Chapter One Cost Management and Strategy: An Overview

Chapter NineInventory Costing and Capacity Analysis1-#Define Absorption and Variable CostingUnderstand the purpose of each methodCompute income using Variable and Absorption CostingChoosing the appropriate capacity level for the budgeted fixed manufacturing cost rate

Learning Objectives1-#Variable Costs Total Variable Cost$6,600$6,500$3,000Units of the Cost Driver Total CostTotal Cost3,500 3,6001-#Fixed Costs $6,600$6,500$3,0003,500 3,600Units of the Cost Driver Total CostTotal Fixed Cost1-#Direct and Indirect CostsDirect CostsCosts that can be easily traced to a product or departmentExample: cost of paint in the paint department of an automobile assembly plantIndirect CostsCosts that must be allocated in order to be assigned to a product or departmentExample: cost of national advertising for an airline1-#

Product Costs1-#VariableOverhead Energy costs Indirect materials Indirect labor Equipment repair and maintenanceManufacturing OH CostsFixedOverhead Factory managers salaries Plant and equipment depreciation Plant security guards Insurance and property taxes for factory building and equipment1-#

Period Costs1-#Inventory Costing Choices: OverviewAbsorption costingCapitalize product costs (inventory)Expense period costs1-#9Inventory Costing Choices: OverviewVariable costingCapitalize variable product costsExpense all fixed costs (product and period)Expense variable period costsThroughput costing (special case of variable costing)Capitalize only direct materials; all other costs are expensed1-#10In Other WordsVariable costing only applies variable manufacturing OH to inventoryAbsorption costing applies all manufacturing OH costs, both fixed and variable, to inventoryDM andDL allocation is the same for both methods

Result in different income reporting, product pricing, and decision making1-#Differences in Income ReportingOperating income will differ between the methodsThe amount of the difference are the fixed costsCapitalized under absorption costing and expensed under variable costingVariable costing reports lowernet income Reduce taxes Companies using absorption costing will not incur lower net income until they sell goods1-#12Example Income Statements

1-#13Other Potential ImpactsProduct costingVariable costing under-costs manufactured goods Absorption costing better defines production costsPricingVariable costing may result in lower pricing, due to lower imputed costsThis is misleading since fixed manufacturing OH remains a period cost on the income statement1-#14When are they Used?External AccountingGAAP requires Absorption Costing for external reporting purposesTaxesThe IRS requires Absorption Costing for tax reporting purposes Where does Variable Costing fit in?As an internal management accounting - toolMore closely reflects what a manager can control1-#15Cost Allocation SystemsThe cost accumulation methodProcess Costing or Job CostingThe cost measurement methodActual, normal or standard The overhead assignment methodVolume based or Activity based1-#Costing SystemsJob costingAccount for distinct cost objects called jobs. Each job may be unique and consumes different resourcesWedding announcements, aircraft, advertisingProcess costingAccount for mass production of identical or similar productsOil refining, orange juice, soda pop1-#17Inventory Costing SystemsVariable Direct Manufacturing Cost (e.g. raw materials)Actual CostingNormal CostingStandard CostingActual priceXActual quantityof inputs usedActual priceXActual quantityof inputs usedStandard priceXStandard quantityof inputs allowedfor actual output achieved1-#18Inventory Costing SystemsFixed Direct Manufacturing Cost (e.g., machine rental)Actual CostingNormal CostingStandard CostingActual priceXActual quantityof inputs usedActual priceXActual quantityof inputs usedStandard priceXStandard quantity of inputs allowedfor actual outputachieved1-#19VariableOverhead Energy costs Indirect materials Indirect labor Equipment repair and maintenanceManufacturing Indirect (OH) CostsFixedOverhead Factory managers salaries Plant and equipment depreciation Plant security guards Insurance and property taxes for factory building and equipment1-#Inventory Costing SystemsVariable Indirect Manufacturing Cost (e.g., electricity)Actual CostingNormal CostingStandard CostingActual variable indirect rateXActual quantity of cost allocation bases usedBudgeted variable indirect rateXActual quantity of cost allocationbases usedStandard variable indirect rateXStandard quantity of cost-allocationbases allowed for actual output achieved1-#21Inventory Costing SystemsFixed Indirect Manufacturing Cost (e.g., security guard)Actual CostingNormal CostingStandard CostingActual fixedindirect rateXActual quantityof cost allocationbases usedBudgeted fixedindirect rateXActual quantityof cost allocationbases used

Standard fixedindirect rateXStandard quantityof cost allocation bases allowed for actual output achieved1-#22Absorbing Fixed Manufacturing OHStandard Costing Systems record budget and variance journal entriesGAAP demands that fixed OH be allocated on a per unit basis to calculate the full cost of the productAbsorption costing - absorbing the fixed costsThe variance between the budgeted and the actual fixed costs is the amount over- or under-appliedTherefore variance analysis of OH is necessary for product costing in a standard costing environment

1-#Defining the Standard Fixed OH RateDetermine the total budgeted fixed factory OH costs for the periodSelect an activity variable for applying fixed factory OH to outputs (e.g., machine hours or direct labor hours)Choose a denominator volume level for the selected activity variable (e.g., practical capacity)Divide the amount in Step 1 by the amount in Step 3 to determine the standard fixed factory OH rate1-#Choosing a Capacity LevelTheoretical (or Ideal) CapacityPractical CapacityNormal CapacityMaster Budget Capacity1-#Calculating Fixed OH VariancesSchmidt Co.s budgeted fixed manufacturing OH at $120,000 for October 2010 The budgeted activity measure for the month is 1,000 units @ 5 DLHs/unit (assume practical capacity)Actual production is 780 units and actual fixed OH is $130,650 for the monthCompute the fixed OH spending and production volume variances

$120,000 budgeted fixed overhead 5,000 DLHsFR == $24.00/DLH1-#Fixed OH Production Volume VarianceFixed OH Production Volume Variance =Standard Fixed OH Application Rate x (Actual Units Produced Denominator Volume, in units)= $120.00/unit x (780 1,000) units= $26,400 U (i.e., under-applied fixed OH)1-#Calculating Fixed OH Variances

GivenGivenUnder- applied1-#Fixed OH Variance: Now You Do It!A company has the following Fixed OH Data:The applied amount is $123,000 The budgeted amount is $120,000 The actual overhead incurred is $140,000Calculate the :Total Fixed OH VarianceFixed OH Production Volume Variance (under/over applied)Fixed OH Spending Variance

1-#Interpretation of Fixed OH VariancesResults from spending more or less than expected for fixed OH itemsSpending (Budget) VarianceProduction Volume VarianceResults from operating at a level other than the denominator volume level Important for product costing purpose, not for control purposes

1-#Effects of Denominator Level Choice for Allocating Fixed OHManagement can manage earningsChanging the denominator volume level results in a different OH application rateResulting in different product costs, and ultimately in a different production volume varianceManagement can allocate between inventory and COGS or write off completely to COGS1-#Comparative Income EffectsVariable CostingAbsorption CostingAre fixed product costs inventoried?NoYesIs there a production volume variance?No

YesAre classifications between variable and fixed costs routinely made?YesInfrequently1-#32Comparative Income EffectsVariable CostingAbsorption CostingHow do changes in unit inventory cost affect operating income if? Production = SalesEqualEqual Production > SalesLowerHigher Production < SalesHigherLower1-#33Comparative Income EffectsVariable CostingAbsorption CostingWhat are the effects on C-V-P for a given level of fixed costs and a given contribution margin per unit?Driven by: unit level of salesDriven by:Unit level of salesUnit level of productionChosen denominator level1-#34Downward Demand CycleIf pricing based on absorption costs and use master budget for the denominator levelAs demand decreases, each unit will absorb more fixed costsResulting in a higher absorbed cost basis and desire to increase costsAlthough the business climate demands otherwise Use Practical Capacity as your denominator basis to avoid this situation1-#35Income ManipulationProduce extra unitsProduction beyond demand will increase the amount of inventory on handThis will result in more fixed costs being capitalized, leaving a smaller amount to be expensedProfits will increase, and potentially, so will a managers bonusbase managers bonuses on profit calculated using variable costing1-#36Other ManipulationsManufacture products that absorb the highest amount of fixed costs, regardless of demand (cherry-picking)Accept an order to increase production, even though another plant may be better suited to handle that orderDefer maintenance1-#37Management CountermeasuresCareful budgeting and inventory planningIncorporate an internal carrying charge for inventoryLengthen the period used to evaluate performanceInclude non-financial as well as financial variables to evaluate performanceBalanced Scorecard1-#38Summary Analysis Variable vs. Absorption CostingVariable costing separates variable and fixed costs on the income statementAbsorption costing includes fixed manufacturing cost as part of product costRequired by GAAP for financial reporting and by the IRS for computing taxable incomeVariable costing meets the three objectives of management control systems MotivateIncent.Reward1-#Standard Costing in Service OrganizationsService organization costs tend to be fixed in the short to medium termProfessional service firms (accountancy)Direct labor is fixed since employees are salariedOther significant costs are related to brick-and-mortar (buildings and equipment)Predominant costs are fixed assets Airlines/Shipping/Telecommunications Industries

1-#