Chapter 9 Lecture Note Outline

CHAPTER 9 – LECTURE NOTE OUTLINE

I. Inventory Costing for Manufacturing Companies

A. Methods of Inventory Costing

1. Variable Costing

a. Variable manufacturing costs included as inventoriable costs initially

b. Fixed manufacturing costs excluded from inventoriable costs; Expensed as incurred

2. Absorption Costing

a. Variable and fixed manufacturing costs included as inventoriable costs initially

b. Required method under GAAP for external and tax reporting

B. Income Statement Presentation [Exhibit 9-1]

1. Variable Costing – Contribution Margin Format

 Fixed manufacturing costs expensed in total

2. Absorption Costing – Gross Margin Format

 Fixed manufacturing costs expensed per unit in cost of goods sold

3. Direct Costing: Not Variable Costing

 Variable costing does not include all direct costs as inventoriable (direct fixed manufacturing and direct nonmanufacturing excluded)

C. Operating Income Differences [Exhibit 9-2]

1. Goods Sold vs. Goods Produced

a. Variable Costing: Quantity sold drives cost and income because fixed costs are expensed as incurred

b. Absorption Costing: Quantities sold and produced drives cost and income because all manufacturing costs are computed on a per unit basis

 EI > BI: Less fixed costs expensed; Lower COGS; Higher Operating Income

 EI < BI: More fixed costs expensed; Higher COGS; Lower Operating Income

1 2. Production-Volume Variance (Fixed Overhead)

a. Not present under Variable Costing

b. Exists under Absorption Costing when actual production volume differs from budgeted production volume

c. Fixed MOH Cost Rate * (Budgeted Production – Actual Production)

3. Comparative Income Effects – [Exhibit 9-3]

D. Income Manipulation -- Buildup of Inventories Under Absorption Costing [Exhibit 9-4]

1. Increase operating income by increasing production (even if no increases in customer demand)

a. Switch to manufacturing products that absorb the highest amounts of fixed manufacturing costs and delaying those that absorb the lowest

b. Defer machine maintenance beyond current accounting period

2. Revise performance evaluations to discourage inventory buildups

a. Careful budgeting reduces management's freedom to build up excess inventory

b. Use variable costing accounting system for internal reporting

c. Incorporate a carrying charge for inventory in the internal system

d. Change to a longer time period to evaluate performance

E. Throughput Costing

1. Only direct materials costs are inventoriable; all other costs expensed as incurred

2. Reporting includes throughput contribution: Revenues minus direct materials costs of goods sold [Exhibit 9-5]

3. Provides less incentive to “produce for inventory” than other methods

II. Fixed Manufacturing Costs – Denominator-Level Capacity

**Applies only to Absorption Costing**

A. Denominator-Level Capacity Choices

1. Theoretical Capacity: Producing at full efficiency all the time

2. Practical Capacity: Reduces theoretical capacity by unavoidable operating interruptions (i.e. scheduled maintenance; holiday shutdowns)

2 3. Normal Capacity Utilization: Satisfies average customer demand over several periods (i.e. 2 – 3 yrs)

4. Master-Budget Capacity Utilization: Expected level of capacity utilization for the next budget period

**Denominator decreases from Theoretical to Master-Budget Capacity Levels**

B. Choosing the Capacity Level

1. Capacity Management

 Use Practical Capacity:

a. Fixes the cost of capacity as the cost to supply capacity (not demand)

b. Directs managers’ attention to unused capacity. Manage it by designing new products, leasing unused capacity to others, or eliminating excess capacity

2. Pricing Decisions

 Use Practical Capacity:

a. Customers are not willing to bear cost of unused capacity

b. Downward Demand Spiral: Continuing reduction in demand for products that occurs when competitors’ prices are not met. As demand drops further, higher unit costs result in more reluctance to meet competitors’ prices.

3. Performance Evaluation

4. Financial Statements

a. Magnitude of production-volume variance

b. Method of disposing of end-of-period variances

5. Regulatory Requirements: IRS requires use of practical capacity

6. Difficulties in forecasting chosen denominator-level capacity

Suggested Problems: 9 – 16; 9 – 17; 9 – 18; 9 – 19; 9 – 20; 9 – 21