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of Managerial Accounting, 6e
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CHAPTER 8:
ABSORPTION AND VARIABLE
COSTING, AND INVENTORY
MANAGEMENT
Cornerstones of Managerial
Accounting, 6e
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Variable and Absorption Income
Statements
Many companies consist of separate business
units called profit centers.
It is important for these companies to determine
both the overall performance of the business and
the performance of the individual profit centers.
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Variable and Absorption Income
Statements (cont.)
Therefore, it is important to develop a segmented
income statement for each profit center.
Two methods of computing income have been
developed:
one based on variable costing and
the other based on full or absorption costing.
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Absorption Costing
Absorption costing assigns all manufacturing
costs to the product.
Direct materials, direct labor, variable overhead, and
fixed overhead define the cost of a product.
Under this method, fixed overhead is assigned to
the product through the use of a predetermined
fixed overhead rate and is not expensed until the
product is sold.
Fixed overhead is an inventoriable cost.
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Variable Costing
Variable costing stresses the difference between
fixed and variable manufacturing costs.
Variable costing assigns only variable
manufacturing costs to the product; these costs
include direct materials, direct labor, and variable
overhead.
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Variable Costing (cont.)
Fixed overhead is treated as a period expense
and is excluded from the product cost.
Under variable costing, fixed overhead of a
period is seen as expiring that period and is
charged in total against the revenues of the
period.
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Comparison of Variable and
Absorption Costing Methods
Generally accepted accounting principles (GAAP)
require absorption costing for external reporting.
The Financial Accounting Standards Board
(FASB), the Internal Revenue Service (IRS), and
other regulatory bodies do not accept variable
costing as a product-costing method for external
reporting.
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Comparison of Variable and
Absorption Costing Methods (cont.)
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Comparison of Variable and
Absorption Costing Methods (cont.)
The only difference between the two approaches
is the treatment of fixed factory overhead.
The unit product cost under absorption costing is
always greater than the unit product cost under
variable costing.
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Comparison of Variable and
Absorption Costing Methods
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Production, Sales, and Income
Relationships
The relationship between variable-costing income
and absorption-costing income changes as the
relationship between production and sales
changes.
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Production, Sales, and Income
Relationships (cont.)
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Segmented Income Statements
Using Variable Costing
Variable costing is useful in preparing segmented
income statements because it gives useful
information on variable and fixed expenses.
A segment is a subunit of a company of sufficient
importance to warrant the production of
performance reports.
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Segmented Income Statements
Using Variable Costing (cont.)
Segments can be divisions, departments, product
lines, customer classes, and so on.
In segmented income statements, fixed expenses
are broken down into two categories:
direct fixed expenses and
common fixed expenses.
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Direct Fixed Expenses
Direct fixed expenses are fixed expenses that
are directly traceable to a segment.
These are sometimes referred to as avoidable
fixed expenses or traceable fixed expenses
because they vanish if the segment is eliminated.
For example, if the segments were sales regions, a
direct fixed expense for each region would be the rent
for the sales office.
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Common Fixed Expenses
Common fixed expenses are jointly caused by
two or more segments.
These expenses persist even if one of the
segments to which they are common is
eliminated.
Example: Depreciation on the corporate headquarters
building or the salary of the CEO would be a common
fixed expense for most large companies.
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Decision Making for Inventory
Management
Inventory can definitely affect operating income.
In addition to the product cost of inventory, there
are other types of costs that relate to inventories
of raw materials, work in process, and finished
goods.
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Inventory-Related Costs
If the inventory is a material or good purchased
from an outside source, then these inventory-
related costs are known as ordering costs and
carrying costs.
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Inventory-Related Costs (cont.)
If the material or good is produced internally, then
the costs are called setup costs and carrying
costs.
Ordering costs are the costs of placing and receiving an
order.
Carrying costs are the costs of keeping and storing
inventory.
Stockout costs are the costs of not having a product
available when demanded by a customer or the cost of
not having a raw material available when needed for
production.
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Economic Order Quantity:
The Traditional Model
Once a company decides to carry inventory, two
basic questions must be addressed:
How much should be ordered?
When should the order be placed?
In choosing an order quantity, managers need to
be concerned only with ordering and carrying
costs.
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Economic Order Quantity:
The Traditional Model
The formulas for calculating these are as follows:
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The Economic Order Quantity
Maintaining an order quantity equal to the
average inventory may not be the best choice.
Some other order quantity may produce a lower
total cost.
The objective is to find the order quantity that
minimizes the total cost.
The number of units in the optimal size order
quantity is called the economic order quantity
(EOQ).
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The Economic Order Quantity
Since EOQ is the quantity that minimizes total
inventory-related costs, a formula for computing it
is:
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Reorder Point
Knowing when to place an order (or setup for
production) is also an essential part of any
inventory policy.
The reorder point is the point in time when a
new order should be placed (or setup started).
It is a function of the EOQ, the lead time, and the
rate at which inventory is used.
Lead time is the time required to receive the economic
order quantity once an order is placed or a setup is
started.
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Reorder Point (cont.)
Knowing the rate of usage and lead time allows
us to compute the reorder point that
accomplishes these objectives:
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Safety Stock
Safety stock is extra inventory carried to serve
as insurance against changes in demand.
Safety stock is computed by multiplying the lead
time by the difference between the maximum rate
of usage and the average rate of usage:
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Just-in-Time Approach
to Inventory Management
The just-in-time (JIT) approach maintains that
goods should be pulled through the system by
present demand rather than being pushed
through on a fixed schedule based on anticipated
demand.
The material or subassembly arrives just in time
for production to occur so that demand can be
met.
Fast-food restaurants use this type of pull system.
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Limitations of Just-in-Time
Approach
JIT does have limitations.
It is often referred to as a program of
simplification—yet this does not imply that JIT is
simple or easy to implement.
It requires time for building sound relationships
with suppliers.
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Limitations of Just-in-Time
Approach (cont.)
Insisting on immediate changes in delivery times
and quality may not be realistic and may cause
difficult confrontations between a company and
its suppliers.
Reductions in inventory buffers may cause a
regimented workflow and high levels of stress
among production workers.
It requires careful and thorough planning and
preparation.
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