Inventory Costing and Capacity Analysis
Chapter 9: Inventory Costing and Capacity Analysis
Overview of Inventory Costing Methods
Variable Costing
Definition: A method of inventory costing where all variable manufacturing costs (both direct and indirect) are considered as inventoriable costs. This method is also known as direct costing.
Absorption Costing
Definition: A method of inventory costing that includes all variable and fixed manufacturing costs as inventoriable costs. In this method, inventory is said to "absorb" all manufacturing costs.
Throughput Costing
Definition: A method of inventory costing where only direct material costs are capitalized, while all other costs are treated as period expenses. It directly reflects revenues minus all direct material costs of goods sold.
Key Differences Between Costing Methods
Income Differences
Operating income will vary between absorption and variable costing. The variance represents fixed manufacturing costs that are capitalized in inventory under absorption costing but expensed under variable costing.
Accounting for Fixed Manufacturing Costs
When inventory levels change, the operating income is affected by how fixed manufacturing costs are accounted for, leading to discrepancies between the two costing methods.
Example Case Study: Standard Costing System in Practice
Direct Costs
Traced to products using standard prices and inputs based on actual outputs produced.
Indirect Costs
Allocated using standard indirect rates times standard inputs allowed for the actual outputs.
Cost Drivers
Variable manufacturing costs driven by produced units.
Variable marketing costs driven by units sold.
Budgeted Volume and Production Data
Years of Data: 2014, 2015, 2016
Budgeted Production Units: 8,000 (all years)
Actual Production Units: 2014 = 8,000, 2015 = 5,000, 2016 = 10,000
Units Sold: 2014 = 6,000, 2015 = 6,500, 2016 = 7,500
Selling Price Per Unit: $1,000
Direct Material Cost Per Unit: $110
Direct Labor Cost Per Unit: $40
Variable Manufacturing Overhead: $50
Fixed Manufacturing Costs: $1,080,000 (all years)
Fixed Marketing Costs: $1,380,000 (all years)
Variable Marketing Cost Per Unit: $185
Comparative Income Statements
Panel A: Variable Costing
Revenues
$1,000 x 6,000 = $6,000,000
Variable Cost of Goods Sold
Calculation:
$200 x 8,000 = $1,600,000
Net Variable Cost of Goods Sold
$6,000,000 - $400,000 = $5,600,000
Operating Income Calculation
Revenues - Variable Costs = Contribution Margin
Panel B: Absorption Costing
Revenues
$1,000 x 6,000 = $6,000,000
Cost of Goods Sold
Calculation:
Including Fixed and Variable Costs: Starting from zero ending and beginning inventories, calculating through total costs and adjusting inventory products.
Operating Income
Final calculations demonstrate a higher operating income under absorption costing leading to variations noted in section headings.
Management Implications of Costing Methods
Incentives from Absorption Costing
Absorption costing may motivate managers to increase inventory levels to enhance perceived profitability, which could result in negative long-term effects unless justified by expected growth.
Controls for Absorption Costing
Suggestions for management to mitigate absorption costing issues include careful budgeting, use of internal carrying charges on inventory, changing evaluation periods, and including non-financial metrics in performance evaluations.
Capacity Analysis in Absorption Costing
Capacity Concepts
Various capacity levels can be utilized in absorption costing. The choice significantly affects the allocation of fixed manufacturing costs and overall operating income.
Capacity Levels to Consider
Theoretical Capacity
Theoretical level produced at full efficiency without interruptions.
Practical Capacity
Capacity accounting for unavoidable interruptions (maintenance, holidays).
Normal Capacity Utilization
Average customer demand over time.
Master-Budget Capacity Utilization
Outlook for the current fiscal period, typically one year.
Effects of Capacity Choices on Financial Reporting
Choosing different denominator levels can alter the budgeted fixed manufacturing cost per unit reported:
Practical Capacity for internal management focus allowing awareness of unused capacity.
Master-Budget Capacity Utilization can obscure unused capacity.
IRS and Capacity Utilization
The IRS allows using practical capacity for calculating budgeted fixed manufacturing costs per unit, leading to beneficial tax implications while permitting flexibility in financial reporting.
Glossary of Key Terms
Absorption Costing: Method of costing that includes all variable and fixed manufacturing costs in product costs.
Variable Costing: Method of costing that includes only variable manufacturing costs as product costs.
Throughput Costing: Method where only direct materials are included in product costs with other costs treated as period expenses.
Manufacturing Costs: Direct costs incurred in the production of goods; divided into variable and fixed costs.
Production-Volume Variance: Difference resulting from the actual production volume compared to planned volume for costs allocations.
Summary and Conclusion
Evidence from the comparative analysis indicates that absorption costing practices should be monitored closely to avoid unintended managerial incentives to increase inventory unproductively. Moreover, the appropriate capacity consideration is critical for effective financial forecasting and performance evaluation in manufacturing contexts.