Test bank accounting management 11e chapter 09 INVENTORY COSTING AND CAPACITY ANALYSIS

As a manufacturing cost, the issue of inventory costing and its effect on operating income under different costing systems exists.. Variable costing – contribution-margin format Costs ca

CHAPTER 9

INVENTORY COSTING AND CAPACITY ANALYSIS

LEARNING OBJECTIVES

1. Identify what distinguishes variable costing from absorption costing

2. Prepare income statements under absorption costing and variable costing

3. Explain differences in operating income under absorption costing and variable costing

4. Understand how absorption costing can provide undesirable incentives for managers to build up finished goods inventory

5. Differentiate throughput costing from variable costing and absorption costing

6. Describe the various capacity concepts that can be used in absorption costing

7. Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate

8. Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand

9. Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects the production-volume variance

CHAPTER OVERVIEW

Chapter 9 is about fixed manufacturing costs As a manufacturing cost, the issue of inventory costing and its effect on operating income under different costing systems exists As a fixed cost, the issue of rate

calculations and choice of a denominator exists These issues can be studied separately through the structure

of the chapter though both have the common characteristic of how best to determine the cost of manufacturing

a product when that cost changes upon being applied as a cost per unit of product

For external reporting all usual and reasonable manufacturing costs are considered as costs of the product using absorption costing Managers, however, often find the behavior aspect of costs, rather than the function

of those costs, to be most helpful in making decisions about volume and profit and use variable costing for internal reports These two costing approaches yield different operating income amounts when production and sales differ

The investment base for a manufacturing-sector company is usually the source for most of the fixed

manufacturing costs and with the emphasis on technology, many companies have more fixed manufacturing

purposes is highlighted throughout the chapter.

The calculation of breakeven point using absorption costing is illustrated in the appendix to the chapter

CHAPTER OUTLINE

I. Fixed manufacturing costs – the difference in inventory costing systems

Learning Objective 1:

Identify what distinguishes variable costing from absorption costing

A. Classification issue

1. Methods of inventory costing

a. Variable costing of inventory

i. All variable manufacturing costs included as inventoriable costs—assets initially

ii. All fixed manufacturing costs excluded from inventoriable costs because charged to income as incurred—expenses

b. Absorption costing of inventory: required method under GAAP for external reporting and tax reporting in most countries

i. All variable manufacturing costs included as inventoriable costs—assets initially

ii. All fixed manufacturing costs included as inventoriable costs—assets initially All nonmanufacturing costs in the value chain, whether variable or fixed, charged to income as incurred within the accounting period

Do multiple choice 1 Assignments start with L O 3.

Learning Objective 2:

Prepare income statements under absorption costing and variable costing

B Income statement presentation [Exhibit 9-1]

1 Highlighted by format indicating cost classification

a Variable costing – contribution-margin format

Costs categorized by variable or fixed—only variable manufacturing costs inventoriable

Fixed costs expensed in total Absorption costing – gross-margin format

Costs categorized by manufacturing or nonmanufacturing—all manufacturing costs inventoriable

Fixed manufacturing costs expensed per unit in cost of goods sold

2 Direct costing: not accurate term to describe variable costing

Variable costing does not include all direct costs as inventoriable (only direct variable manufacturing costs—direct fixed manufacturing and direct nonmanufacturing excluded)

Variable costing includes direct and some indirect variable manufacturing costs as inventoriable

Not all variable costs are inventoriable costs—must be manufacturing variable costs

Do multiple choice 2 and 3 Assignments start with L.O 3.

Operating income differences [Exhibit 9-2]

Learning Objective 3:

Explain differences in operating income under absorption costing and variable costing

Goods sold versus goods produced [Exhibit 9-3]

Variable costing: quantity sold drives cost and income Absorption costing: quantity sold and produced drives cost and income Inventory increase from beginning to end: less fixed costs expensed Inventory decrease from beginning to end: more fixed costs expensed

c Low levels of inventory have less effect (less “material” in amount)

Do multiple choice 4 Assign Exercises 9-16, 9-18, 9-20, and 9-21

Income manipulation—undesirable buildup of inventories [Exhibit 9-4]

Using reported income based on absorption costing to increase operating income by increasing production (even if no increase in customer demand)

Learning Objective 4:

Understand how absorption costing can provide undesirable incentives for managers to build up finished goods inventory

Switch to manufacturing products that absorb highest amounts of fixed manufacturing costs and delaying those that absorb the least or lower fixed manufacturing costs

ii Accept orders to increase production at one plant rather than produce at a better suited plant

Defer maintenance beyond current accounting period Increase amount of inventory units each year

b Revising performance evaluation—reducing undesirable effects of absorption costing

Careful budgeting and inventory planning to reduce management freedom to build

up excess inventory Change the accounting system from absorption costing to variable costing for internal reporting

Incorporate a carrying charge for inventory in the internal accounting system Change to a longer time period to evaluate performance

Include nonfinancial as well as financial variable in measures for performance

evaluation [Concepts in Action]

Do multiple choice 5 Assign Exercise 9-23, Problems 9-30 and 9-33.

Learning Objective 5:

Differentiate throughput costing from variable costing and absorption costing

Another costing method – throughput costing (also called super-variable costing)

Method of inventory costing in which only direct material costs are inventoriable costs; all other costs are costs of the period in which incurred

Reporting includes throughput contribution: revenues minus all direct material costs of goods sold

[Exhibit 9-5]

Advocates say it provides less incentive to produce for inventory than other methods

E Comparison of inventory costing methods [Exhibit 9-6] [Surveys of Company

Practice]

Do multiple choice 6 Assign Exercises 9-17 and 9-19.

Fixed manufacturing cost capacity analysis and denominator-level capacity concepts

Learning Objective 6:

Describe the various capacity concepts that can be used in absorption costing

Choices for denominator-level capacity (absorption costing issue)

Supply–based choices (available from the plant—upper limit or constraint)

Theoretical capacity: producing at full efficiency all the time: largest

denominator/smallest rate

Practical capacity: reduces theoretical capacity by unavoidable operating

interruptions: somewhat smaller than theoretical denominator/larger rate

Demand-based choices (demand for product is constraint)

Normal capacity utilization: satisfies average customer demand over several

periods: typically lesser than practical denominator/larger rate

Master-budget capacity utilization: expected level of capacity utilization for the

next budget period: usually smallest denominator/largest rate

Do multiple choice 7 Assign Exercise 9-24 and Problem 9-34.

Choices for capacity level to compute budgeted fixed overhead cost rate

Different costs for different purposes

Learning Objective 7:

Understand the major factors management considers in choosing a capacity level to compute the budgeted fixed overhead cost rate

Effect on product costing and capacity management

Highlighting the cost of capacity acquired but not used by use of practical capacity level

b Managing unused capacity (practical capacity level) by designing new products, leasing to others, eliminating excess capacity

Do multiple choice 8 Assign Exercise 9-25.

Learning Objective 8:

Describe how attempts to recover fixed costs of capacity may lead to price increases and lower demand

Effect on pricing decisions

Customers willing to pay price that covers cost of capacity actually used but not willing to bear cost of unused capacity—use of practical capacity

Using smaller denominator of supply-based capacity levels with unused capacity means larger cost per unit

Continuing reduction in demand for product when not meeting competitors’ prices

may result in downward demand spiral resulting in higher and higher units costs

and more reluctance to meet competitors’ prices

Using practical capacity level avoids recalculation of rate—use of capacity available rather than capacity used to meet demand

Do multiple choice 9 Assign Problems 9-36, 9-39, and 9-40.

Effect on performance evaluation

Use of appropriate capacity level for time-span of performance period: if current year

is evaluation period, use short-term measure such as master-budget capacity utilization (the principal short-run planning and control tool)

Use of responsibility accounting to classify part of difference between practical capacity level and master-budget capacity utilization as planned unused capacity

Learning Objective 9:

Explain how the capacity level chosen to calculate the budgeted fixed overhead cost rate affects the production-volume variance.

Effect on financial statements

Magnitude of favorable/unfavorable production-volume variance affected by choice

of denominator used to calculate the rate (absorption costing) Method of handling end-of-period variances results in different effect on financial

statements [Refer to Chapter 4]

Adjusted allocation-rate approach—effectively changes to actual costing so denominator choice has no effect on end-of-period financial statements Proration approach—denominator choice has no effect on end-of-period financial statements as underallocated or overallocated is spread among ending balances of work-in-process inventory, finished goods inventory, and cost of goods sold

c Immediate write-off to cost of goods sold approach—denominator choice has

an effect on end-of-period financial statements [Exhibit 9-7]

Regulatory requirements: IRS requires use of practical capacity level to calculate the rate and

proration for tax reporting

Difficulties in forecasting chosen denominator-level capacity

Practical capacity (supply concept) provides more reliable estimate

b Normal capacity utilization (demand concept) more difficult to estimate but shorter time span for master-budget capacity utilization more reliably estimated Other issues

Managers use range of activity due to uncertainty about the future: denominator-level concept (normal or standard costing) use a single amount of activity—unused

capacity allows gain from meeting sudden demand surges Events affect amount of fixed costs used in numerator of rate calculation

c Capacity as a total concept for an organization with parts of value chain having individual capacity concerns

Do multiple choice 10 Assign any of Exercises 22, 27, 28 or 29 and Problems

9-35, 37, 38.

III Breakeven point with absorption costing

Do multiple choice 11 and 12 Assign Exercise 9-26, Problems 9-31 and 9-32.

Chapter Quiz Solutions: 1.c 2.d 3.c 4.b 5.a 6.d 7.c 8.a 9.b 10.d 11.c 12.a

CHAPTER QUIZ

1. The main difference between variable costing and absorption costing is

a the treatment of nonmanufacturing costs

a. the accounting for variable manufacturing costs

b. the accounting for fixed manufacturing costs

c. their value for decision makers

The following data apply to questions 2 and 3

Alvin Inc planned and actually manufactured 200,000 units of its single product in 2001, its first year of operations Variable manufacturing costs were $30 per unit of product Planned and actual fixed

manufacturing costs were $600,000, and marketing and administrative costs totaled $400,000 in 2001 Alvin sold 120,000 units of product in 2001 at a selling price of $40 per unit

2 [CMA Adapted] Alvin’s 2001 operating income using variable costing is

a $800,000 b $600,000 c $440,000 d $200,000

3 [CMA Adapted] Alvin’s 2001 operating income using absorption costing is

a $840,000 b $800,000 c $440,000 d $200,000.

4 [CPA Adapted] Operating income using variable costing as compared to absorption costing would be higher

a when the quantity of beginning inventory equals the quantity of ending inventory.

b when the quantity of beginning inventory is more than the quantity of ending inventory.

c when the quantity of beginning inventory is less than the quantity of ending inventory.

d under no circumstances.

5 Absorption costing enables managers to increase operating income in the short run by changing production schedules Which statement is true regarding such action?

a The reason for increased operating income is the deferral of fixed manufacturing overhead contained in unsold inventory.

b A desirable effect of these changes in production is “cherry picking” the production line.

c This is done through decreases in the production schedule as customer demand for product falls.

d None of the above statements are true regarding manager’s action to increase operating income through changes in the production schedule.

6 The proponents of throughput costing

a maintain that variable costing undervalues inventories.

b maintain that it provides more incentive to produce for inventory than do either variable or absorption costing.

c argue that only direct materials and direct labor are “truly variable” and all indirect

manufacturing costs be written off in the period in which they are incurred.

d treat all costs except those related to variable direct materials as costs of the period in which they are incurred.

7.

The absolute minimum absorption-inventory cost that would be reported under the best conceivable operating conditions is a description of which type of denominator-level concept cost?

a Master-budget utilization

b Practical capacity

c Theoretical capacity

d Normal utilization

8 Use of capacity levels based on demand

a hides the amount of unused capacity.

b highlights the cost of capacity acquired but not used.

c yields a cost rate that does not include a charge for unused capacity.

d results in a price that covers the cost of capacity customers expect to pay.

9 A company may experience the downward demand spiral when

a the use of theoretical capacity as a denominator-level has contributed to budgets that project sales to be higher than actually attainable.

b spreading capacity costs over a small number of units and setting selling prices even higher

to recover those costs.

c engaged in a cyclical business and after experiencing an upturn.

d the production-volume variance is unfavorable each time period during a year

10 The manner in which a company deals with end-of-period variances will determine the effect production-volume variances have on the company’s end-of-period operating income When the chosen capacity level exceeds the actual production level, which approach to end-of-period variances results in an unfavorable production-volume variance affect on that period’s operating income?

a Proration approach

b Adjusted allocation-rate approach

c Theoretical approach

d Write-off variances to cost of goods sold approach

11 Under a variable costing system, the breakeven point is a function of

Sales Volume Production Volume

12 Under an absorption costing system, the breakeven point is a function of

Sales Volume Production Volume

b No Yes

WRITING/DISCUSSION EXERCISES

1. Identify what distinguishes variable costing from absorption costing

What is the background of the concept of variable costing? H Thomas Johnson and Robert

Kaplan describe the origins of cost accounting practices in their book, Relevance Lost: The Rise and Fall of Management Accounting, (Harvard Business School Press, 1987) According to them, J Maurice Clark, economist at the University of Chicago, was influential in giving prominence to the concept of fixed and variable costs in cost accounting for use in decision making during the 1920s

2 Prepare income statements under absorption costing and variable costing

Compare the assumptions made for the text example of Stassen Company (year 2003) for preparation of absorption and variable costing income statements and the assumptions made for the cost-volume-profit model in Chapter 3 Which of the assumptions is not stated about CVP because it is not critical to the calculation of income on a variable costing basis but is a critical assumption when comparing variable to absorption costing? Assumptions

from Stassen model that match to the cost-volume-profit model assumptions:

1 One cost driver of output units (driven by units produced or sold)[linear relation]

2 Costs are divided into variable or fixed classification

3 Unit selling price, unit variable costs, and fixed costs are known (budgeted)

4 Single product or constant sales mix

One assumption from Stassen model needed for comparison of variable costing to absorption costing: Units produced are different than units sold

The CVP model does not explicitly state an assumption about a change in inventory level because such a change would have no effect on operating income Absorption costing, however, has

manufacturing fixed costs as part of the unit cost of the product If inventories increase (more units produced than units sold) manufacturing fixed costs are “parked” on the balance sheet rather than expensed through cost of goods sold If inventories decrease, manufacturing fixed costs are pulled from the balance sheet to the income statement and expensed in a greater amount than the amount of that year’s fixed costs in total

3 Explain differences in operating income under absorption costing and variable

costing

The authors of the text note that by keeping inventory levels low, the differences between absorption costing and variable costing become less in amount What other factors could minimize the differences between these two types of costing inventory? Companies that have a

steady flow of production and sales would tend to have less fluctuation in the levels of inventory, and

therefore less variation in comparing absorption costing and variable costing If a company has a pattern of