ACCT 315– COST ACCOUNTING

MODULE 3 – INVENTORY COSTING

AND CAPACITY ANALYSIS
(CHAPTER 9)
Learning Objectives (1 of 2)
9.1 Identify what distinguishes variable costing from
absorption costing
9.2 Compute income under absorption costing and variable
costing and explain the difference in income
9.3 Understand how absorption costing can provide
undesirable incentives for managers to build up inventory
9.4 Differentiate throughput costing from variable costing and
absorption costing
9.5 Describe the different capacity concepts that can used in
absorption costing

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Learning Objectives (2 of 2)
9.6 Examine the key factors managers use to choose a
capacity level to compute the budgeted fixed
manufacturing cost rate
9.7 Understand issues that play an important role in capacity
planning and control

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Module Overview
Inventory-Costing Denominator-Level Capacity
The two most common Given a firm’s level of spending
methods of costing on fixed manufacturing costs,
inventory in manufacturing what capacity level should
companies are VARIABLE managers and accountants use
costing and ABSORPTION to compute the fixed
costing. The choice manufacturing cost per unit
determines which produced?
manufacturing costs are
treated as inventoriable
costs.

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Inventory Costing Choices: Overview
• Variable costing is a method of inventory costing in which
all variable manufacturing costs (direct and indirect) are
included as inventoriable costs.
• Absorption costing is a method of inventory costing in
which all variable and fixed manufacturing costs are
included as inventoriable costs. You can say that inventory
“absorbs” all manufacturing costs.
• Throughput costing is a method of inventory costing in
which only direct materials are included as inventoriable
costs. All other costs are expensed.

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 Illustration: Calculation of Inventoriable cost per unit : Absorbtion Vs
Variable
• The operating information for the year is as follows:
Units
Budgeted Production 8000
Actual Data
Beginning Inventory 2000
Production 5000
Sales 6500
Ending Inventory 500

Actual price and cost data are as follows:

1. Compute the inventorial cost using Absorbtion and Variable Costing.

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Inventory Costing: Differences in
Income
1. Operating income will differ between absorption and
variable costing if inventory levels change because of the
difference in accounting for fixed manufacturing costs.
2. The amount of the difference represents the amount of
fixed manufacturing costs capitalized as inventory under
absorption costing and expensed as a period cost under
variable costing.

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Comparing Income Effects of Variable
and Absorption Costing—Yr.1
Exhibit 9.1 Comparison of Variable Costing and Absorption Costing for Stassen
Company: Telescope Product-Line Income Statements for 2020

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PREPARATION OF INCOME STATEMENT USING
VARIABLE AND ABSORBTION
Based on the data below prepare the Income Statement Using the Variable and
Absorption Costing Method and Compare Income Statement for 2013
UNITS 2013
Budgeted Production 8000
Actual Data
Beginning Inventory 2000
Production 5000
Sales 6500
Ending Inventory 500

Selling Price $1000

Variable Manufacturing Costs per unit:
Direct Material cost per unit $110
Direct Labor cost per unit $40
Manufacturing Overhead cost per unit $50
Variable Marketing Costs per unit $185
Fixed Manufacturing costs (all indirect) $1,080,000
Fixed Marketing costs (all indirect) $1,380,000
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VARIABLE COSTING VS
ABSORPTION COSTING
VARIABLE COSTING ABSORPTION COSTING

Revenues (6500 x $1000) $6,500,000 Revenues (6500 x $1000) $6,500,000

Variable costs Cost of goods sold

Beginning inventory (2000 Beginning inventory (2000 x
x$200) $400,000 $335) $670,000
Variable manufacturing
costs(5000 x $200) 1,000,000 Manufacturing costs (5000 x $335) $1,675,000

COG available for sale 1,400,000 COG available for sales 2,345,000
Deduct ending inventory(500 x Deduct ending inventory (500 x
$200) (100.000) $335) ($167,500)
Variable cost of goods sold 1,300,000 COGS $2,177,500
Variable operating costs (6500 x Prod. Vol Variance(8000-5000)x
$185 1,202,500 $135 $405,000U
Total variable costs (2,502,500) Cost of goods sold ($2,582,500)
Contribution margin 3,997,500 Gross margin $3,917,500
Fixed costs Operating costs
Fixed manufacturing costs 1,080,000 Variable operating costs (6500 x
$185) 1,202,500
Fixed operating costs 1,380,000
Fixed operating costs 1,380,000
Total fixed costs (2,460,000)
Total operating costs ($2,582,500)
Operating income $1.537,500
Operating income $1,335,000
DIFFERENCES IN OPERATING INCOME BETWEEN
ABSORBTION AND VARIABLE COSTING

• The differences between the two methods is due to :

• A) Fixed Costs Component in Opening Inventory under
Absorption Costing
• B) Fixed Costs Component in Ending Inventory under
Absorption Costing

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Reconciliation Statement
Operating Income as per Absorption
Costing xxxxx
Add : Fixed Cost portion in opening
Inventory xxxxx
Less: Fixed Cost portion in Ending
Inventory (xxxxx)
Operating Income as per Variable
Costing xxxxxx

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Reconciliation of Income for the three
months (From AC to VC)
Jan

Operating Income as per $ 1,335,000

Absorption Costing

Add: Fixed Manufacturing Costs In (2000 x $135) = $270,000

Opening Inventory

Less: Fixed Manufacturing costs (500 units x $135)= $ 67,500

in Ending Inventory

Operating Income as per Variable $ 1,537,500

Costing

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Reconciliation of Income for the three
months (From VC to AC)
Jan

Operating Income as per Variable $ 1,537,500

1,335,000
Absorption Costing
Costing

Add: Fixed Manufacturing Costs In (500

(2000x x$135)
$135)==$67,500
$270,000
OpeningInventory
Ending Inventory

Less: Fixed Manufacturing costs (500 units

(2000 unitsx x$135)=
$135)=$$67,500
270,000
in Opening
Ending Inventory
Inventory

Operating Income as per Variable $ 1,335,000

1,537,500
Costing
Absorption Costing

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Comparative Income Effects Variable
and Absorption Costing
Exhibit 9.3 Comparative Income Effects of Variable Costing and Absorption
Costing

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Absorption Costing and Performance
Measurement (1 of 2)
Absorption costing is the required inventory method for
external financial reporting in most countries.
Absorption costing is preferred for several reasons:
• It is cost-effective and less confusing
• It can help prevent managers from taking actions that
make their performance measure look good but that hurt
the income they report to shareholders.
• It measures the cost of all manufacturing resources
(variable or fixed) necessary to produce inventory.

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Absorption Costing and Performance
Measurement (2 of 2)
• An important attribute of absorption costing is that it
enables a manager to increase margins and operating
income by producing more ending inventory.
• Producing for inventory is justified when a firm’s managers
anticipate rapid growth in demand and want to produce
and store additional units to deal with possible production
shortages in the next year.

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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.
• One way to prevent the unnecessary buildup of inventory
for bonus purposes is to base manager’s bonuses on profit
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Proposals for Revising Performance
Evaluation
• Management has several options to reduce the
undesirable effects of absorption costing:
– Focus on 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 (compare ratio of
ending/beginning inventory to ratio of units
produced/sold)

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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

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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 period expenses.
• Throughput margin equals revenues minus all direct
material cost of the goods sold.

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Throughput Costing Illustrated
Exhibit 9.5 Throughput Costing for Stassen Company: Telescope Product-Line
Income Statements for 2020 and 2021

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Alternative Inventory-Costing
Systems Compared
Exhibit 9.6 Comparison of Alternative Inventory-Costing Systems

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Capacity Concepts—Denominator-
Level Capacity Overview
Given a firm’s level of spending on fixed manufacturing
costs, what capacity level should managers and accountants
use to compute the fixed manufacturing cost per unit?
We have seen that the difference between variable- and
absorption-costing methods arises solely from the treatment
of fixed manufacturing costs.
Spending on fixed manufacturing costs enables firms to
obtain the scale or capacity needed to satisfy the expected
market demand from customers. Determining the “right”
amount of spending, or the appropriate level of capacity, is
one of the most strategic and most difficult decisions
managers face.

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Denominator Level Capacity—
Concepts
Too much capacity means firms will incur the cost of unused
capacity; having too little means that demand from some
customers may be unfulfilled.
In business and accounting, capacity ordinarily means a
“constraint” or an “upper limit.”
The choice of the capacity level used to allocate budgeted
fixed manufacturing costs to products can greatly affect
operating income.

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Capacity Levels
Four different capacity levels can be used as the
denominator to compute the budgeted fixed manufacturing
cost rate:
1. Theoretical capacity
2. Practical capacity
3. Normal capacity utilization
4. Master-budget capacity utilization

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Theoretical Capacity
• Theoretical capacity is the level of capacity based on
producing at full efficiency all the time.
• It is theoretical in the sense that it does not allow for any
slowdowns due to plant maintenance, shutdown periods,
or interruptions because of downtime on the assembly
lines.
• Theoretical capacity levels, in the real world, are
unattainable, but they represent the ideal goal of capacity
utilization a company can aspire to.

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Practical Capacity
• Practical capacity is the level of capacity that reduces
theoretical capacity by considering unavoidable operating
interruptions like scheduled maintenance time and
shutdowns for holidays.
• Both theoretical capacity and practical capacity measure
capacity levels in terms of what a plant can supply.
• Our next two levels measure capacity levels in terms of
demand.

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Normal Capacity Utilization and
Master-Budget Capacity Utilization
• Normal capacity utilization is the level of capacity utilization
that satisfies average customer demand over a period that
is long enough to consider seasonal, cyclical, and trend
factors.
• Master-budget capacity utilization is the level of capacity
utilization that managers expect for the current budget
period, which is typically one year.

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Effects of Capacity Levels on Budgeted
Fixed Manufacturing Cost Rate
The choice of capacity level can have a huge impact on budgeted fixed
manufacturing cost per unit as shown here: It is possible and even likely that
budgeted demand will be below production capacity levels.

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Choosing a Capacity Level
The choice of denominator-level capacity to use may differ
based on the purpose for which the choice is being made.
Some of those purposes include the following:
1. Product costing and capacity management
2. Pricing
3. Performance evaluation
4. External reporting
5. Tax requirements

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Product Costing and Capacity
Management
• For product costing and capacity management, using
practical capacity as the denominator level sets the cost of
capacity at the cost of supplying the capacity, regardless of
demand for the capacity.
• Highlighting the cost of capacity acquired but not used
directs managers’ attention toward managing unused
capacity.
• In contrast, using either of the capacity levels based on
demand hides the amount of unused capacity.

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Pricing Decisions
• To understand the best choice for pricing decisions, let’s
look first at the downward demand spiral for a company. It
is the continuing reduction in the demand for its products
that occurs when competitor prices are not met; demand
drops further, and the fixed costs are spread over fewer
units, resulting in greater and greater costs per unit.
• Practical capacity, by contrast, is a more stable measure
because it calculates the fixed cost rate based on capacity
available rather than capacity used to meet demand.

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Performance Evaluation
• Unused capacity adds costs to products.
• Mid-level managers have no control over those costs but
do have control over prices.
• Should the marketing managers be held accountable for
the manufacturing overhead costs unrelated to their
potential customer base (practical capacity versus master-
budget capacity utilization)?
• Where differences between practical capacity and master-
budget capacity utilization are large, that difference is often
classified as planned unused capacity.

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Financial Reporting (1 of 2)
• The magnitude of the favorable/unfavorable production-
volume variance under absorption costing is affected by
the choice of the denominator level used to calculate the
budgeted fixed manufacturing cost per unit.
• Recall from Chapter 4 that the production-volume variance
can be disposed of three ways:
– Adjusted allocation-rate approach (recalculate at year
end)
– Proration approach (spread to Work-in-Process,
Finished Goods, and Cost of Goods Sold)
– Write-off to Cost of Goods Sold.

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Financial Reporting (2 of 2)
The objective in choosing the method to dispose of the
production-volume variance is to write-off the portion of the
variance that represents the cost of capacity not used to
support the production of output during the period.
Recall that the production-volume variance = Budgeted fixed
manufacturing overhead – Fixed manufacturing overhead
allocated using budgeted cost per output unit allowed for
actual output produced.

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Effects of Capacity Levels on Income
Statement
Exhibit 9.7 Income-Statement Effects of Using Alternative Capacity-Level
Concepts: Stassen Company for 2020

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Tax Requirements
For tax reporting purposes in the United States, the Internal
Revenue Service (I R S) requires companies to assign
inventoriable indirect production costs by a “method of
allocation which fairly apportions such costs among the
various items produced.”
The I R S accepts approaches that involve the use of either
overhead rates or standard costs.
Under either approach, the I R S permits the use of practical
capacity to calculate budgeted fixed manufacturing cost per
unit. Further, the production-volume variance generated this
way can be deducted for tax purposes in the year in which
the cost is incurred.

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Planning and Control of Capacity
Costs: Other Issues
A few other factors should be taken into account when
planning capacity levels and in deciding how best to control
and assign capacity costs:
• The level of uncertainty about both the expected costs and
the expected demand for the installed capacity
• The presence of capacity-related issues in
nonmanufacturing settings
• The potential use of activity-based costing techniques in
allocating capacity costs

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Terms to Learn
Absorption costing
Direct costing
Downward demand spiral
Master-budget capacity utilization
Normal capacity utilization
Practical capacity
Super-variable costing
Theoretical capacity
Throughput costing
Variable costing

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