Chapter Eight
Absorption and Variable Costing,
and Inventory Management
COPYRIGHT © 2012 Nelson Education Ltd.
Learning Objectives
1. Explain the difference between absorption and
variable costing
2. Prepare segmented income statements
3. Discuss inventory management under the
economic order quantity and just-in-time (JIT)
models
8-2
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OBJECTIVE 1
Explain the difference
between absorption
and variable costing
Absorption Costing Income
Statement
• Assigns all manufacturing costs to the product
–
–
–
–
direct materials
direct labour
variable overhead
fixed overhead
• Fixed overhead is applied to the product using
a predetermined overhead rate
• Required by generally accepted accounting
principles (GAAP) for external reporting
8-4
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Variable Costing Income
Statement
• Assigns only variable manufacturing
costs to the product
– direct materials
– direct labour
– variable overhead
• Fixed overhead is treated as a period
expense
8-5
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Example: Cornerstone 8-1
How to Compute Inventory Cost under Absorption Costing
Information:
Units in beginning inventory
Units produced
Units sold ($300 per unit)
Variable costs per unit:
Direct materials
Direct labour
Variable overhead
Fixed costs:
Fixed overhead per unit produced
Fixed selling and administrative
---10,000
8,000
$50
$100
$50
$25
$100,000
8-6
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Example
Required:
1. How many units are in ending inventory?
2. Using absorption costing, calculate the perunit product cost
3. What is the value of ending inventory?
8-7
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Example
Units
Units ending
= beginning +
inventory
inventory
=
0
=
2,000
+
Units
–
produced
10,000
–
Units
sold
8,000
8-8
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Absorption Costing
Direct materials
Per unit
Direct labour
Variable overhead
Fixed overhead
Unit product cost
$ 50
100
50
25
$225
Value of ending inventory = 2,000 × $225 = $450,000
8-9
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Example: Cornerstone 8-2
How to Compute Inventory Cost under Variable Costing
Information:
Units in beginning inventory
Units produced
Units sold ($300 per unit)
Variable costs per unit:
Direct materials
Direct labour
Variable overhead
Fixed costs:
Fixed overhead per unit produced
Fixed selling and administrative
---10,000
8,000
$50
$100
$50
$25
$100,000
8-10
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Example
Required:
1. How many units are in ending inventory?
2. Using variable costing, calculate the perunit product cost
3. What is the value of ending inventory?
8-11
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Example
Units
Units ending
= beginning +
inventory
inventory
=
0
=
2,000
+
Units
–
produced
10,000
–
Units
sold
8,000
8-12
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Variable Costing
Direct materials
Direct labour
Variable overhead
Unit product cost
$ 50
Only variable
costs
100
50
$200
Value of ending inventory = 2,000 × $200 = $400,000
When inventory on hand exists, variable costing results in
lower ending inventory than absorption costing
8-13
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Absorption and Variable
Costing
DM
Absorption
Costing
Unit Cost
DM
DL
DL
Var OH
Var OH
Variable
Costing
Unit Cost
Fixed OH
Absorption Costing includes Fixed Overhead in
Unit Cost, Variable Costing does not
8-14
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Example: Cornerstone 8-3
How to Prepare an Absorption-Costing Income Statement
Information:
Units in beginning inventory
Units produced
Units sold ($300 per unit)
Variable costs per unit:
Direct materials
Direct labour
Variable overhead
Fixed costs:
Fixed overhead per unit produced
Fixed selling and administrative
---10,000
8,000
$50
$100
$50
$25
$100,000
8-15
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Example
Required:
1. Calculate the cost of goods sold under
absorption costing
2. Prepare an income statement using
absorption costing
8-16
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Example
Cost of
goods sold
Absorption
= unit product
cost
=
$225
×
Units sold
×
8,000
$50 + $100 + $50 + $25
= $1,800,000
8-17
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Fairchild Company
Absorption-Costing Income Statement
Sales ($300 × 8,000)
Less: Cost of goods sold
Gross Margin
$2,400,000
1,800,000
$ 600,000
Less: Selling and administrative expenses
Net Income
100,000
$ 500,000
Fixed selling and
administrative costs
8-18
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Example: Cornerstone 8-4
How to Prepare a Variable-Costing Income Statement
Information:
Units in beginning inventory
Units produced
Units sold ($300 per unit)
Variable costs per unit:
Direct materials
Direct labour
Variable overhead
Fixed costs:
Fixed overhead per unit produced
Fixed selling and administrative
---10,000
8,000
$50
$100
$50
$25
$100,000
8-19
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Example
Required:
1. Calculate the cost of goods sold under
variable costing
2. Prepare an income statement using variable
costing
8-20
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Example
Cost of
goods sold
=
Variable unit
product cost
×
Units sold
=
$200
×
8,000
$50 + $100 + $50
=
$1,600,000
8-21
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Fairchild Company
Variable-Costing Income Statement
Sales ($300 × 8,000)
$2,400,000
Less variable expenses:
Variable cost of goods sold
Contribution margin
1,600,000
$ 800,000
Less fixed expenses:
Fixed overhead
$250,000
Fixed selling and administrative 100,000
Net Income
350,000
$ 450,000
8-22
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Production, Sales, and
Income Relationships
If
Then
1.
Production > Sales
Absorption Income > Variable Income
2.
Production < Sales
Absorption Income < Variable Income
3.
Production = Sales
Absorption Income = Variable Income
8-23
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OBJECTIVE 2
Prepare segmented
income statements
Segmented Income
Statements
• Segment is a subunit of a company
–
–
–
–
divisions
departments
product lines
customer classes
• Fixed expenses are broken down into two
categories:
– direct fixed expenses
• directly traceable to a segment
– common fixed expenses
• jointly caused by two or more segments
25
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Segment Margin
Sales
– Variable Cost of Goods Sold
– Variable Selling Expense
Contribution Margin
– Direct fixed overhead
– Direct selling and administrative
Segment Margin
8-26
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Example: Cornerstone 8-5
How to Prepare a Segmented Income Statement
Information:
Sales
Variable cost of goods sold
Direct fixed overhead
•
•
DVD Players
$290,000
150,000
20,000
Sales commissions, 5% of sales
Direct fixed selling and administrative expense
estimated:
◦
◦
•
•
MP3 Players
$400,000
200,000
30,000
$10,000 for the MP3 line
$15,000 for the DVD line
Common fixed overhead est., $100,000
Common selling and administrative est., $20,000
8-27
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Example
Required:
Prepare a segmented income statement for
Audiomatronics Inc. for the coming year, using
variable costing
28
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Audiomatronics Inc.
Segmented Income Statement
For the Coming Year
MP3 Players
DVD Players
Total
$290,000
(150,000)
(14,500)
$690,000
(350,000)
Sales
$400,000
Variable cost of goods sold (200,000)
Variable selling expense
(20,000)
5% × $290,000
Sales commissions = 5% of Sales
5% × $400,000
8-29
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Audiomatronics Inc.
Segmented Income Statement
For the Coming Year
MP3 Players
DVD Players
Total
$290,000
(150,000)
(14,500)
$125,500
$690,000
(350,000)
(34,500)
$305,500
(20,000)
(15,000)
$ 90,500
(50,000)
(25,000)
$230,500
Sales
$400,000
Variable cost of goods sold (200,000)
Variable selling expense
(20,000)
Contribution Margin
$180,000
Less direct fixed expenses:
Direct fixed overhead
(30,000)
(10,000)
Direct selling & admin.
Segment margin
$140,000
Segment margin reflects only those costs directly related to the
operation of the segment. Common costs are not included in the
segment margin
8-30
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Audiomatronics Inc.
Segmented Income Statement
For the Coming Year
MP3 Players
DVD Players
Total
$290,000
(150,000)
(14,500)
$125,500
$690,000
(350,000)
(34,500)
$305,500
(20,000)
(15,000)
$ 90,500
(50,000)
(25,000)
$230,500
Sales
$400,000
Variable cost of goods sold (200,000)
Variable selling expense
(20,000)
Contribution Margin
$180,000
Less direct fixed expenses:
Direct fixed overhead
(30,000)
(10,000)
Direct selling & admin.
Segment margin
$140,000
Less common fixed expenses:
Common fixed overhead
Common selling & admin.
Operating Income
(100,000)
(20,000)
$110,500
8-31
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OBJECTIVE  3
Discuss inventory
management under the
economic order quantity and
just-in-time (JIT) models
Ordering Costs
• Costs of placing and receiving an order
• Examples:
– order processing costs
– cost of insurance for shipment
– unloading costs
8-33
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Carrying Costs
• Costs of carrying inventory
• Examples:
– insurance
– inventory taxes
– obsolescence
– opportunity cost of funds ties up in inventory,
handling costs, and storage space
8-34
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Stockout Costs
• Occur when demand is not known
• Costs of not having:
– product available when demanded by a customer
– raw materials available when needed for production
• Examples:
– lost sales
– costs of expediting
– costs of interrupted production
8-35
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Traditional Reasons for
Carrying Inventory
• To balance ordering or setup costs and carrying costs
• To satisfy customer demand
• To avoid shutting down manufacturing facilities because
of:
–
–
–
–
Machine failure
Defective parts
Unavailable parts
Late delivery of parts
• To buffer against unreliable production processes
• To take advantage of discounts
• To hedge against future price increases
8-36
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Example: Cornerstone 8-6
How to Calculate Ordering Cost,
and Total Inventory-Related Cost
Information:
• Mall-o-Cars Inc. uses part X7B to repair
water pumps
–
–
–
–
10,000 units of part X7B are used each year
currently purchased in lots of 1,000 units
cost of $25 to place an order
carrying cost is $2 per part per year
8-37
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required:
1. How many orders for Part X7B does Mall-oCars place per year?
2. What is the total ordering cost of Part X7B
per year?
3. What is the total carrying cost of Part X7B
per year?
4. What is the total cost of Mall-o-Car’s
inventory policy for Part X7B per year?
8-38
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Example
1. Number of orders
= Annual number of units used ÷
Number of units in an order
= 10,000 / 1,000
= 10 orders per year
8-39
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Example
2. Total ordering cost
= Number of orders × Cost per order
= 10 orders × $25
= $250
8-40
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Example
3. Total carrying cost
=
Average number of
units in inventory
×
Cost of carrying
one unit in
inventory
= (1,000/2) × $2
= $1,000
8-41
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Example
4. Total inventory-related cost
=
Total ordering cost
+
Total carrying cost
= $250 + $1,000
= $1,250
8-42
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Economic Order Quantity (EOQ):
The Traditional Inventory Model
•
•
•
Number of units in the optimal size order
Minimizes total inventory-related costs
Formula:
2 × CO × D/CC
Cost of placing
one order
Annual demand
in units
Cost of carrying
one unit in
inventory
8-43
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Example: Cornerstone 8-7
How to Calculate the EOQ
Information:
• Mall-o-Cars Inc. uses Part X7B to repair water
pumps
–
–
–
–
10,000 units of Part X7B are used each year
Currently purchased in lots of 1,000 units
Cost of $25 to place an order
Carrying cost is $2 per part per year
8-44
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Example
Required:
1. What is the EOQ for Part X7B?
2. How many orders per year for Part X7B will Mall-o-Cars
place under the EOQ policy?
3. What is the total annual ordering cost of Part X7B for a
year under the EOQ policy?
4. What is the total annual carrying cost of Part X7B per
year under the EOQ policy?
5. What is the total annual inventory-related cost for Part
X7B under the EOQ?
8-45
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Example
1. Economic Order Quantity (EOQ)
=
(2 × $25 × 10,000) /$2
=
500,000/2
= 500 units
8-46
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Example
2. Number of orders
= Annual number of units used / Number of
units in an order
= 10,000 / 500
= 20 orders per year
8-47
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Example
3. Total ordering cost
= Number of orders × Cost per order
= 20 orders × $25
= $500
8-48
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Example
4. Total carrying cost
=
Average number of
units in inventory
×
Cost of carrying
one unit in
inventory
= (500/2) × $2
= $500
8-49
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Example
5. Total inventory-related cost
=
Total ordering cost
= $500
+
Total carrying cost
+
$500
= $1,000
8-50
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Reorder Point
• Point in time when a new order should be
placed
• Function of:
– EOQ
– Lead time
– Rate at which inventory is used
Reorder point = Rate of usage × Lead time
8-51
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Example: Cornerstone 8-8
HOW TO Calculate the Reorder Point
Information:
Mall-o-Cars Inc. uses Part X7B to repair water pumps
– 10,000 units of Part X7B are used each year
– Used at a rate of 40 parts per day
– Takes 5 days from time of order to arrival of order
Required:
Calculate the reorder point
8-52
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Example
Reorder point = Daily usage × Lead time
Reorder point = 40 × 5 days
Reorder point = 200
8-53
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Example: Cornerstone 8-9
How to Calculate Safety Stock and
the Reorder Point with Safety Stock
Information:
• Mall-o-Cars Inc. uses Part X7B to repair water
pumps
– 10,000 units of Part X7B are used each year
– Used at an average rate of 40 parts per day
• But some days as many as 50 parts are used
– Takes 5 days from the time of order to the arrival of
the order
8-54
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required:
1. Calculate the amount of safety stock
2. Calculate the reorder point with safety stock
8-55
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Example
1. Safety stock
= (Maximum daily usage – Average daily usage)
× lead time
= (50 – 40) × 5 days
= 50
8-56
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Example
2. Reorder point
= Maximum daily usage × lead time
= 50 × 5 days
= 250
OR
= (Average daily usage × lead time) + Safety stock
= (40 × 5 days) + 50
= 250
8-57
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Just-in-Time (JIT) Approach
• Goods pushed through the system by present
demand rather than being pushed through on a
fixed schedule based on anticipated demand
• Each operation produces only what is necessary
to satisfy the demand of the succeeding operation
• Reduces all inventories to very low levels
• Reduces inventory carrying costs
8-58
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