Inventory Costing and Capacity

Analysis

Class Teacher:
Dr. Muhammad Ilyas
 Variable 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.
• All fixed manufacturing costs are excluded from inventoriable costs.
• However, it should be noted that variable costing is an imprecise term to
describe this inventory-costing method because only variable
manufacturing costs are inventoried.
• Variable nonmanufacturing costs are still treated as period costs and are
expensed.
 Variable and Absorption Costing

• Absorption costing method consider all variable manufacturing costs and

all fixed manufacturing costs as inventoriable costs.
• The Inventory “absorbs” all manufacturing costs.
• Under absorption costing the operating income varies with respect to the
level fixed cost allocation.
 Comparing Variable and Absorption Costing

Main Example: Stassen Company

• Stassen manufactures optical consumer-products manufacturer, and focus
on its product line of high-end telescopes.
• Stassen’s management wants to prepare an income statement for 2014
(the fiscal year just ended).
Operating information for the year 2014
Units
Beginning Inventory 0
Production 8,000
Sales 6,000
Ending inventory 2,000
 Comparing Variable and Absorption Costing
• Actual price and cost data for 2014 are as follows:

Description Amount
Selling price $1,000
Variable manufacturing cost per unit
- Direct material cost per unit $110
- Direct manufacturing labor cost per unit $40
- Manufacturing overhead cost per unit $50
Total variable manufacturing cost per unit $200
Variable marketing cost per unit sold $185
Fixed manufacturing costs (all indirect) $1,080,000
Fixed marketing costs (all indirect) $1,380,000
 Comparing Variable and Absorption Costing

Assumptions:
1. Stassen incurs manufacturing and marketing costs only.
2. There are no price, efficiency and spending variances.
3. Work-in-process inventory is zero.
4. Stassen budgeted production of 8,000 units for 2014. This was used to
calculate the budgeted fixed manufacturing cost per unit of $135
($1,080,000/8,000 units).
5. The actual production for 2014 is 8,000 units. As a result, there is no
production-volume variance for manufacturing costs in 2014.
 Comparing Variable and Absorption Costing

Based on the preceding information in slides # 4,5 and 6, Stassen’s

inventoriable costs per unit produced in 2014 under the two inventory costing
methods are as follows:
 Comparing Income Statements for One Year

• Comparison of operating income based variable costing and absorption

costing for a sales volume of 6000 units.
• The variable-costing income statement uses the contribution-margin format.
• The absorption-costing income statement uses the gross-margin format.
• For the 6000 units sales, the operating income in the variable costing is lower
than the operating income in absorption costing.
• The reason is, in absorption costing fixed costs added to the ending inventory
are not transferred to the expense account in income statement.
• While in variable costing all the fixed costs are deducted as period expense
from the revenue.
 Panel A: VARIABLE COSTING
Revenues: $1,000 x 6,000 units $6,000,000
Variable cost of goods sold
Beginning inventory: $200 x 0 units $0
Variable manufacturing costs: $200 x 8,000 units $1,600,000
Cost of goods available for sale $1,600,000
Deduct ending inventory: $200 x 2,000 units $(400,000)
Variable cost of goods sold $1,200,000
Variable marketing costs: $185 x 6,000 units sold $1,110,000
Contribution margin $3,690,000
Fixed manufacturing costs $1,080,000
Fixed marketing costs $1,380,000
Operating income $1,230,000
Manufacturing costs expensed in Panel A
Variable cost of goods sold $1,200,000
Fixed manufacturing costs $1,080,000
Total $2,280,000
 Panel B: ABSORPTION COSTING
Revenues: $1,000 x 6,000 units $6,000,000
Cost of goods sold
Beginning inventory: $335 x 0 units $0
Variable manufacturing costs: $200 x 8,000 units $1,600,000
Allocated fixed manufacturing costs: $135 x 8,000 units $1,080,000
Cost of goods available for sale $2,680,000
Deduct ending inventory: $335 x 2,000 units $(670,000)
Cost of goods sold $2,010,000
Gross Margin $3,990,000
Variable marketing costs: $185 x 6,000 units sold $1,110,000
Fixed marketing costs $1,380,000
Operating Income $1,500,000
Manufacturing costs expensed in Panel B
Cost of goods sold $2,010,000
 Fixed cost expensed under different level of sales

Variable costing Absorption Costing

Fixed Manufacturing Overhead

Fixed Manufacturing Overhead Included in Amount

Inventory Expensed

Units Sold Ending Included in Amount =$135 × Ending =$135 × Units

Inventory Inventory Expensed Inv. Sold

6,000 2,000 $0 $1,080,000 $270,000 $810,000

7,000 1,000 $0 $1,080,000 $135,000 $945,000
8,000 0 $0 $1,080,000 $0 $1,080,000
 Comparing Income Statements for Multiple Years
• In 2015, Stassen has a production-volume variance because actual telescope production
differs from the budgeted level of production of 8,000 units per year used to calculate the
budgeted fixed manufacturing cost per unit.
• The actual quantity sold for 2015 is 6,500 units, which is the same as the sales quantity
budgeted for that year.
Comparing Income Statements for Multiple Years
Comparing Income Statements for Multiple Years
 Production Volume Variance Calculation

Production Volume Variance = Budgeted FC- (Actual Production × Budgeted

FC per unit

Year Budgeted Fixed Actual Output Production-Volume Variance

Manufacturing Costs

2014 $1,080,000 8,000 units $0

2015 $1,080,000 5,000 units $1,080,000 – (5000×135)=

$405,000 U
 Comparing Income Statements for Multiple Years

The difference between operating income under absorption costing and

variable costing can be computed by formula 1, which focuses on fixed
manufacturing costs in beginning inventory and ending inventory:
 Comparing Income Statements for Multiple Years

• Why do variable costing and absorption costing report different operating

income numbers?
• In general, if inventory increases during an accounting period, less operating
income will be reported under variable costing than absorption costing.
• Conversely, if inventory decreases, more operating income will be reported
under variable costing than absorption costing.
• The difference in reported operating income is due solely to (a) moving fixed
manufacturing costs into inventories as inventories increase and (b) moving
fixed manufacturing costs out of inventories as inventories decrease under
absorption costing.
 Variable Costing and the Effect of Sales
and Production on Operating Income

Given a constant contribution margin per unit and constant fixed costs, the period-to-period
change in operating income under variable costing is driven solely by changes in the quantity of
units actually sold.
 Relevant Exercise for Practice
EX. 9-16 Variable and absorption costing, explaining operating-income differences. Nascar
Motors assembles and sells motor vehicles and uses standard costing. Actual data relating to
April and May 2014 are as follows:
 Relevant Exercise for Practice

The selling price per vehicle is $24,000. The budgeted level of production used to
calculate the budgeted fixed manufacturing cost per unit is 500 units. There are no
price, efficiency, or spending variances. Any production-volume variance is written off
to cost of goods sold in the month in which it occurs.
1. Prepare April and May 2014 income statements for Nascar Motors under (a) variable
costing and (b) absorption costing.
2. Prepare a numerical reconciliation and explanation of the difference between
operating income for each month under variable costing and absorption costing.
 Absorption Costing and Performance
Measurement

Absorption Costing Incentives: Absorption costing can encourage managers to

produce more inventory, boosting operating income and increasing bonuses and
stock-based compensation.
Ethical Issues: Managers may produce inventory without anticipated demand,
prioritizing personal compensation over company improvement.
Risks of Overproduction: Producing for inventory is risky in volatile or innovation-
driven industries, where products may become obsolete or need heavy
discounting.
Consequences of Overproduction: Excess inventory led to increased costs for
storage, maintenance, and discounted advertising to sell cars.
 Undesirable Buildup of Inventories

• A manager may increase inventory to boost absorption-costing

operating income.
• Increase in production reduces the unfavorable production volume
variance which increases the operating income. Why???
• Because When production increases the unfavorable production
variance reduces which ultimately reduces the CGS and increases the
operating income.
• A higher unfavorable production volume is added to the CGS which is
deducted from the revenue.
Undesirable Buildup of Inventories
 Proposals for Revising Performance Evaluation

1. Focus on careful Budgeting and Inventory Planning

• Reduce the management's freedom to build excess inventory.
• Monitor actual inventories against budgeted amounts.
2. Incorporate an Inventory Carrying Charge
• Assess a monthly carrying charge (e.g., 1%) for inventory.
• Include costs like spoilage and obsolescence in performance evaluations
3. Change the Performance Evaluation Period
Proposals for Revising Performance Evaluation
 Comparing Inventory Costing Methods

Throughput Costing
• Throughput costing, which is also called super-variable costing only
direct material costs are included as inventoriable costs.
• Only the $110 direct material cost per unit is inventoriable under
throughput costing, compared with $335 per unit for absorption
costing and $200 per unit for variable costing.
• Variable direct manufacturing labor costs and variable
manufacturing overhead costs are regarded as period costs and
are deducted as expenses of the period.
Comparing Inventory Costing Methods Using Throughput
costing
 Capacity Planning in absorption costing

• Difference Between Variable and Absorption Costing arises from

the treatment of fixed manufacturing costs.
• Determining the right of spending, or the appropriate level of
capacity is the most important strategic decision.
• Using too much capacity to generate production higher the market
demand will lead to unused capacity costs.
• Insufficient capacity may results in less production than the demand.
 Theoretical Capacity and Practical Capacity

• In business and accounting, capacity ordinarily means a “constraint,” an

“upper limit.”
• Theoretical capacity is the level of capacity based on producing at full
efficiency all the time.
• Stassen can produce 25 units per shift when the production lines are
operating at maximum speed. If we assume 360 days per year, the
theoretical annual capacity for 2 shifts per day is as follows:
 Theoretical Capacity and Practical Capacity

Practical capacity is the level of capacity that reduces

theoretical capacity by considering unavoidable operating
interruptions, such as scheduled maintenance time and shutdowns
for holidays.

Normal capacity utilization: based on future 2-3 years

customers demands
Budgeted capacity utilization: Based on the expected current
period customer demands
The effect of different level of capacity on budgeted fixed
manufacturing cost per unit

Increase in production capacity will reduce the fixed manufacturing cost

per unit and the total production cost per unit
The effect of different level of capacity on budgeted
manufacturing per unit