Chapter 9 Flashcards
The two most common methods of costing inventory in manufacturing companies are
VARIABLE costing and ABSORPTION costing
Variable costing is a method of inventory costing in which
all variable manufacturing costs (direct and indirect) are included as inventoriable costs.
Absorption costing is 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 is a method of inventory costing in
which only direct materials are included as inventoriable costs. All other costs are expensed.
Operating income will differ between absorption and variable costing if
inventory levels change because of the difference in accounting for fixed manufacturing costs.
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.
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.
An important attribute of absorption costing is that it enables a manager to
increase margins and operating income by producing more ending inventory.
Producing for inventory is justified when a firm’s managers
anticipate rapid growth in demand and want to produce and store additional units to deal with possible production shortages in the next year.
To reduce the undesirable effects of absorption costing, management can:
Focus on 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. (compare ratio of ending/beginning inventory to ratio of units produced/sold)
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?
Spending on fixed manufacturing costs enables firms to
obtain the scale or capacity needed to satisfy the expected market demand from customers.
one of the most strategic and most difficult decisions managers face.
Determining the “right” amount of spending, or the appropriate level of capacity
Too much capacity means firms will incur?
having too little means
incur the cost of unused capacity
demand from some customers may be unfulfilled.
Four different capacity levels can be used as the denominator to compute the budgeted fixed manufacturing cost rate:
- Theoretical capacity
- Practical capacity
- Normal capacity utilization
- Master-budget capacity utilization
Theoretical Capacity
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 on the assembly lines.
•Theoretical capacity levels, in the real world, are unattainable but they represent the ideal goal of capacity utilization a company can aspire to.
Practical Capacity
Practical capacity is the level of capacity that reduces theoretical capacity by considering unavoidable operating interruptions like scheduled maintenance time and shutdowns for holidays.
•Both theoretical capacity and practical capacity measure capacity levels in terms of what a plant can supply.
•Our next two levels measure capacity levels in terms of demand.
Normal Capacity Utilization and Master-Budget Capacity Utilization
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.
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:
- Product costing and capacity management
- Pricing
- Performance evaluation
- External reporting
- Tax requirements
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
amount of unused capacity.
Pricing Decisions
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 because it calculates the fixed cost rate based on capacity available rather than capacity used to meet demand
Unused capacity adds
costs to products.
Where there are large differences between practical capacity and master-budget capacity utilization, that difference is often classified as
planned unused capacity
For tax reporting purposes in the United States, the Internal Revenue Service (IRS) requires companies to assign inventoriable indirect production costs by
a “method of allocation which fairly apportions such costs among the various items produced.”
The IRS accepts approaches that involve the use of either
overhead rates or standard costs.
Under either approach, the IRS permits the use of practical capacity to calculate
budgeted fixed manufacturing cost per unit. Further, the production-volume variance generated this way can be deducted for tax purposes in the year in which the cost is incurred.
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:
The level of uncertainty about both the expected costs and the expected demand for the installed capacity
The presence of capacity-related issues in nonmanufacturing settings, and
The potential use of activity-based costing techniques in allocating capacity costs.
