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CHAPTER 9INVENTORY COSTING AND CAPACITY ANALYSIS9-1 Differences in operating income between variable costing and absorption costing are due solely to accounting for fixed costs. Do you agree? Explain.No. Differences in operating income between variable costing and absorption costing are due to accou...

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CHAPTER 9 INVENTORY COSTING AND CAPACITY ANALYSIS 9-1 Differences in operating income between variable costing and absorption costing are due solely to accounting for fixed costs. Do you agree? Explain. No. Differences in operating income between variable costing and absorption costing are due to accounting for fixed manufacturing costs. Under variable costing only variable manufacturing costs are included as inventoriable costs. Under absorption costing both variable and fixed manufacturing costs are included as inventoriable costs. Fixed marketing and distribution costs are not accounted for differently under variable costing and absorption costing. 9-2

Why is the term direct costing a misnomer?

The term direct costing is a misnomer for variable costing for two reasons: a. Variable costing does not include all direct costs as inventoriable costs. Only variable direct manufacturing costs are included. Any fixed direct manufacturing costs, and any direct nonmanufacturing costs (either variable or fixed), are excluded from inventoriable costs. b. Variable costing includes as inventoriable costs not only direct manufacturing costs but also some indirect costs (variable indirect manufacturing costs). 9-3 Do companies in either the service sector or the merchandising sector make choices about absorption costing versus variable costing? No. The difference between absorption costing and variable costs is due to accounting for fixed manufacturing costs. As service or merchandising companies have no fixed manufacturing costs, these companies do not make choices between absorption costing and variable costing. 9-4 Explain the main conceptual issue under variable costing and absorption costing regarding the timing for the release of fixed manufacturing overhead as expense. The main issue between variable costing and absorption costing is the proper timing of the release of fixed manufacturing costs as costs of the period: a. at the time of incurrence, or b. at the time the finished units to which the fixed overhead relates are sold. Variable costing uses (a) and absorption costing uses (b). 9-5 “Companies that make no variable-cost/fixed-cost distinctions must use absorption costing, and those that do make variable-cost/fixed-cost distinctions must use variable costing.” Do you agree? Explain. No. A company that makes a variable-cost/fixed-cost distinction is not forced to use any specific costing method. The Stassen Company example in the text of Chapter 9 makes a variablecost/fixed-cost distinction. As illustrated, it can use variable costing, absorption costing, or throughput costing. A company that does not make a variable-cost/fixed-cost distinction cannot use variable costing or throughput costing. However, it is not forced to adopt absorption costing. For internal

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reporting, it could, for example, classify all costs as costs of the period in which they are incurred. 9-6 The main trouble with variable costing is that it ignores the increasing importance of fixed costs in manufacturing companies. Do you agree? Why? Variable costing does not view fixed costs as unimportant or irrelevant, but it maintains that the distinction between behaviors of different costs is crucial for certain decisions. The planning and management of fixed costs is critical, irrespective of what inventory costing method is used. 9-7 Give an example of how, under absorption costing, operating income could fall even though the unit sales level rises. Under absorption costing, heavy reductions of inventory during the accounting period might combine with low production and a large production volume variance. This combination could result in lower operating income even if the unit sales level rises. 9-8 What are the factors that affect the breakeven point under (a) variable costing and (b) absorption costing? (a) The factors that affect the breakeven point under variable costing are: 1. Fixed (manufacturing and operating) costs. 2. Contribution margin per unit. (b) The factors that affect the breakeven point under absorption costing are: 1. Fixed (manufacturing and operating) costs. 2. Contribution margin per unit. 3. Production level in units in excess of breakeven sales in units. 4. Denominator level chosen to set the fixed manufacturing cost rate. 9-9 Critics of absorption costing have increasingly emphasized its potential for leading to undesirable incentives for managers. Give an example. Examples of dysfunctional decisions managers may make to increase reported operating income are: a. Plant managers may switch production to those orders that absorb the highest amount of fixed manufacturing overhead, irrespective of the demand by customers. b. Plant managers may accept a particular order to increase production even though another plant in the same company is better suited to handle that order. c. Plant managers may defer maintenance beyond the current period to free up more time for production. 9-10 What are two ways of reducing the negative aspects associated with using absorption costing to evaluate the performance of a plant manager? Approaches used to reduce the negative aspects associated with using absorption costing include: a. Change the accounting system:  Adopt either variable or throughput costing, both of which reduce the 9-2

incentives of managers to produce for inventory. Adopt an inventory holding charge for managers who tie up funds in inventory. b. Extend the time period used to evaluate performance. By evaluating performance over a longer time period (say, 3 to 5 years), the incentive to take short-run actions that reduce long-term income is lessened. c. Include nonfinancial as well as financial variables in the measures used to evaluate performance. 

91 1 What denominator-level capacity concepts emphasize the output a plant can supply? What denominator-level capacity concepts emphasize the output customers demand for products produced by a plant? The theoretical capacity and practical capacity denominator-level concepts emphasize what a plant can supply. The normal capacity utilization and master-budget capacity utilization concepts emphasize what customers demand for products produced by a plant. 9-12

Describe the downward demand spiral and its implications for pricing decisions.

The downward demand spiral is the continuing reduction in demand for a company’s product that occurs when the prices of competitors’ products are not met and (as demand drops further), higher and higher unit costs result in more and more reluctance to meet competitors’ prices. Pricing decisions need to consider competitors and customers as well as costs. 9-13 Will the financial statements of a company always differ when different choices at the start of the accounting period are made regarding the denominator-level capacity concept? No. It depends on how a company handles the production-volume variance in the end-of-period financial statements. For example, if the adjusted allocation-rate approach is used, each denominator-level capacity concept will give the same financial statement numbers at year-end. 9-14 What is the IRS’s requirement for tax reporting regarding the choice of a denominatorlevel capacity concept? For tax reporting in the U.S., the IRS requires only that indirect production costs are “fairly” apportioned among all items produced. Overhead rates based on normal or master-budget capacity utilization, as well as the practical capacity concept are permitted. At year-end, proration of any variances between inventories and cost of goods sold is required (unless the variance is immaterial in amount). 9-15 “The difference between practical capacity and master-budget capacity utilization is the best measure of management’s ability to balance the costs of having too much capacity and having too little capacity.” Do you agree? Explain. No. The costs of having too much capacity/too little capacity involve revenue opportunities potentially forgone as well as costs of money tied up in plant assets.

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9-16 In comparing the absorption and variable cost methods, each of the following statements is true except: a. SG&A fixed expenses are not included in inventory in either method. b. Only the absorption method may be used for external financial reporting. c. Variable costing charges fixed overhead costs to the period they are incurred. d. When inventory increases over the period, variable net income will exceed absorption net income. SOLUTION Choice "d" is correct. Inventory under the absorption method includes fixed overhead costs, while the variable cost method includes fixed overhead costs as period costs. Fixed overhead costs will hit the income statement under variable costing in the period they are incurred, while under the absorption method, an increase in inventory results in more costs (fixed overhead) remaining on the balance sheet. These costs will not hit the income statement (and therefore net income) until the inventory is sold, which implies the absorption method will produce a higher net income in this situation. The other choices are incorrect as the statements contained in them are accurate. The statement in "a" is accurate, as all SG&A expenses, fixed and variable, will be period costs (not included in inventory) under either method. The statement in "b" is accurate, as the absorption method should be used for financial reporting. The variable cost method is used internally, but does not fit under GAAP and is therefore not reported externally. The statement in "c" is accurate, as fixed overhead costs under variable costing will hit the income statement as an expense in the period they are incurred. 9-17 Queen Sales, Inc. has just completed its first year of operations. The company has not had any sales to date. Queen has incurred the following costs associated with its production as of December 31, Year 1: Direct materials

$45,000

Production labor

35,000

Bookkeeper salary

28,000

Factory utilities

18,500

Office rent

12,000

Factory supervisor salary

9,600

Machine maintenance contract

7,500

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Under absorption costing, what is the inventory amount shown on the balance sheet at December 31, Year 1? a. $155,600 b. $115,600 c. $98,500 d. $80,000 SOLUTION Choice "b" is correct. Absorption costing, which is required under U.S. GAAP, requires all product costs to be included in inventory. No segregation is made between fixed and variable costs, and the costs are expensed when the product is sold. All of the costs listed, except for the bookkeeper salary and the office rent, are product costs. Choice "a" is incorrect. Period costs, in this case, the bookkeeper salary and the office rent, are expensed immediately. They are not included in inventory and are expensed even if the company has no sales. Choice "c" is incorrect. Indirect and fixed costs related to production are included in the cost of the product under absorption costing. The factory supervisor and the maintenance contract costs are product costs that are considered to be inventoriable. Choice "d" is incorrect. Production costs in addition to the prime costs of direct material ($45,000) and direct labor ($35,000) are included in the inventory under absorption costing until such time that the goods are sold. 9-18 King Tooling has produced and sold the following number of units of their only product during their first two years in business: Produced

Sold

Year ended December 31, Year 1

50,000

40,000

Year ended December 31, Year 2

50,000

55,000

Production costs per unit have not changed over the two-year period. Under variable costing, what is the amount of cost of sales relative to the cost of sales shown on the GAAP income statement of the company? Year 1

Year 2

a. Higher

Higher

b. Higher

Lower

c. Lower

Higher

d. Lower

Lower

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SOLUTION Choice "b" is correct. When more units are produced in a period than sold, a portion of the fixed manufacturing overhead is included in the ending inventory under absorption costing (GAAP). Under variable costing, all fixed manufacturing overhead is an immediate expense. As a result, the ending inventory is lower under variable costing and the cost of sales is higher. The opposite effect is present when the number of units sold exceeds the number of units produced. Choice "a" is incorrect. The cost of sales under variable costing is less than the cost of sales under GAAP when the number of units sold exceeds the number of units produced for a period. Choice "c" is incorrect. If units produced in any period exceed the units sold during that period, the GAAP cost of sales is lower than the cost of sales under variable costing since the fixed costs of production are immediately expensed under the variable costing method. The opposite is true when the units sold exceed the units produced during the period. Choice "d" is incorrect. The cost of sales under variable costing is more than the cost of sales under GAAP when the number of units produced exceeds the number of units sold for a period. 9-19

The following information relates to Drexler Inc.’s Year 3 financials: Direct labor

$420,000

Direct materials

210,000

Variable overhead

205,000

Fixed overhead

355,000

Variable SG&A expenses

150,000

Fixed SG&A expenses

195,000

Year 3 period costs for Drexler, under both the absorption and variable cost methods, will be Absorption Cost Method a. $345,000

Variable Cost Method $700,000

b. $345,000

$905,000

c. $550,000

$700,000

d. $550,000

$905,000

SOLUTION Choice "a" is correct. Under the absorption method, only variable and fixed SG&A expenses are period costs. Direct labor, direct materials, variable, and fixed overhead are product costs. Under the variable cost method, variable SG&A expenses, fixed SG&A expenses, and fixed overhead are all period costs, while direct labor, direct materials, and variable overhead are product costs.

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Choice "b" is incorrect. This answer choice incorrectly adds variable overhead as a period cost under the variable cost method. Choice "c" is incorrect. This answer choice incorrectly adds variable overhead as a period cost under the absorption method. Choice "d" is incorrect. This answer choice incorrectly adds variable overhead as a period cost under both methods. 9-20 Which of the following statements is not true regarding the use of variable and absorption costing for performance measurement? a. The net income reported under the absorption method is less reliable for use in performance evaluations because the cost of the product includes fixed costs, which means the level of inventory affects net income. b. The net income reported under the contribution income statement is more reliable for use in performance evaluations because the product cost does not include fixed costs. c. Variable costing isolates contribution margins to aid in decision making. d. The Internal Revenue Service allows either absorption or variable costing as long as the method is not changed from year to year, while U.S. GAAP only allows absorption costing. SOLUTION The answer is choice "d". This is not a true statement. The I.R.S. only allows absorption costing for financial statements, which is the same method required for U.S. GAAP. Choices “b” and “c” are factually accurate. Variable costing is useful for decision making because it segregates costs based on behavior, identifies the contribution margin, and expenses fixed costs rather than unitizing them into the cost of products. Choice “a” is again a true statement. Under absorption costing, the choice of output and inventory affects the realized level of net income, making it more susceptible to manipulation and a less reliable measure of managerial performance. 9-21 Variable and absorption costing, explaining operating-income differences. Nascar Motors assembles and sells motor vehicles and uses standard costing. Actual data relating to April and May 2017 are as follows:

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The selling price per vehicle is $24,000. The budgeted level of production used to calculate the budgeted fixed manufacturing cost per unit is 500 units. There are no price, efficiency, or spending variances. Any production-volume variance is written off to cost of goods sold in the month in which it occurs. Required: 1. Prepare April and May 2017 income statements for Nascar Motors under (a) variable costing and (b) absorption costing. 2. Prepare a numerical reconciliation and explanation of the difference between operating income for each month under variable costing and absorption costing. SOLUTION (30 min.) 1.

Variable and absorption costing, explaining operating-income differences.

Key inputs for income statement computations are April Beginning inventory Production Goods available for sale Units sold Ending inventory

0 500 500 350 150

May 150 400 550 520 30

The budgeted fixed cost per unit and budgeted total manufacturing cost per unit under absorption costing are (a) (b) (c)=(a)÷(b) (d) (e)=(c)+(d)

Budgeted fixed manufacturing costs Budgeted production Budgeted fixed manufacturing cost per unit Budgeted variable manufacturing cost per unit Budgeted total manufacturing cost per unit

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April $2,000,000 500 $4,000 $10,000 $14,000

May $2,000,000 500 $4,000 $10,000 $14,000

(a)

Variable costing April 2017

Revenuesa Variable costs Beginning inventory Variable manufacturing costsb Cost of goods available for sale Deduct ending inventoryc Variable cost of goods sold Variable operating costsd

$

0 5,000,000 5,000,000 (1,500,000) 3,500,000 1,050,000

Total variable costs Contribution margin Fixed costs Fixed manufacturing costs Fixed operating costs Total fixed costs Operating income a $24,000 × 350; $24,000 × 520 b $10,000 × 500; $10,000 × 400

(b)

a

$12,480,000 $1,500,000 4,000,000 5,500,000 (300,000) 5,200,000 1,560,000

4,550,000 3,850,000 2,000,000 600,000

6,760,000 5,720,000 2,000,000 600,000

2,600,000 $1,250,000

2,600,000 $3,120,000

c $10,000 × 150; $10,000 × 30 d $3,000 × 350; $3,000 × 520

Absorption costing

Revenuesa Cost of goods sold Beginning inventory Variable manufacturing costsb Allocated fixed manufacturing costsc Cost of goods available for sale Deduct ending inventoryd Adjustment for prod.-vol. variancee Cost of goods sold Gross margin Operating costs Variable operating costsf Fixed operating costs Total operating costs Operating income $24,000 × 350; $24,000 × 520 $10,000 × 500; $10,000 × 400 c $4,000 × 500; $4,000 × 400 b

May 2017

$8,400,000

d e f

April 2017 $8,400,000 $

0 5,000,000 2,000,000 7,000,000 (2,100,000) 0

May 2017 $12,480,000 $2,100,000 4,000,000 1,600,000 7,700,000 (420,000) 400,000 U

4,900,000 3,500,000 1,050,000 600,000

7,680,000 4,800,000 1,560,000 600,000

1,650,000 $1,850,000

$14,000 × 150; $14,000 × 30 $2,000,000 – $2,000,000; $2,000,000 – $1,600,000 $3,000 × 350; $3,000 × 520

2.

9-9

2,160,000 $ 2,640,000

Absorption-costing Variable-costing operating income – operating income

=

Fixed manufacturing costs Fixed manufacturing costs in ending inventory in beginning inventory –

April: $1,850,000 – $1,250,000 $600,000

= ($4,000...