Inventory Costingand

Capacity Analysis

1. Identify what distinguishes variable costing from absorption costing

2. Compute income under variable costing and absorption costing and explain the difference in income

3. Understand how absorption costing can provide undesirable incentives for managers to build up inventory

4. Differentiate throughput costing from variable costing and absorption costing

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5. Describe the various capacity concepts that firms can use in absorption costing

6. Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate

7. Understand other issues that play an important role in capacity planning and control

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The inventory costing system that is chosen determines which manufacturing costs are treated as inventoriable costs.

The denominator-level capacity choice focuses on the cost allocation base used to set budgeted fixed manufacturing cost rates.

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Variable costing—a method of inventory costing in which all variable manufacturing costs (direct and indirect) are included as inventoriable costs. (Also known as direct costing)

Absorption costing—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—only direct materials are capitalized; all other costs are expensed.

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Operating income will differ between absorption and variable costing.

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.

If inventory levels change, operating income will differ between the two methods because of the difference in accounting for fixed manufacturing costs.

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Absorption costing is the required inventory method for external financial reporting in most countries. Also preferred because: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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One unfavorable attribute of absorption costing is that it enables managers to increase margins and, therefore, operating income, by producing more ending inventory.

Producing for inventory can be justified when rapid growth is forecasted, but should not be undertaken simply to boost profits.

To reduce an undesirable buildup of inventory, companies can use variable costing for internal reporting purposes including performance measurement.

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To reduce the undesirable effects of absorption costing, management can:Focus on careful budgeting and inventory planning.Incorporate an internal carrying charge for inventoryChange (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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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 = Revenues minus all Direct material cost of the goods sold.

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We have concluded the discussion of inventory costing and will begin capacity analysis.

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?

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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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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.Too much capacity means firms will incur the cost of unused capacity; having too little means that demand from some customers may be unfulfilled.

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The choice of the capacity level used to allocate budgeted fixed manufacturing costs to products can greatly affect operating income.

Four different capacity levels can be used as the denominator to compute the budgeted fixed manufacturing cost rate:1. Theoretical capacity2. Practical capacity3. Normal capacity utilization4. Master-budget capacity utilization

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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.

In the real world, theoretical capacity levels are unattainable but they represent the ideal goal of capacity utilization a company can aspire to.

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Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions like maintenance and holiday shutdowns.

Engineering and human resource factors are important when estimating theoretical or practical capacity.

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Both theoretical and practical capacity measure capacity levels in terms of what a plant can supply. Normal Capacity Utilization and Master-Budget Capacity Utilization, in contrast, measure capacity levels in terms of demand for the output of the plant. It is possible and even likely that budgeted demand will be below production capacity levels.

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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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The choice of capacity level can have a huge impact on budgeted fixed manufacturing cost per unit as shown here:

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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:1.Product costing and capacity management2.Pricing3.Performance evaluation4.External reporting5.Tax requirements

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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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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 as it calculates the fixed cost rate based on capacity available rather than capacity used to meet demand.

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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 vs master-budget capacity utilization)

Where there are large differences between practical capacity and master-budget capacity utilization, that difference is often classified as planned unused capacity.

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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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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.That objective is also helpful in determining which capacity should be used to develop the budgeted fixed manufacturing cost per unit.

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The IRS permits the use of practical capacity to calculate budgeted fixed manufacturing costs per unit AND allows for the write-off of the production-volume variance generated this way.

The tax benefit can be significant.

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A few other factors should be taken into account when planning capacity levels and in deciding how best to control and assign capacity costs. They are:1.Difficulty of obtaining demand-side denominator-level concepts2.Difficulty of forecasting fixed manufacturing costs3.Capacity issues for nonmanufacturing parts of the value chain4.In ABC Costing, a capacity level must be chosen for each cost driver

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TERMS TO LEARN PAGE NUMBER REFERENCE

Absorption costing Page 330

Direct costing Page 329

Downward demand spiral Page 346

Master-budget capacity utilization

Page 344

Normal capacity utilization Page 344

Practical capacity Page 344

Super-variable costing Page 341

Theoretical capacity Page 343

Throughput costing Page 341

Variable costing Page 329

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