Chapter 9

Inventory Costing
and Capacity
Analysis

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Cost

OverviewChapter 9

Inventory Costing Methods

Denominator Issues
Example: working backwards
BEPs: VC versus AC
Solution to extra problem (on webpage)

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Absorption Costing

All manufacturing cost are considered

inventoriable:

All variable mfg. costs (both direct & indirect)

All fixed mfg. costs (both direct & indirect)

Separates costs by business function.

Other costing terms:
(1) Super-full absorption costing: includes some mfg. related admin
costsused for tax.
(2) Full-product costing: costs from all areas of value chain are
attached to product costsfor L-T pricing.

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Variable Costing
All variable manufacturing costs are
considered inventoriable.
Separates costs by cost behavior.
Some managers call this direct costing
which is a poor choice of name. Why?
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Throughput Costing
Also called super-variable costing.
Only variable direct materials are
inventoriable. Assumes that only DM are
variable in the short run.
Reduces incentives to build up inventories.
Relatively new and not widely used.
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STOP! The big picture

Managers make a number of accounting
choices that affect income, for example:
Costing
Systems

Fixed Mfg.
Costs

Flow of
Costs

Actual

AC

Job

FIFO

Normal

VC

Process

LIFO

Standard

Tput

Other

Avg.
Specific I.D.
Standard
Retail

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Cost

Inventory-Costing Methods
The difference between variable costing
and absorption costing is based on the
treatment of fixed manufacturing costs.
AC includes fixed mfg. costs in cost of inventory,
while VC does not. VC expenses all fixed costs
as period costs.
2009 Foster School of Business

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Comparing Income Statements:

Absorption vs. Variable Costing
The following data pertain to Davenport Pencils:
Produce one product: #2 pencils. 1 box = 1 gross.
Sales price = $8/box; Sold 40,000 boxes
DM = $3 / box; DL = $0.50 / box
VMOH = $0.25 / box
FMOH = $100,000 / year
Sales commission = $0.75 / box
Fixed admin. expenses = $30,000 / year
Budget = actual production = 50,000 boxes
2009 Foster School of Business

Cost

Comparing Income Statements

What is the cost per box under VC?
$3.00 + 0.50 + 0.25 = $3.75
What is the cost per box under AC?
$3.00 + 0.50 + 0.25 + 2.00* = $5.75
* Fixed mfg. OH rate = $2.00 / box = $100,000 / 50,000 boxes

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Comparing Income Statements

Absorption Costing

Variable Costing

Revenue $320,000
CoGS
230,000
GM
90,000
S&A
60,000
Op. Inc. $ 30,000

Revenue $320,000
VC
180,000
CM
140,000
FC
130,000
Op. Inc. $ 10,000

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Comparison of Variable
and Absorption Costing
Variable costing operating income : $10,000
Absorption costing operating income : $30,000
Absorption costing operating income is
$20,000 higher.
Why?

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Comparison of Variable
and Absorption Costing
Production exceeds sales.
The 10,000 unit increase in ending inventory
are valued as follows:
Absorption costing: 10,000 $5.75 = $ 57,500
Variable costing:

10,000 $3.75 = $ 37,500

Difference:
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$ 20,000
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Comparison of Variable
and Absorption Costing
COGS
Absorption costing: 40,000 X $5.75 = $230,000
Variable costing: 40,000 X $3.75 = $150,000
Plus all the fixed mfg. OH = $100,000
Lower costs recognized under
absorption costing:
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$ 20,000
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Comparison of Variable
and Absorption Costing
Under absorption costing, each of the
additional 10,000 boxes in ending inventory is
storing $2/box cost that will be expensed later
when sold.
10,000 units of inventory $2.00 = $20,000

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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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Absorption Costing & Inventory

Buildup
What happens over the long run?
How might you mitigate the incentive to
build up inventory?

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Alternative Denominator-Level
Concepts
Theoretical capacity
Practical capacity
Normal capacity
Master-budget capacity
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Budgeted Fixed Manufacturing

Overhead Rate
Lloyds 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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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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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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Effect of Denominator Level

Choice
The larger the denominator level, the:
Lower the budgeted FM rate.
Lower Fixed Mfg. costs in E.Inv.
Higher the unfavorable PVV for fixed OH
RememberFixed mfg. are either expensed in
the period or stored in E.Inv.
What denominator level would you want to use
for tax purposes? [practical is required for tax]
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Decision Making
Assume that Lloyds Bicycles standard
hours are 2 hours per unit.
What is the budgeted fixed manufacturing
overhead cost per unit?

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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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Exerciseworking backward
QQQ Company has op. income of $120,000
under absorption costing, and op. income
would be $100,000 under variable costing.
FMOH = $500,000
Budgeted and actual production = 200,000
units.
Did inventory increase or decrease during the
period? By how much?
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In-class problem
Answer depends on the FMOH rate for
B.Inv and choice of inventory cost-flow
method (FIFO, WA, LIFO, etc.).
Assume no change in FMOH rate. Then
choice of cost-flow method does not matter.
FMOH rate = $500k / 200k = $2.50 / unit

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Calculation of BE points
Unique solution under Variable Costing:
BEPvc = Total FC / UCM

Solution depends on production level under

Absorption Costing:
BEPac = [Total FC + (FM rate* (BEPac Units
Produced))] / UCM
BEPac = [Total FC (FMR*UP)] / (UCM FMR)
What happens to the BEP when more units are produced?
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