Inventory Costing
and Capacity Analysis
Chapter 9
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
9-1
Learning Objective 1
Identify what distinguishes
variable costing from
absorption costing.
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9-2
Inventory-Costing Methods
The difference between variable costing
and absorption costing is based on the
treatment of fixed manufacturing overhead.
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9-3
Variable Costing
Direct
Materials
Variable
Factory
Labor
Variable
Overhead
Work in Process Inventory
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9-4
Variable Costing
Work in Process
Inventory
Finished Goods
Inventory
Fixed Factory
Labor
Cost of Goods Sold
Income Summary
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9-5
Learning Objective 2
Prepare income statements
under absorption costing
and variable costing.
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9-6
Comparing Income Statements
The following data pertain to Davenport Fixtures:
Year 1
Beginning inventory
-0Produced
10,000
Sold
8,000
Ending inventory
2,000
Year 2
2,000
11,500
13,000
500
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Total
-021,500
21,000
500
9-7
Comparing Income Statements
The following information is on a per unit basis:
Sales price:
$71.00
Variable manufacturing costs:
Direct materials:
Direct manufacturing labor:
Indirect manufacturing costs:
$ 4.00
$21.00
$24.00
Fixed manufacturing costs:
$ 4.50
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9-8
Comparing Income Statements
(Absorption Costing)
Total fixed production costs are $54,000
at a normal capacity of 12,000 units.
Fixed nonmanufacturing costs are
$30,000 per year.
Variable nonmanufacturing costs are
$2.00 per unit sold.
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9-9
Comparing Income Statements
(Absorption Costing)
Revenues
Cost of goods sold
Volume variance (U)
Gross margin
Nonmanufacturing costs
Operating income
$568,000
428,000
9,000
$131,000
46,000
$ 85,000
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9 - 10
Comparing Income Statements
(Absorption Costing)
Revenues for Year 1 are $568,000.
What is the cost of goods sold?
8,000 × $49 = $392,000
What is the manufacturing contribution margin?
$568,000 – $392,000 = $176,000
Net contribution margin = $160,000
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9 - 11
Comparing Income Statements
(Variable Costing)
Revenues
Cost of goods sold
Variable nonmanufacturing costs
Contribution margin
Fixed manufacturing costs
Fixed nonmanufacturing costs
Operating income
$568,000
392,000
16,000
$160,000
54,000
30,000
$ 76,000
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9 - 12
Learning Objective 3
Explain differences in operating
income under absorption
costing and variable costing.
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9 - 13
Operating Income
(Absorption Costing)
What are revenues for Year 2?
13,000 × $71 = $923,000
What is the cost of goods sold?
13,000 × $53.50 = $695,500
Is there a volume variance?
(12,000 – 11,500) × $4.50 = $2,250
underallocated fixed manufacturing costs
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9 - 14
Operating Income
(Absorption Costing)
What is the gross margin?
$923,000 – ($695,500 + $2,250) = $225,250
What are the nonmanufacturing costs?
13,000 units sold × $2.00 = $26,000
variable costs + $30,000 fixed costs = $56,000
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9 - 15
Operating Income
(Absorption Costing)
What is the operating income before taxes?
$225,250 – $56,000 = $169,250
What is the operating income for the
two years combined?
$85,000 + $169,250 = $254,250
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9 - 16
Income Statements
(Absorption Costing)
Revenues
Cost of goods sold
Volume variance (U)
Gross margin
Nonmfg. costs
Operating income
Year 1
Year 2
Combined
$568,000 $923,000 $1,491,000
428,000 695,500 1,123,500
9,000
2,250
11,250
$131,000 $225,250 $ 356,250
46,000
56,000
102,000
$ 85,000 $169,250 $ 254,250
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9 - 17
Operating Income
(Variable Costing)
Revenues for Year 2 are $923,000.
What is the cost of goods sold?
13,000 × $49 = $637,000
What is the manufacturing contribution margin?
$923,000 – $637,000 = $286,000
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9 - 18
Operating Income
(Variable Costing)
What is the net contribution margin?
$286,000 – $26,000 variable nonmanufacturing costs
= $260,000 net contribution margin
What is the operating income before taxes?
$260,000 – $54,000 fixed manufacturing costs
– $30,000 fixed nonmanufacturing costs = $176,000
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9 - 19
Income Statements
(Variable Costing)
Revenues
Cost of goods sold
Mfg. contr. margin
Variable nonmfg.
Net contr. margin
Year 1
$568,000
392,000
$176,000
16,000
$160,000
Year 2
$923,000
637,000
$286,000
26,000
$260,000
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Combined
$1,491,000
1,029,000
$ 462,000
42,000
$ 420,000
9 - 20
Income Statements
(Variable Costing)
Year 1
Net contr. margin
$160,000
Fixed mfg. costs
54,000
Fixed nonmfg. costs
30,000
Operating income $ 76,000
Year 2
$260,000
54,000
30,000
$176,000
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Combined
$420,000
108,000
60,000
$252,000
9 - 21
Comparison of Variable
and Absorption Costing
Variable costing operating income Year 1: $76,000
Absorption costing operating income Year 1: $85,000
Absorption costing operating income is $9,000 higher.
Why?
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9 - 22
Comparison of Variable
and Absorption Costing
Production exceeds sales in Year 1.
The 2,000 units in ending inventory
are valued as follows:
Absorption costing: 2,000 × $53.50 = $107,000
Variable costing:
Difference:
2,000 × $49.00 = $ 98,000
$
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9,000
9 - 23
Comparison of Variable
and Absorption Costing
Variable costing operating income Year 2: $176,000
Absorption costing operating income Year 2: $169,250
Variable costing operating income is $6,750 higher.
Why?
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9 - 24
Comparison of Variable
and Absorption Costing
Sales exceeded units produced in Year 2.
13,000 – 11,500 = 1,500 decrease in inventory
Absorption costing: 1,500 × $53.50 = $80,250
Variable costing:
1,500 × $49.00 = $73,500
Higher cost of goods sold under
absorption costing:
$ 6,750
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9 - 25
Comparison of Variable
and Absorption Costing
Variable costing combined net income:
$252,000
Absorption costing combined net income: $254,250
Absorption costing is higher by
$2,250
500 units in inventory × $4.50 = $2,250
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9 - 26
Comparison of Variable
and 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
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9 - 27
Learning Objective 4
Understand how absorption
costing can provide undesirable
incentives for managers to
build up finished goods inventory.
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9 - 28
Inventory Buildup
Assume that Davenport Fixtures produced
4,400 units in Year 1 and sold 4,100.
What is the production volume variance?
(12,000 – 4,400) × $4.50 = $34,200 U
What is the net operating income or loss
for the period?
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9 - 29
Inventory Buildup
Revenues (4,100 × $71)
Cost of goods sold (4,100 × $53.50)
Volume variance
Gross margin
Nonmanufacturing costs
Net loss
$291,100
219,350
34,200
$ 37,550
38,200
$
650
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9 - 30
Inventory Buildup
How many units are in ending inventory?
4,400 – 4,100 = 300
How much cost is in ending inventory?
300 × $53.50 = $16,050
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9 - 31
Inventory Buildup
Suppose that management decides to
produce 9,000 units next year.
Sales remain the same (4,100 units).
What is the volume variance?
(12,000 – 9,000) × $4.50 = $13,500 U
What is the operating income or loss?
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9 - 32
Inventory Buildup
Revenues (4,100 × $71)
$291,100
Cost of goods sold (4,100 × $53.50)
219,350
Volume variance
13,500
Gross margin
$ 58,250
Nonmanufacturing costs
38,200
Net income
$ 20,050
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9 - 33
Inventory Buildup
How many units are in ending inventory?
300 + 9,000 – 4,100 = 5,200
How much cost is in ending inventory?
5,200 × $53.50 = $278,200
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9 - 34
Learning Objective 5
Differentiate throughput
costing from variable costing
and absorption costing.
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9 - 35
Throughput Costing
Revenues
Variable direct materials
cost of goods sold
Throughput contribution margin
Manufacturing costs
Nonmanufacturing costs
Operating loss
$568,000
32,000
$536,000
504,000
46,000
$ 14,000
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9 - 36
Throughput Costing
Manufacturing Costs:
Labor $21.00 × 10,000
$210,000
Indirect costs $24.00 × 10,000
240,000
Fixed costs
54,000
Total manufacturing costs
$504,000
What are other nonmanufacturing costs for the year?
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9 - 37
Throughput Costing
Nonmanufacturing Costs:
Variable $2.00 × 8,000
$16,000
Fixed
30,000
Total
$46,000
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9 - 38
Throughput Costing
Variable costing operating income:
$76,000
Throughput costing operating loss:
$14,000
Difference in operating income:
$90,000
How can this difference be explained?
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9 - 39
Throughput Costing
The 2,000 units in ending inventory
are valued as follows:
Variable
2,000 × $49 = $98,000
Throughput
2,000 × $4 = $8,000
$90,000 difference
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9 - 40
Throughput Costing
Absorption costing operating income: $85,000
Throughput costing operating loss:
$14,000
Difference in operating income:
$99,000
How can this difference be explained?
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9 - 41
Throughput Costing
The 2,000 units in ending inventory
are valued as follows:
Absorption
2,000 × $53.50 =
$107,000
Throughput
2,000 × $4
= $8,000
$99,000 difference
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9 - 42
Comparison of Inventory
Costing Methods
Actual Costing
Variable
Costing
Absorption
Costing
Throughput
Costing
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9 - 43
Comparison of Inventory
Costing Methods
Normal Costing
Variable
Costing
Absorption
Costing
Throughput
Costing
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9 - 44
Comparison of Inventory
Costing Methods
Standard Costing
Variable
Costing
Absorption
Costing
Throughput
Costing
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9 - 45
Learning Objective 6
Describe the various
capacity concepts
that can be used in
absorption costing.
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9 - 46
Alternative Denominator-Level
Concepts
Theoretical capacity
Practical capacity
Normal capacity
Master-budget capacity
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9 - 47
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.
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9 - 48
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?
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9 - 49
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
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9 - 50
Learning Objective 7
Understand the major factors
management considers in choosing
a capacity level to compute the
budgeted fixed overhead cost rate.
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9 - 51
Choosing a Capacity Level
What factors are considered
in choosing a capacity level?
Product
costing
Pricing
decision
Performance
evaluation
Financial
statements
Regulatory
requirements
Difficulty
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9 - 52
Decision Making
Assume that Lloyd’s Bicycles’ standard
hours are 2 hours per unit.
What is the budgeted fixed manufacturing
overhead cost per unit?
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9 - 53
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
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9 - 54
Learning Objective 8
Describe how attempts to
recover fixed costs of capacity
may lead to price increases
and lower demand.
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9 - 55
Downward Demand Spiral
The downward demand spiral is the continuing
reduction in demand that occurs when the prices
of competitors are not met and demand drops.
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9 - 56
Learning Objective 9
Explain how the capacity
level chosen to calculate
the budgeted fixed overhead
cost rate affects the
production-volume variance.
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9 - 57
Effect on Financial Statements
Assume that Lloyd’s Bicycles actually used
8,400 machine-hours during the year.
What is the production volume variance?
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9 - 58
Production Volume Variance
Production volume variance
= (Denominator level – Actual level)
× Budgeted fixed manufacturing overhead rate
Theoretical capacity:
(10,000 – 8,400) × $20.00 = $32,000 U
Practical capacity:
(8,500 – 8,400) × $23.53 = $2,353 U
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9 - 59
Production Volume Variance
Normal capacity:
(7,500 – 8,400) × $26.67 = $24,003
Master-budget capacity:
(6,000 – 8,400) × $33.33 = $79,992
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9 - 60
End of Chapter 9
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9 - 61