Inventory Costing and Capacity
Analysis
Session 9
Cost Accounting
Horngreen, Datar, Foster
Learning Objectives
 Distinguish variable costing from absorption costing
 Explain differences in operating income under absorption costing and
variable costing
 Understand how absorption costing can provide undesirable incentives
for managers
 Differentiate throughput costing from variable costing and absorption
costing
 Denominator-level capacity concepts that can be used in absorption
costing
 Explain effects of the denominator level on the production-volume
variance
 How attempts to recover fixed costs of capacity may lead to a downward
demand spiral
Cost Accounting
Horngreen, Datar, Foster
Learning Objective 1
Identify what distinguishes
variable costing from
absorption costing.
Cost Accounting
Horngreen, Datar, Foster
Inventory-Costing Methods
 The difference between variable costing and absorption
costing is based on the treatment of fixed manufacturing
overhead.
Variable
Factory
Labor
Direct
Materials
Work in Process Inventory
Cost Accounting
Horngreen, Datar, Foster
(variable)
Overhead
Variable Costing
Work in Process
Inventory
Finished Goods
Inventory
Fixed Factory
Overhead
Cost of Goods Sold
Income Summary
Cost Accounting
Horngreen, Datar, Foster
Absorption Costing
Work in Process
Inventory incl fixed
costs
Finished Goods
Inventory
Cost of Goods Sold
Income Summary
Cost Accounting
Horngreen, Datar, Foster
Learning Objective 2
Prepare income statements
under absorption costing
and variable costing.
Cost Accounting
Horngreen, Datar, Foster
Comparing Income Statements
 The following data pertain to Davenport Fixtures:
Beginning inventory
Produced
Sold
Ending inventory
Cost Accounting
Year 1
-010,000
8,000
2,000
Year 2
2,000
11,500
13,000
500
Horngreen, Datar, Foster
Total
-021,500
21,000
500
Comparing Income Statements
 The following information is on a per unit
basis:
Sales price:
Variable manufacturing costs:
Direct materials:
Direct manufacturing labor:
Indirect manufacturing costs:
Fixed manufacturing costs:
Cost Accounting
Horngreen, Datar, Foster
$71.00
$ 4.00
$21.00
$24.00
$ 4.50
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.
Revenues
Cost of goods sold
Volume variance (U)
Gross margin
Nonmanufacturing costs
Operating income
Cost Accounting
$568,000
428,000
9,000
$131,000
46,000
$ 85,000
Horngreen, Datar, Foster
Comparing Income Statements
(Absorption Costing)
 Revenues for Year 1 are $568,000.
 What is the cost of goods sold?
• 8,000 × $53,5 = $428,000
 What is the Gross margin?
• $568,000 – $428,000 –9.000 = $131,000
• Operating Income = $131,000 - $46,000 = $85,000
Cost Accounting
Horngreen, Datar, Foster
Comparing Income Statements
(Variable Costing)
Revenues
Cost of goods sold
Variable nonmanufacturing costs
Contribution margin
Fixed manufacturing costs
Fixed nonmanufacturing costs
Operating income
Cost Accounting
Horngreen, Datar, Foster
$568,000
392,000
16,000
$160,000
54,000
30,000
$ 76,000
Learning Objective 3
Explain differences in operating
income under absorption
costing and variable costing.
Cost Accounting
Horngreen, Datar, Foster
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
 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
Cost Accounting
Horngreen, Datar, Foster
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
Revenues
Cost of goods sold
Volume variance (U)
Gross margin
Nonmfg. costs
Operating income
Cost Accounting
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
Horngreen, Datar, Foster
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
 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
Cost Accounting
Horngreen, Datar, Foster
Income Statements (Variable Costing)
Year 1
Revenues
$ 568,000
Cost of goods sold
392,000
Mfg. contr. margin
$176,000
Variable nonmfg.
16,000
Net contr. margin
$160,000
Fixed mfg. costs
54,000
Fixed nonmfg. costs
30,000
Operating income
$ 76,000
Cost Accounting
Year 2
$923,000
637,000
$286,000
26,000
$260,000
54,000
30,000
$176,000
Horngreen, Datar, Foster
Combined
$1,491,000
1,029,000
$ 462,000
42,000
$ 420,000
108,000
60,000
$252,000
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.
 Variable costing operating income Year 2: $176,000
 Absorption costing operating income Year 2: $169,250
 Variable costing operating
Why?
income is $6,750 higher.
Cost Accounting
Horngreen, Datar, Foster
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: 2,000 × $49.00 = $ 98,000
Difference:
$ 9,000





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:
Cost Accounting
Horngreen, Datar, Foster
$ 6,750
Comparison of Variable and
Absorption Costing




Variable costing combined net income:
Absorption costing combined net income:
Absorption costing is higher by
500 units in inventory × $4.50 = $2,250
Absorption costing
operating income
Fixed manufacturing
costs in ending
inventory under
absorption costing
Cost Accounting
$252,000
$254,250
$2,250
Variable costing
operating income
–
EQUALS
–
Fixed manufacturing
costs in beginning
inventory under
absorption costing
Horngreen, Datar, Foster
Learning Objective 4
Understand how absorption
costing can provide undesirable
incentives for managers to
build up finished goods inventory.
Cost Accounting
Horngreen, Datar, Foster
Undesirable effects of producing for
inventory
 Production of items that absorb minimal fixed manufacturing
costs may be delayed.
 A plant manager may accept a particular order to increase
production even though another plant in the same company
is better suited to handle that order.
 A plant manager may defer maintenance.
Cost Accounting
Horngreen, Datar, Foster
Revising Performance Evaluation
 Budget carefully and use inventory planning.
 Discontinue the use of absorption costing for internal
reporting and instead use variable costing.
 Incorporate a carrying charge for inventory.
 Lengthen the time period used to evaluate performance.
 Include nonfinancial as well as financial variables in the
measures used to evaluate performance.
• Ending inventory in units this period ÷ Ending inventory in units last
period
• Sales in units this period ÷ Ending inventory in units this period
Cost Accounting
Horngreen, Datar, Foster
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?
Revenues (4,100 × $71)
Cost of goods sold (4,100 × $53.50)
Volume variance
Gross margin
Nonmanufacturing costs
Net loss
Cost Accounting
Horngreen, Datar, Foster
$291,100
219,350
34,200
$ 37,550
38,200
$ 650
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
 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?
Cost Accounting
Horngreen, Datar, Foster
Inventory Buildup
Revenues (4,100 × $71)
Cost of goods sold (4,100 × $53.50)
Volume variance
Gross margin
Nonmanufacturing costs
Net income
 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
Cost Accounting
Horngreen, Datar, Foster
$291,100
219,350
13,500
$ 58,250
38,200
$ 20,050
Learning Objective 5
Differentiate throughput
costing from variable costing
and absorption costing.
Cost Accounting
Horngreen, Datar, Foster
Throughput Costing
Revenues
Variable direct materials
cost of goods sold
Throughput contribution margin
Manufacturing costs
Nonmanufacturing costs
Operating loss
Cost Accounting
Horngreen, Datar, Foster
$568,000
32,000
$536,000
504,000
46,000
$ 14,000
Throughput Costing
Manufacturing Costs:
Labor $21.00 × 10,000
Indirect costs $24.00 × 10,000
Fixed costs
Total manufacturing costs
Cost Accounting
Horngreen, Datar, Foster
$210,000
240,000
54,000
$504,000
Throughput Costing
 What are other nonmanufacturing costs for the year?
 Nonmanufacturing Costs:
• Variable $2.00 × 8,000
• Fixed
• Total




$16,000
30,000
$46,000
Variable costing operating income:
$76,000
Throughput costing operating loss:
$14,000
Difference in operating income:
$90,000
How can this difference be explained?
Cost Accounting
Horngreen, Datar, Foster
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
Cost Accounting
Horngreen, Datar, Foster
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?
Cost Accounting
Horngreen, Datar, Foster
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
Cost Accounting
Horngreen, Datar, Foster
Comparison of Inventory Costing
Methods
Actual Costing
Variable
Costing
Cost Accounting
Absorption
Costing
Throughput
Costing
Horngreen, Datar, Foster
Comparison of Inventory Costing
Methods
Normal Costing
Variable
Costing
Cost Accounting
Absorption
Costing
Throughput
Costing
Horngreen, Datar, Foster
Comparison of Inventory Costing
Methods
Standard Costing
Variable
Costing
Cost Accounting
Absorption
Costing
Throughput
Costing
Horngreen, Datar, Foster
Learning Objective 6
Describe the various
capacity concepts
that can be used in
absorption costing.
Cost Accounting
Horngreen, Datar, Foster
Alternative Denominator-Level Concepts
 The choice of the denominator used to allocate budgeted
fixed manufacturing costs to products can greatly affect the
numbers a normal or standard (absorption) costing system
will report prior to the end of an accounting period.




Theoretical capacity
Practical capacity
Normal capacity
Master-budget capacity
Cost Accounting
Horngreen, Datar, Foster
Theoretical Capacity
 Theoretical capacity xt
(maximum or ideal capacity) is the denominator level
concept that is based on producing at full (peak) efficiency
all the time.
Cost Accounting
Horngreen, Datar, Foster
Practical Capacity
 Practical capacity xp
is the denominator-level concept that reduces theoretical
capacity by unavoidable operating interruptions.
 The use of practical capacity is required by the Internal
Revenue Service (IRS).
Cost Accounting
Horngreen, Datar, Foster
Normal Capacity
 Normal capacity xn
is the denominator-level concept based on the level of
capacity utilization that satisfies average customer demand
over several periods.
 It includes seasonal, cyclical, and trend factors.
Cost Accounting
Horngreen, Datar, Foster
Master-Budget Capacity
 Master-budget capacity xm
is the denominator-level concept based on the expected
level of capacity utilization for the next budget period
(typically one year).
Cost Accounting
Horngreen, Datar, Foster
Learning Objective 7
Understand the major factors
management considers in choosing
a capacity level to compute the
budgeted fixed overhead cost rate.
Cost Accounting
Horngreen, Datar, Foster
Choosing a Capacity Level
What factors are considered
in choosing a capacity level?
Product
costing
Pricing
decision
Financial
Regulatory
statements requirements
Cost Accounting
Performance
evaluation
Difficulty
Horngreen, Datar, Foster
Learning Objective 8
Describe how attempts to
recover fixed costs of capacity
may lead to price increases
and lower demand.
Cost Accounting
Horngreen, Datar, Foster
Downward Demand Spiral
 The use of normal capacity utilization or master-budget
capacity utilization can result in capacity costs being spread
over a small number of output units.
 The downward demand spiral is the continuing reduction in
demand that occurs when the prices of competitors are not
met and demand drops.
Cost Accounting
Horngreen, Datar, Foster