency
variances, or spending variances. Therefore the
budgeted (standard) price and cost data for 2009
are the same as the actual price and cost data
Data for Stassen Company for 2009 (Cont)
• Work-in-process inventory is zero.
• Stassen budgeted production of 8,000 units for
2009. This was used to calculate the budgeted
fixed manufacturing cost per unit of $135
($1,080,000/8,000 units).
• Stassen budgeted sales of 6,000 units for 2009,
which is the same as the actual sales for 2009.
Data for Stassen Company for 2009 (Cont)
• The actual production for 2009 is 8,000 units
As a result, there is no production volume
variance for manufacturing costs in 2009. Later
examples, based on data for 2010 and 2011,
do include production-volume variances
However, even in those cases the income
statements contain no variances other than the
production-volume variance
• All variances are written off to cost of goods sold
in the period (year) in which they occur
Unit Cost Computations
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor,
and variable mfg. overhead
Selling & administrative expenses
per unit sold
Fixed costs per year:
Manufacturing overhead
Selling & administrative expenses
8,000
$
$
200
185
$1.08 mil
$1.38 mil
Unit (Inventoriable) Cost Computations
Unit product cost is determined as follows:
Direct materials, direct labor,
and variable mfg. overhead
Fixed mfg. overhead
($? ÷ ? units)
Unit product cost
Absorption
Costing
Variable
Costing
$
$
Selling and administrative expenses are
always treated as period expenses and
deducted from revenue.
Comparative Income Statements
Reconciliation
We can reconcile the difference between
absorption and variable income as follows:
Variable costing net operating income
$ 1,230,000
Add: Fixed mfg. overhead costs
deferred in inventory
(2,000 units × $135 per unit)
270,000
Absorption costing net operating income $ 1,500,000
Fixed mfg. overhead
Units produced
=
$1,080,000
8,000 units
= $135.00 per unit
Fixed Manufacturing Costs Expensed for
Different Sales Levels
Variable Costing
Absorption Costing
Fixed Manufacturing
Costs
Fixed Manufacturing
Costs
Units
Sold
Ending Included in
Inventory Inventory
Included in
Inventory
Amount
Expensed
Amount
Expensed
=$135 X
Ending Inv.
=$135 X
Units Sold
6,000
2,000
$0
$1,080,000
$270,000
$810,000
7,000
1,000
$0
$1,080,000
$135,000
$945,000
8,000
0
$0
$1,080,000
$0
$1,080,000
Data for Stassen Company for 2009, 2010,
2011
• In both 2010 and 2011, Stassen has a productionvolume variance because actual telescope
production differs from the budgeted level of
production of 8,000 units per year used to
calculate budgeted fixed manufacturing cost per
unit.
• The actual quantities sold for 2010 and 2011 are
the same as the sales quantities budgeted for
these respective years, which are given in units in
the following table:
Production/Sales Data for 2009, 2010,
2011
2009
Beginning Inventory
2010
2011
0
2,000
500
Production
8,000
5,000
10,000
Sales
6,000
6,500
7,500
Ending Inventory
2,000
500
3,000
• All other 2009 data given earlier for Stassen also apply for
2010 and 2011.
Comparative Income Statements – Three Years
Operating Income Summary
2009
2010
2011
1. Absorption-costing
operating income
$1,500,000 $1,335,000
$2,490,000
2. Variable-costing
operating income
$1,230,000 $1,537,500
$2,152,500
3. Difference
4. Difference as a %
of absorption-costing
operating income
$270,000
$(202,500)
$337,500
18.0%
(15.2%)
13.6%
Operating Income Differences
2009
2010
2011
Absorptioncosting
operating
income
-
Variable-costing
operation
income
=
Fixed
manufacturing
costs in ending
inventory under
absorption costing
$1,500,000
-
$1,230,000
=
($135 x 2,000 units)
$270,000
=
$270,000
$1,537,500
=
($135 X 500 units)
($202,500)
=
($202,500)
$2,152,500
=
($135 x 3,000 units)
$337,500
=
$337,500
$1,335,000
$2,490,000
-
-
-
Fixed
manufacturing
costs in beginning
inventory under
absorption costing
-
($135 x 0 units)
-
($135 X 2,000 units)
-
($135 x 500 units)
Summary
Performance Issues and Absorption
Costing
• Managers may seek to manipulate income by
producing too many units
• Production beyond demand will increase the
amount of inventory on hand
• This will result in more fixed costs being
capitalized as inventory
• That will leave a smaller amount of fixed costs
to be expensed during the period
• Profit increases, along with stock prices, and
potentially so does a manager’s bonus
Income Effects of Inventory Buildup
Other Manipulation Schemes Beyond
Simple Overproduction
• 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 for extra production
Inventories and Costing Methods
• One way to prevent the unnecessary buildup of
inventory for bonus purposes is to base manager’s
bonuses on profit calculated using Variable Costing
• Drawback: complicated system of producing two
inventory figures – one for external reporting and the
other for bonus calculations
Management Countermeasures for
Profit Manipulation Schemes
• 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
Denominator-Level Capacity Concepts
• Consider the Stassen Company example again.
• Recall that the annual fixed manufacturing costs of
the production facility are $1,080,000
• Stassen uses absorption costing with standard
costs for external reporting purposes, and it
calculates its budgeted fixed manufacturing rate on
a per unit basis
• Let’s examine four different capacity levels used as
a denominator to compute the budgeted fixed
manufacturing cost rate: theoretical capacity,
practical capacity, normal capacity utilization, and
master-budget capacity utilization
Effect on Budgeted Fixed Manufacturing
Cost Rate
Denominator- Level
Capacity Concept
Budgeted Fixed
Manufacturing
Costs per Year
Budget
Budgeted
Capacity
Fixed
Level (in Manufacturing
units)
Cost per Unit
Theoretical capacity
$1,080,000
18,000
$60
Practical capacity
$1,080,000
12,000
$90
Normal capacity
utilization
$1,080,000
10,000
$108
Master-budget capacity
utilization
$1,080,000
8,000
$135
Total Budgeted Manufacturing Cost per
Unit
Budgeted
Variable
Manufacturing
Cost per Unit
Budgeted
Fixed
Manufacturing
Cost per Unit
Budgeted
Total
Manufacturing
Cost per Unit
Theoretical
capacity
$200
$60
$260
Practical capacity
$200
$90
$290
Normal capacity
utilization
$200
$108
$308
Master-budget
capacity utilization
$200
$135
$335
DenominatorLevel Capacity
Concept
Downward Demand Spiral
Master-Budget
Capacity
Utilization
Denominator
Level (Units)
Budgeted
Variable
Manufacturing
Cost per Unit
8,000
$200
$135
$335
6,000
$200
$180
$380
4,000
$200
$270
$470
3,000
$200
$360
$560
Budgeted
Fixed
Budgeted Total
Manufacturing Manufacturing
Cost per Unit
Cost per Unit