Description
Q1. What was the point of the Dead Duck Brewery illustration? (Hint: when to stop a product line or raise prices?)Q2. Proponents of variable costing believe that having fixed cost per unit distorts the costing picture and results in inventory recessions. What is the downside of using variable costing?Q3. What is the major difference between throughput variances and traditional flexible budget variances?
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CHAPTER 9
Inventory Costing
and
Capacity Analysis
Inventory Costing Choices: Overview
• Absorption costing—product costs are
capitalized; period costs are expensed.
• Variable costing—variable product and period
costs are capitalized; fixed product and period
costs are expensed.
• Throughput costing—only direct materials are
capitalized; all other costs are expensed.
Costing Comparison
• Variable costing is a method of inventory
costing in which only variable manufacturing
costs are included as inventoriable costs.
• Absorption costing is a method of inventory
costing in which all variable manufacturing
costs and all fixed manufacturing costs are
included as inventoriable costs.
Differences in Income
• Operating income will differ between
absorption and variable costing.
• The amount of the difference represents the
amount of fixed product costs capitalized as
inventory under absorption costing, and
expensed as a period costs under variable
costing.
Comparative Income Statements
Comparative Income Statements—Three
Years
Comparative Income Effects
Are fixed product
costs inventoried?
Is there a
production-volume
variance?
Are classifications
between variable
and fixed costs
routinely made?
Variable Costing
Absorption Costing
No
Yes
No
Yes
Yes
Infrequently
Comparative Income Effects
Variable Costing
Absorption Costing
Production = Sales
Equal
Equal
Production > Sales
Lower
Higher
Production < Sales
Higher
Lower
How do changes in
unit inventory cost
affect operating
income if…?
Comparative Income Effects
What are the
effects on costvolume-profit for a
given level of fixed
costs and a given
contribution margin
per unit?
Variable Costing
Absorption Costing
Driven by:
unit level
of sales
Driven by:
Unit level of
sales
Unit level of
production
Chosen
denominator
level
1.
2.
3.
Comparison of Alternative Inventory
Costing Systems
• Variable Direct Manufacturing Cost
Actual Costing
Actual prices
X
Actual quantity
of inputs used
Normal Costing Standard Costing
Actual prices
X
Actual quantity
of inputs used
(c) 2012 Pearson Prentice Hall. All rights reserved.
Standard prices
X
Standard quantity
of inputs allowed
for actual output
achieved
Comparison of Alternative Inventory
Costing Systems
• Variable Indirect Manufacturing Cost
Actual Costing
Normal Costing Standard Costing
Actual variable
indirect rates
X
Actual quantity of
cost-allocation
bases used
Standard variable
indirect rates
X
Standard quantity of
cost-allocation
bases allowed for
actual output
achieved
Budgeted variable
indirect rates
X
Actual quantity of
cost-allocation
bases used
(c) 2012 Pearson Prentice Hall. All rights reserved.
Comparison of Alternative Inventory
Costing Systems
• Fixed Direct Manufacturing Cost
Actual Costing
Actual prices
X
Actual quantity
of inputs used
Normal Costing Standard Costing
Actual prices
X
Actual quantity
of inputs used
(c) 2012 Pearson Prentice Hall. All rights reserved.
Standard prices
X
Standard quantity
of inputs allowed
for actual output
achieved
Comparison of Alternative Inventory
Costing Systems
• Fixed Indirect Manufacturing Cost
Actual Costing
Actual fixed
indirect rates
X
Actual quantity
of cost-allocation
bases used
Normal Costing Standard Costing
Budgeted fixed
indirect rates
X
Actual quantity
of cost-allocation
bases used
(c) 2012 Pearson Prentice Hall. All rights reserved.
Standard fixed
indirect rates
X
Standard quantity
of cost-allocation
bases allowed for
actual output
achieved
Performance Issues and Absorption
Costing
• Managers may seek to manipulate income by
producing too many units.
• Production beyond demand will increase the amount
of inventory on hand.
• This will result in more fixed costs being capitalized as
inventory.
• That will leave a smaller amount of fixed costs to be
expensed during the period.
• Profit increases, and potentially, so does a manger’s
bonus.
Inventories and Costing Methods
• One way to prevent the unnecessary buildup
of inventory for bonus purposes is to base
manager’s bonuses on profit calculated using
variable costing.
• Drawback: complicated system of producing
two inventory figures—one for external
reporting and the other for bonus
calculations.
Other Manipulation Schemes Beyond
Simple Overproduction
• Deciding to manufacture products that absorb
the highest amount of fixed costs, regardless
of demand (“cherry-picking”)
• Accepting an order to increase production,
even though another plant in the same firm is
better suited to handle that order
• Deferring maintenance
Management Countermeasures for Fixed
Cost Manipulation Schemes
• Careful budgeting and inventory planning
• Incorporate an internal carrying charge for
inventory
• Change (lengthen) the period used to evaluate
performance
• Include nonfinancial as well as financial
variables in the measures to evaluate
performance
Income Effects of Inventory Buildup
Extreme Variable Costing:
Throughput Costing
• Throughput costing (super-variable costing) is
a method of inventory costing in which only
direct material costs are included as inventory
costs. All other product costs are treated as
operating expenses.
Throughput Costing Illustrated
Costing Systems Compared
Example: Dead Duck Brewery
Background
• Brewery in CA
• Specialty Brews
• Existing reporting under traditional absorption
costing
• Direct labor traced to product lines
• Products marketed through wholesale
distributors
• Selling and Admin costs allocated on sales dollars
Background Continued
• Three product line :
- Dead Duck Pale Ale 1,000,000 gallons
- Roadkill Red 10,000 gallons
- Mallard Stout 10,000 gallons
Dead Duck Brewery
Traditional Income Statement
For the year ended December 31, 2003
Total gallons sold:
1,000,000
DD Pale Ale
Total
(Per gallon)
Revenue
10,000
Roadkill Red Ale
Total
(Per gallon)
10,000
Mallard Stout
Total
(Per gallon)
Total
$ 7,950,000 $
7.95 $
67,500 $
6.75 $
79,300 $
7.93 $ 8,096,800
Cost of Goods Sold
Direct Material
Direct Labor
Overhead Applied
Total Cost of Goods Sold
4,200,000
300,000
1,500,000
6,000,000
4.20
0.30
1.50
6.00
32,000
3,000
15,000
50,000
3.20
0.30
1.50
5.00
43,000
3,000
15,000
61,000
4.30
0.30
1.50
6.10
4,275,000
306,000
1,530,000
6,111,000
Gross Margin
1,950,000
1.95
17,500
1.75
18,300
1.83
1,985,800
General and Administrative
Administrative
Marketing
Depreciation
Amortization
Other
Total General and Administrative
1,133,077
475,000
78,550
73,640
14,728
1,774,995
1.13
0.48
0.08
0.07
0.01
1.77
9,620
5,000
667
625
125
16,037
0.96
0.50
0.07
0.06
0.01
1.60
11,302
5,000
783
734
146
17,965
1.13
0.50
0.08
0.07
0.01
1.80
1,154,000
500,000
80,000
75,000
15,000
1,824,000
Net Operating Income
$
161,800
Highlights from Traditional Costing
Gross Margin
DD Pale Ale
$1.95 per gallon
Roadkill Red $1.75 per gallon
Mallard Stout $1.83 per gallon
Traditional Costing
Tells management that DD Pale Ale costs $6.00
per gallon
In a “price war”, management would view $6.00
per gallon as the price floor.
Highlights from TOC
• Throughput Margin
- DD Pale Ale
- Roadkill Red
- Mallard Stout
$3.75 per gallon
$3.55 per gallon
$3.63 per gallon
All have a positive contribution margin
TOC approach
Tells management that DD Pale Ale costs $4.20
per gallon
In a “price war”, management would view $4.20
per gallon as the price floor.
Caution
• In the 1960s, the adoption of variable costing
vs. absorption costing lead to fierce price wars
in industry
• All costs become variable in the end and
management’s focus only on current variable
costs can lead to unfortunate choices
ABC Approach
Gross Margin
DD Pale Ale
$2.03 per gallon
Roadkill Red
$(2.32) per gallon
Mallard Stout $(2.10) per gallon
ABC Consultant’s Advice
• Eliminate Roadkill Red and Mallard Stout and
you will stem the loss of $38,237 and $38,965
per product line.
• The net savings will be $78,202
In Reality, Economics Matter
TOC tells you that the elimination of Roadkill
Red and Mallard Stout will instead cause a
decrease in operating profit of $31,360
The delta between the expectation of gaining
$78,202 and losing an additional $31,360 is
$109,562
Recap
• ABC attributes a higher operating income to
Dead Duck Pale Ale
• TOC says that all products contribute to the
fixed costs and the profit margin
• Use a combination of ABC and TOC to decide if
a product line should be eliminated or pricing
adjusted
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