CH 9

CHAPTER 9
Inventory Costing
and
Capacity Analysis
2009 Pearson Prentice Hall. All rights reserved.
Learning Objective 1
Identify what
distinguishes variable
costing from absorption
costing
Recall:
Manufacturing costs
Inventoriable costs
Product costs
Inventory costing?
Inventory-Costing Methods
The difference between variable costing

and absorption costing is based on the
treatment of fixed manufacturing costs.
Costing Comparison
Variable costing is a method of inventory
costing in which only variable manufacturing

costs (direct and indirect) are included as
inventoriable costs
Absorption costing is a method of inventory
costing in which all variable manufacturing
costs and all fixed manufacturing costs are
included as inventoriable costs
Absorption costing is the method required for
GAAP for external financial reporting.
Assumptions
Standard costing
Cost driver for variable MFG costs: units
produced; for variable MKT costs is units sold

No price variance, efficiency variance and
spending variance
Budgeted production: 8,000 units
Production volume variance: written off
Data for Stassen Company for

2009
Inventoriable costs per unit

under the two methods
Variable C. Absorption
C.
Variable MFG cost/unit
Direct MTLs
Direct MFG labor
MFG OH
$ 110
40
50 200
200
Fixed MFG cost/unit
135
Total inventoriable cost/unit
$335
--$200
$110
40
50
Compute income under absorption
costing and variable costing, and
explain the difference in income
Comparing Income
Statements
A variable costing income statement classifies
cost based on behavior. An absorption costing

income statement classifies cost based on
character (manufacturing, selling,
administrative).
Absorption-costing income statements need
not differentiate between variable and fixed
costs.
Data for Stassen Company for

2009
Comparing Income Statements For

one year
Differences in Income
Operating Income will differ between
Absorption and Variable Costing

The amount of the difference represents the
amount of Fixed Product Costs capitalized as
Inventory under Absorption costing, and
expensed as a period costs under Variable
Costing

one year
Variable C.
C.
Variable MFG costs
Inventoriable
($200/unit)
Fixed MFG costs
Inventoriable
($1,080,000/year)
Absorption
Inventoriable
Deducted as
an expense
The difference between variable and absorption

costing is how fixed MFG costs are accounted for.

one year
If inventoriable levels change, operating
income will differ between the two methods.
Explaining differences in
operating income
Summary
2009
2011
1. Absorption C. OI
$2,490,000
2.Variable C. OI
2,152,500
3. Difference:
337,500
4. Difference as a %
13.6%
of absorption OI
2010
$1,500,00 $1,335,000
1,230,000 1,537,500
270,000 (202,500)
18.0% (15.2%)
Summary
If inventory increases during an accounting
period, less operating income will be reported

under variable costing than absorption costing.
If inventory decreases during an accounting
period, more operating income will be reported
under variable costing than absorption costing.
The difference is due solely to (a) moving fixed
MFG costs into inventories as inventories
increase and (b) moving fixed MFG costs out of
inventories as inventories decrease.
Explain the differences in operating

income
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
mangers bonus
Understand how absorption
costing can provide undesirable
incentives for managers to
build up inventory.
Income Effects of Inventory

Buildup
Inventories and Costing

Methods
One way to prevent the unnecessary buildup
of inventory for bonus purposes is to base

managers bonuses on profit calculated using
Variable Costing
Drawback: complicated system of producing
two inventory figures one for external
reporting and the other for bonus calculations
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
Proposals for revising performance

evaluation
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
Differentiate throughput
costing from variable costing
and absorption costing.
Throughput Costing
Throughput costing or super-variable
costing is an inventory valuation method in

which only direct material costs are included
in inventoriable costs. All other costs are
period costs and expensed in the period
incurred.
Throughput contribution is defined as
revenues minus direct material cost of goods
sold.
Throughput Costing
Illustrated
Comparison of Inventory
Costing Methods
Actual
Actual Costing
Costing
Variable
Variable
Costing
Costing
Absorption
Absorption
Costing
Costing
Throughput
Throughput
Costing
Costing
Costing Methods
Normal
Normal Costing
Costing
Variable
Variable
Costing
Costing
Absorption
Absorption
Costing
Costing
Throughput
Throughput
Costing
Costing
Costing Methods
Standard
Standard Costing
Costing
Variable
Variable
Costing
Costing
Absorption
Absorption
Costing
Costing
Throughput
Throughput
Costing
Costing
Costing Systems Compared
Describe the various capacity
concepts that can be used in
absorption costing
Alternative DenominatorLevel
Concepts
Theoretical capacity
Practical capacity
Normal capacity
Master-budget capacity
Alternative Denominator-Level
Concepts
Theoretical capacity is the level of capacity
based on producing at full efficiency all the

time. This measure of capacity does not allow
for plant maintenance, shutdowns,
interruptions, or any other factors. Theoretical
capacity may be achieved for short periods of
time, but it cannot be sustained. Theoretical
capacity represents an ideal goal of capacity
utilization.
Concepts
Practical capacity is the level of capacity that
reduces theoretical capacity by considering

unavoidable operating interruptionsscheduled
maintenance or holidays, for example.
Normal capacity is the level of capacity
utilization that satisfies average customer
demand over a period of timeoften two to three
years.
Master-budget capacity utilization is the
level of capacity that managers expect for the
current time period, frequently one year.
Concepts
Theoretical and practical capacity measure
capacity in terms of what a plant can supply.

Normal capacity and master-budget utilization
measure capacity in terms of demand.
The capacity level chosen will affect the
budgeted fixed overhead cost rate. As a lower
capacity level is chosen, the fixed cost per
unit increases.
Effect on budgeted fixed mfg.

cost rate
Effect on budgeted fixed mfg.

cost rate
Explain the key factors in choosing a
capacity level to compute the
budgeted fixed overhead cost rate
Choosing a Capacity Level

For external reporting purposes, the choice of
capacity measure will affect the magnitude of

the production-volume variance. How this
variance is disposed of at the end of the year
will impact the companys operating income.

What factors are considered
in choosing a capacity level?
Product
costing
Financial
statements
Pricing
decision
Performance
evaluation
Regulatory
requirements
Difficulties in
forecasting
capacity level

Theoretical capacity is rarely used to calculate
budgeted fixed manufacturing cost per unit

because it is significantly different from the
real capacity available to a company.
Practical capacity is frequently used to
calculate budgeted fixed manufacturing cost
per unit. This approach sets the cost of
capacity at the cost of supplying the capacity
regardless of demand.

Practical capacity, then, highlights the cost of
capacity acquired but not used and may serve

to direct managers attention toward more
effective capacity management.
In performance evaluation managers must
guard against using a long-run measure such
as normal capacity usage for a short-run
purpose such as annual bonuses. Masterbudget utilization would be more effective in
this situation.

For tax reporting in the United States the IRS
requires the use of practical capacity to

calculate budgeted fixed overhead cost per
unit.
Describe how attempts to
recover fixed costs of capacity
may lead to price increases
and lower demand.
Pricing decisions and

downward demand spiral
The downward demand spiral is the
continuing reduction in demand that occurs

when competitor prices are not met. As
demand drops, and when normal capacity and
master budget capacity is used, unit costs
become increasingly higher resulting in an
increased reluctance to meet competitors
prices.
Downward demand spiral

and its effect on cost
Pricing decisions and

downward demand spiral
As the company increases prices to cover
fixed costs, demand drops due to the higher

price, resulting in another price increase to
cover still higher per-unit costs.

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CHAPTER 9

2009 Pearson Prentice Hall. All rights reserved.

The difference between variable costing

2009 Pearson Prentice Hall. All rights reserved.

costing in which only variable manufacturing

produced; for variable MKT costs is units sold

2009 Pearson Prentice Hall. All rights reserved.

Data for Stassen Company for

2009 Pearson Prentice Hall. All rights reserved.

Inventoriable costs per unit

2009 Pearson Prentice Hall. All rights reserved.

A variable costing income statement classifies

cost based on behavior. An absorption costing

2009 Pearson Prentice Hall. All rights reserved.

Data for Stassen Company for

2009 Pearson Prentice Hall. All rights reserved.

Comparing Income Statements For

2009 Pearson Prentice Hall. All rights reserved.

Absorption and Variable Costing

2009 Pearson Prentice Hall. All rights reserved.

Comparing Income Statements For

The difference between variable and absorption

Comparing Income Statements For

income will differ between the two methods.

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

period, less operating income will be reported

2009 Pearson Prentice Hall. All rights reserved.

Explain the differences in operating

2009 Pearson Prentice Hall. All rights reserved.

Performance Issues and Absorption

by producing too many units

2009 Pearson Prentice Hall. All rights reserved.

Income Effects of Inventory

2009 Pearson Prentice Hall. All rights reserved.

Inventories and Costing

of inventory for bonus purposes is to base

2009 Pearson Prentice Hall. All rights reserved.

Other Manipulation Schemes

the highest amount of fixed costs, regardless

2009 Pearson Prentice Hall. All rights reserved.

Proposals for revising performance

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2009 Pearson Prentice Hall. All rights reserved.

costing is an inventory valuation method in

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2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

2009 Pearson Prentice Hall. All rights reserved.

Costing Systems Compared

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based on producing at full efficiency all the

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Practical capacity is the level of capacity that

reduces theoretical capacity by considering

capacity in terms of what a plant can supply.

2009 Pearson Prentice Hall. All rights reserved.

Effect on budgeted fixed mfg.