Chapter 9 – Income Effects of Denominator Level on Inventory Valuation PDF

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Professor: Charles Triemstra
Fall 2017
Cost and Managerial Accounting 1...

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Chapter 9 – Income Effects of Denominator Level on Inventory Valuation Denominator Level Choices:  Theoretical capacity – ideal situation with no delays or shutdowns  Practical capacity – include shutdowns such as for maintenance, inspections, etc.  Normal capacity – satisfies average customer demand over several periods and GAAP (IFRS/ASPE)  Master budget capacity – satisfies customer demand in one period and tax requirements Capacity and Product Costing  Using theoretical or practical capacity as the denominator:  Reduces the amount of fixed manufacturing overhead assigned to inventory  Increases the production-volume variance  Generally, the lower the capacity amount used in the denominator  The higher the fixed overhead cost rate  The higher the costs assigned to each unit produced  The lower the production-volume variance Capacity, Product Pricing, & Performance Evaluation  Using master-budget capacity can lead to a downward demand spiral  When sales decrease, master-budget fixed overhead rate increases costs and prices, leading to further sales decreases  Using normal capacity provides no meaningful feedback on performance  Normal capacity is an average over several years but performance is assessed more frequently Inventory Costing Choices: Overview  Absorption (or full) 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  Accounting Standards accepted (IFRS/ASPE):  Standard costing, using practical capacity  Full absorption costing, using normal capacity  FIFO or average cost inventory valuation Absorption (Full) Costing  Product costs are capitalized  All variable and fixed manufacturing costs are included as inventoriable costs  Period costs are expensed  All variable and fixed non-manufacturing costs are classified as period costs  Costs of production are transferred from inventory to COGS when the goods are sold  Timing of recognition of COGS is matched to income revenue Variable (Direct) Costing  Product costs are capitalized  Only variable manufacturing costs are included as inventoriable costs  Period costs are expensed  All fixed costs and all non-manufacturing costs are classified as period costs  Variable costs of production are transferred from inventory to COGS when the goods are sold  Timing of recognition of COGS is matched to incoming revenue Differences in Income

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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 cost under variable costing

Comparative Income Effects

Are fixed product costs inventoried? Is there a production-volume-variance? Are classifications between variable & fixed costs routinely made? How do changes in inventory cost affect operating income if…? Production = Sales Production > Sales Production < Sales What are the effects on cost-volume-profit (for a given level of fixed costs and a given contribution margin per unit?

Variable Costing No No Yes

Absorption Costing

Equal Lower Higher Driven by:  Unit level of sales

Equal Higher Lower Driven by:  Unit level of sales  Unit level of production  Chosen denominator level

Yes Yes Infrequently

Comparison of Alternative Inventory Costing Systems: Type of Costing Actual Costing Normal Costing Variable Direct Actual Prices Actual prices Manufacturing Cost X X Actual quantity of Actual quantity of inputs used inputs used Variable Indirect Manufacturing Cost

Actual variable indirect rates X Actual quantity of cost-allocation bases used

Budgeted variable indirect rates X Actual quantity of cost-allocation bases used

Fixed Direct Manufacturing Cost

Actual prices X Actual quantity of inputs used

Actual prices X Actual quantity of inputs used

Fixed Indirect Manufacturing Cost

Actual fixed indirect rates X Actual quantity of cost-allocation bases used

Budgeted fixed indirect rates X Actual quantity of cost-allocation bases used

Differences in Operating Income:

Standard Costing Standard prices X Standard quantity of inputs allowed for actual output achieved Standard variable indirect rates X Standard quantity of cost-allocation bases allowed for actual output achieved Standard prices X Standard quantity of inputs allowed for actual output achieved Standard fixed indirect rates X Standard quantity of cost-allocation bases allowed for actual output achieved

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(Absorption costing operating income) – (Variable costing operating income) = (Fixed manufacturing costs in ending inventory) – (Fixed manufacturing costs in beginning inventory)

Performances Issued 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  Operating income increases, and potentially, so do management bonuses 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 Revising Performance Evaluation  Change the accounting system  Use variable or throughput costing  Careful budgeting and inventory planning  Reduce the possibility of inventory build-up  Incorporate a carrying charge for inventory  Change the time period  Include non-financial and financial performance measures Throughput Costing  Also known as “super-variable costing”  Only variable direct materials are capitalized as products costs  All other costs are expensed as period expenses when they are incurred  Reduces the motivation to increase inventories  Reducing inventory levels means less funds are tied up in inventory Variable Costing Breakeven  One breakeven point dependent on  Fixed costs  Contribution margin per unit  Unit level of sales  Q = (Total Fixed Costs + Target operating income) / Contribution margin per unit  A function of sales  As sales increase, operating income increases Absorption Costing Breakeven  Breakeven (more than one) depends on:  Fixed costs

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 Contribution margin per unit  Unit level of sales  Unit level of production  Overhead cost rate Q = Total Fixed costs + Target operating income + [Fixed manufacturing OH cost rate x (Breakeven sales in units – Units produced)] A function of sales and production  Many scenarios that produce the same breakeven result...