CHAPTER 9INVENTORY COSTING AND CAPACITY ANALYSIS

9-1 No. Differences in operating income between variable costing and absorption costing are due to accounting for fixed manufacturing costs. Under variable costing only variable manufacturing costs are included as inventoriable costs. Under absorption costing both variable and fixed manufacturing costs are included as inventoriable costs. Fixed marketing and distribution costs are not accounted for differently under variable costing and absorption costing.

9-2 The term direct costing is a misnomer for variable costing for two reasons:a. Variable costing does not include all direct costs as inventoriable costs. Only variable

direct manufacturing costs are included. Any fixed direct manufacturing costs, and any direct nonmanufacturing costs, (either variable or fixed) are excluded from inventoriable costs.

b. Variable costing includes as inventoriable costs not only direct manufacturing costs but also some indirect costs (variable indirect manufacturing costs).

9-3 No. The difference between absorption costing and variable costs is due to accounting for fixed manufacturing costs. As service or merchandising companies have no fixed manufacturing costs, these companies do not make choices between absorption costing and variable costing.

9-4 The main issue between variable costing and absorption costing is the proper timing of the release of fixed manufacturing costs as costs of the period:

a. at the time of incurrence, orb. at the time the finished units to which the fixed overhead relates are sold.

Variable costing uses (a) and absorption costing uses (b).

9-5 No. A company that makes a variable-cost/fixed-cost distinction is not forced to use any specific costing method. The Stassen Company example in the text of Chapter 9 makes a variable-cost/fixed-cost distinction. As illustrated, it can use variable costing, absorption costing, or throughput costing.

A company that does not make a variable-cost/fixed-cost distinction cannot use variable costing or throughput costing. However, it is not forced to adopt absorption costing. For internal reporting, it could, for example, classify all costs as costs of the period in which they are incurred.

9-6 Variable costing does not view fixed costs as unimportant or irrelevant, but it maintains that the distinction between behaviors of different costs is crucial for certain decisions. The planning and management of fixed costs is critical, irrespective of what inventory costing method is used.

9-7 Under absorption costing, heavy reductions of inventory during the accounting period might combine with low production and a large production volume variance. This combination could result in lower operating income even if the unit sales level rises.

9-1

9-8 (a) The factors that affect the breakeven point under variable costing are:1. Fixed costs,2. Contribution margin per unit.

(b) The factors that affect the breakeven point under absorption costing are:1. Fixed costs,2. Contribution margin per unit,3. Production level in units in excess of breakeven sales in units.4. Denominator level chosen to set the fixed manufacturing cost rate.

9-9 Examples of dysfunctional decisions managers may make to increase reported operating income are:a. Plant managers may switch production to those orders that absorb the highest amount of

fixed manufacturing overhead, irrespective of the demand by customers.b. Plant managers may accept a particular order to increase production even though another

plant in the same company is better suited to handle that order.c. Plant managers may defer maintenance beyond the current period to free up more time

for production.

9-10 Approaches used to reduce the negative aspects associated with using absorption costing include:a. Change the accounting system:

• Adopt either variable or throughput costing, both of which reduce the incentives of managers to produce for inventory.

• Adopt an inventory holding charge for managers who tie up funds in inventory.b. Extend the time period used to evaluate performance. By evaluating performance over a

longer time period (say, 3 to 5 years), the incentive to take short-run actions that reduce long-term income is lessened.

c. Include nonfinancial as well as financial variables in the measures used to evaluate performance.

9-11 The theoretical capacity and practical capacity denominator-level concepts emphasize what a plant can supply. The normal capacity utilization and master-budget capacity utilization concepts emphasize what customers demand for products produced by a plant.

9-12 The downward demand spiral is the continuing reduction in demand for its product that occurs when the prices of competitors’ products are not met and (as demand drops further), higher and higher unit costs result in more and more reluctance to meet competitors’ prices. Pricing decisions need to consider competitors and customers as well as costs.

9-13 No. It depends on how a company handles the production-volume variance in the end-of-period financial statements. For example, if the adjusted allocation-rate approach is used, each denominator-level capacity concept will give the same financial statement numbers at year end.

9-2

9-14 For tax reporting in the U.S., the IRS requires companies to use the practical capacity concept. At year end, proration of any variances between inventories and cost of goods sold is required (unless the variance is immaterial in amount).

9-15 No. The costs of having too much capacity/too little capacity involve revenue opportunities potentially forgone as well as costs of money tied up in plant assets.

9-16 (30 min.) Variable and absorption costing, explaining operating income differences.

1. Key inputs for income statement computations are:

April May

Beginning inventoryProductionGoods available for saleUnits soldEnding inventory

0500 500350 150

150400 550520 30

The fixed cost per unit and total manufacturing costs per unit under absorption costing are:

April May(a) Fixed manufacturing costs(b) Units produced(c)=(a)÷(b) Fixed manufacturing costs per unit(d) Variable manufacturing costs per unit(e)=(c)+(d) Total manufacturing costs per unit

$2,000,000500

$4,000$10,000$14,000

$2,000,000400

$5,000$10,000$15,000

9-3

9-16 (Cont’d.)

(a) Variable costing

April 2003 May 2003

Revenuesa $8,400,000 $12,480,000Variable costs Beginning inventory $ 0 $1,500,000

Variable manufacturing costsb 5,000,000 4,000,000 Cost of goods available for sale 5,000,000 5,500,000

Deduct ending inventoryc 1,500,000 300,000 Variable cost of goods sold 3,500,000 5,200,000

Variable operating costsd 1,050,000 1,560,000 Total variable costs 4,550,000 6,760,000 Contribution margin 3,850,000 5,720,000Fixed costs Fixed manufacturing costs 2,000,000 2,000,000 Fixed operating costs 600,000 600,000 Total fixed costs 2,600,000 2,600,000 Operating income $1,250,000 $3,120,000 a $24,000 × 350; $24,000 × 520 c $10,000 × 150; $10,000 × 30b $10,000 × 500; $10,000 × 400 d $3,000 × 350; $3,000 × 520

(b) Absorption costing

April 2003 May 2003

Revenuesa $8,400,000 $12,480,000Cost of goods sold Beginning inventory $ 0 $2,100,000

Variable manufacturing costsb 5,000,000 4,000,000

Fixed manufacturing costsc 2,000,000 2,000,000 Cost of goods available for sale 7,000,000 8,100,000

Deduct ending inventoryd 2,100,000 450,000 Cost of goods sold 4,900,000 7,650,000

Gross margin 3,500,000 4,830,000Operating costs

Variable operating costse 1,050,000 1,560,000Fixed operating costs 600,000 600,000 Total operating costs 1,650,000 2,160,000

Operating income $1,850,000 $ 2,670,000 a $24,000 × 350; $24,000 × 520 d ($14,000 × 150; $15,000 × 30)b $10,000 × 500; $10,000 × 400 e ($3,000 × 350; $3,000 × 520)c ($4,000 × 500); ($5,000 × 400)

9-4

9-16 (Cont’d.)

2. – = – April:

$1,850,000 – $1,250,000 = ($4,000 × 150) – ($0)$600,000 = $600,000

May:$2,670,000 – $3,120,000 = ($5,000 × 30) – ($4,000 × 150)

– $450,000 = $150,000 – $600,000 – $450,000 = – $450,000

The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into inventories as inventories increase (as in April) and out of inventories as they decrease (as in May).

9-16 Excel ApplicationInventory Costing and Capacity Analysis

Nascar Motors

Original Data

Unit Data April MayBeginning Inventory 0 150

Production 500 400Sales 350 520

Ending Inventory 150 30

Revenue and Cost DataSelling Price $24,000 $24,000 Variable CostsManufacturing Costs per Unit Produced $10,000 $10,000 Operating Costs per Unit Sold 3,000 3,000 Fixed CostsManufacturing Costs $2,000,000 $2,000,000 Operating Costs 600,000 600,000

Variable Absorption Inventoriable Costs Costing CostingVariable Manufacturing Costs $10,000 $10,000 Fixed Indirect Manufacturing Costs 4,000 5,000Total Inventoriable Costs $10,000 $14,000

9-5

Excel Solution 9-16 (Cont’d)Problem 1

Panel A: Variable CostingApril May

Revenues (350 x $24,000; 520 x $24,000) $8,400,000 $12,480,000 Variable Costs

Beginning Inventory ($10,000 x 0; 150) - 1,500,000 Variable Manufacturing Costs ($10,000 x 500; 400) 5,000,000 4,000,000 Cost of Goods Available for Sale 5,000,000 5,500,000 Ending Inventory ($10,000 x 150; 30) 1,500,000 300,000 Variable Cost of Goods Sold 3,500,000 5,200,000 Variable Operating Costs ($3,000 x 350; 520) 1,050,000 1,560,000 Total Variable Costs 4,550,000 6,760,000

Contribution Margin 3,850,000 5,720,000 Fixed Costs

Fixed Manufacturing Costs 2,000,000 2,000,000 Fixed Operating Costs 600,000 600,000 Total Fixed Costs 2,600,000 2,600,000

Operating Income $1,250,000 $3,120,000

Panel B: Absorption CostingApril May

Revenues $8,400,000 $12,480,000 Cost of Goods Sold

Beginning Inventory ($14,000 x 0; 150) - 2,100,000 Variable Manufacturing Costs ($10,000 x 500; 400) 5,000,000 4,000,000 Fixed Manuf. Costs ($4000 x 500; $5000 x 400) 2,000,000 2,000,000 Cost of Goods Available for Sale 7,000,000 8,100,000 Ending Inventory ($14,000 x 150; $15,000 x 30) 2,100,000 450,000 Cost of Goods Sold 4,900,000 7,650,000

Gross Margin 3,500,000 4,830,000 Operating CostsVariable Operating Costs ($3,000 x 350; 520) 1,050,000 1,560,000 Fixed Operating Costs 600,000 600,000 Total Operating Costs 1,650,000 2,160,000

Operating Income $1,850,000 $2,670,000

9-6

9-17 (20 min.) Throughput costing (continuation of Exercise 9-16).1. April 2003 May 2003

Revenuesa $8,400,000 $12,480,000Direct material cost of goods sold

Beginning inventory

Direct materials in goods manufacturedb$ 0 3,350,000

$1,005,000 2,680,000

Cost of goods available for sale

Deduct ending inventoryc3,350,000

1,005,000 3,685,000

201,000 Total direct material cost of goods sold

Throughput contributionOther costs

2,345,000 6,055,000

3,484,000 8,996,000

Manufacturing costs 3,650,000d 3,320,000e

Other operating costs 1,650,000 f 2,160,000 g

Total other costsOperating income

5,300,000 $ 755,000

5,480,000 $3,516,000

a $24,000 × 350; $24,000 × 520 e ($3,300 × 400) + $2,000,000b $6,700 × 500; $6,700 × 400 f ($3,000 × 350) + $600,000c $6,700 × 150; $6,700 × 30 g($3,000 × 520) + $600,000d($3,300 × 500) + $2,000,000

2. Operating income under:April May

Absorption costingVariable costingThroughput costing

$1,850,0001,250,000

755,000

$2,670,0003,120,0003,516,000

In April, throughput costing has the lowest operating income whereas in May, throughput costing has the highest operating income. Throughput costing puts greater emphasis on sales as the source of operating income than does either absorption or variable costing.

3. Throughput costing puts a penalty on producing without a corresponding sale in the same period. Costs other than direct materials that are variable with respect to production are expensed in the period of incurrence, whereas under variable costing they would be capitalized. As a result, throughput costing provides less incentive to produce for inventory than either variable costing or absorption costing.

9-7

9-18 (40 min.) Variable and absorption costing, explaining operatingincome differences.

1. Key inputs for income statement computations are:

January February MarchBeginning inventoryProductionGoods available for saleUnits soldEnding inventory

0 1,0001,000 700 300

300 8001,100 800 300

300 1,2501,550

1,500 50

The fixed manufacturing costs per unit and total manufacturing costs per unit under absorption costing are:

January February March(a) Fixed manufacturing costs(b) Units produced(c)=(a)÷(b) Fixed manufacturing costs per unit(d) Variable manufacturing costs per unit(e)=(c)+(d) Total manufacturing costs per unit

$400,0001,000$400$900

$1,300

$400,000800

$500$900

$1,400

$400,0001,250$320$900

$1,220

9-8

9-18 (Cont’d.)

(a) Variable CostingJanuary 2004 February 2004 March 2004

Revenuesa $1,750,000 $2,000,000 $3,750,000Variable costs

Beginning inventoryb $ 0 $270,000 $ 270,000

Variable manufacturing costsc 900,000 720,000 1,125,000 Cost of goods available for sale

Ending inventoryd900,000

270,000 990,000 270,000

1,395,000 45,000

Variable cost of goods sold

Variable operating costse

Total variable costs

630,000 420,000

1,050,000

720,000 480,000

1,200,000

1,350,000 900,000

2,250,000 Contribution marginFixed costs

Fixed manufacturing costsFixed operating costs Total fixed costs

Operating income

400,000 140,000

700,000

540,000 $ 160,000

400,000 140,000

800,000

540,000 $ 260,000

400,000 140,000

1,500,000

540,000 $ 960,000

a $2,500 × 700; $2,500 × 800; $2,500 × 1,500b $? × 0; $900 × 300; $900 × 300c $900 × 1,000; $900 × 800; $900 × 1,250d $900 × 300; $900 × 300; $900 × 50e $600 × 700; $600 × 800; $600 × 1,500

9-9

9-18 (Cont'd.)

(b) Absorption CostingJanuary 2004 February 2004 March 2004

Revenuesa

Cost of goods sold

Beginning inventoryb $ 0

$1,750,000

$ 390,000

$2,000,000

$ 420,000

$3,750,000

Variable manufacturing costsc 900,000 720,000 1,125,000

Fixed manufacturing costsd 400,000 400,000 400,000 Cost of goods available for sale 1,300,000 1,510,000 1,945,000

Deduct ending inventorye 390,000 420,000 61,000 Cost of goods sold 910,000 1,090,000 1,884,000

Gross margin 840,000 910,000 1,866,000Operating costs

Variable operating costsf 420,000 480,000 900,000

Fixed operating costs 140,000 140,000 140,000 Total operating costs 560,000 620,000 1,040,000 Operating income $ 280,000 $ 290,000 $ 826,000

a $2,500 × 700; $2,500 × 800; $2,500 × 1,500b ($?× 0; $1,300 × 300; $1,400 × 300)c $900 × 1,000, $900 × 800, $900 × 1,250d ($400 × 1,000); ($500 × 800); ($320 × 1,250)e ($1,300 × 300); ($1,400 × 300); ($1,220 × 50)f $600 × 700; $600 × 800; $600 × 1,500

9-10

9-18 (Cont’d.)

2. – = –

January: $280,000 – $160,000 = ($400 × 300) – $0$120,000 = $120,000

February: $290,000 – $260,000 = ($500 × 300) – ($400 × 300)$30,000 = $30,000

March: $826,000 – $960,000 = ($320 × 50) – ($500 × 300)– $134,000 = – $134,000

The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into inventories as inventories increase (as in January) and out of inventories as they decrease (as in March).

9-11

9-19 (20–30 min.) Throughput costing (continuation of Exercise 9-18).

1.January February March

Revenuesa

Direct material cost of goods soldBeginning inventoryb $ 0

$1,750,000

$150,000

$2,000,000

$ 150,000

$3,750,000

Direct materials in goods manufacturedc

Cost of goods available for saleDeduct ending inventoryd

Total direct material cost of goods sold

500,000 500,000

150,000 350,000

400,000 550,000

150,000 400,000

625,000 775,000

25,000 750,000

Throughput contribution 1,400,000 1,600,000 3,000,000Other costs

Manufacturinge

Operatingf

Total other costsOperating income

800,000 560,000

1,360,000 $ 40,000

720,000 620,000

1,340,000 $ 260,000

900,000 1,040,000

1,940,000 $1,060,000

a $2,500 × 700; $2,500 × 800; $2,500 × 1,500b ($? × 0; $500 × 300; $500 × 300)c $500 × 1,000; $500 × 800; $500 × 1,250d $500 × 300; $500 × 300; $500 ×50e ($400 × 1,000) + $400,000 ($400 × 800) + $400,000 ($400 × 1,250) + $400,000f ($600 × 700) + $140,000 ($600 × 800) + $140,000 ($600 × 1,500) + $140,000

9-12

9-19 (Cont'd.)

2. Operating income under:January February March

Absorption costingVariable costingThroughput costing

$280,000160,00040,000

$290,000260,000260,000

$826,000960,000

1,060,000

Throughput costing puts greater emphasis on sales as the source of operating income than does absorption or variable costing.

3. Throughput costing puts a penalty on producing without a corresponding sale in the same period. Costs other than direct materials that are variable with respect to production are expensed when incurred, whereas under variable costing they would be capitalized as an inventoriable cost.

9-20 (40 min) Variable vs. absorption costing.1.

Income Statement for the Zwatch Company, Variable CostingFor the Year Ended December 31, 2004

Revenues: $22 × 345,400 $7,598,800Variable costs Beginning inventory: $5.10 × 85,000 $ 433,500 Variable manufacturing costs: $5.10 × 294,900 1,503,990 Cost of goods available for sale 1,937,490 Deduct ending inventory: $5.10 × 34,500 175,950 Variable cost of goods sold 1,761,540 Variable operating costs: $1.10 × 345,400 379,940 Total variable costs (at standard costs) 2,141,480 Adjustment for variances 0 Total variable costs 2,141,480Contribution margin 5,457,320Fixed costs Fixed manufacturing overhead costs 1,440,000 Fixed operating costs 1,080,000 Adjustment for fixed cost variances 0 Total fixed costs 2,520,000Operating income $2,937,320

9-13

9-20 (Cont’d.)

Absorption Costing Data

Fixed manufacturing overhead allocation rate = Fixed manufacturing overhead/Denominator level machine-hours = $1,440,000/6,000

= $240 per machine-hour

Fixed manufacturing overhead allocation rate per unit = Fixed manufacturing overhead allocation rate/standard production rate = $240/50

= $4.80 per unit

Income Statement for the Zwatch Company, Absorption CostingFor the Year Ended December 31, 2004

Revenues: $22 × 345,400 $7,598,800Cost of goods sold Beginning inventory ($5.10 + $4.80) × 85,000 $ 841,500 Variable manuf. costs: $5.10 × 294,900 1,503,990 Fixed manuf. costs: $4.80 × 294,900 1,415,520 Cost of goods available for sale $3,761,010 Deduct ending inventory: ($5.10 + $4.80) × 34,500 (341,550) Adjust for manuf. variances ($4.80 × 5,100)a 24,480 Cost of goods sold 3,443,940 Gross margin 4,154,860Operating costs Variable operating costs: $1.10 × 345,400 $ 379,940 Fixed operating costs 1,080,000 Adjust for operating cost variances 0 Total operating costs 1,459,940 Operating income $2,694,920 a Production volume variance

= [(6,000 hours × 50) – 294,900) × $4.80= (300,000 – 294,900) × $4.80= $24,480

2. Zwatch’s pre-tax profit margins –

Under variable costing: Revenues $7,598,800 Operating income 2,937,320 Pre-tax profit margin 38.7%

Under absorption costing: Revenues $7,598,800 Operating income 2,694,920 Pre-tax profit margin 35.5%

9-14

9-20 (Cont’d.)

3. Operating income using variable costing is about 9% higher than operating income calculated using absorption costing.

Variable costing operating income – Absorption costing operating income =$2,937,320 – $2,694,920 = $242,400

Fixed manufacturing costs in beginning inventory under absorption costing – Fixed manufacturing costs in ending inventory under absorption costing =

($4.80 × 85,000) – ($4.80 × 34,500) = $242,400

4. The factors the CFO should consider include:(a) Effect on managerial behavior, and(b) Effect on external users of financial statements.

Absorption costing has many critics. However, the dysfunctional aspects associated with absorption costing can be reduced by:

Careful budgeting and inventory planning, Adding a capital charge to reduce the incentives to build up inventory, and Monitoring nonfinancial performance measures.

9-15

9-21 (10 min.) Absorption and variable costing.

The answers are 1(a) and 2(c). Computations:

1. Absorption Costing:

Revenuesa

Cost of goods sold:

Variable manufacturing costsb

Fixed manufacturing costsc

Gross margin

$2,400,000 360,000

$4,800,000

2,760,000 2,040,000

Operating costs:Variable operatingd Fixed operating

Operating income

1,200,000 400,000 1,600,000

$ 440,000

a $40 × 120,000b $20 × 120,000c Fixed manufacturing rate = $600,000 ÷ 200,000 = $3 per output unit Fixed manufacturing costs = $3 × 120,000

d $10 × 120,000

2. Variable Costing:

Revenuesa

Variable costs:Variable manufacturing cost of goods soldb Variable operating costsc

Contribution marginFixed costs:

Fixed manufacturing costsFixed operating costs

Operating income

$2,400,000 1,200,000

600,000 400,000

$4,800,000

3,600,000 1,200,000

1,000,000 $ 200,000

a $40 × 120,000b $20 × 120,000c $10 × 120,000

9-16

9-22 (40 min) Absorption vs. variable costing.

1. The number of Mimic pills sold in 2004 is:44,800 × 365 × 3 = 49,056,000 pills

Ending inventory on December 31, 2004, is 5,694,000 pills:Unit data Beginning inventory 0 Production 54,750,000 Sales 49,056,000 Ending inventory 5,694,000

Variable cost data Manufacturing costs per pill produced Direct materials $0.05 Direct manufacturing labor 0.04 Manufacturing overhead 0 .11 Total variable manufacturing costs $0 .20

Fixed cost data Manufacturing costs $ 7,358,400 R&D 4,905,600 SG&A 19,622,400

Wholesale selling price per pill $1.20

Fixed manufacturing costs allocation rate per pill $0.15 (Given) (7,358,400 ÷ 54,750,000)

2. Variable costing:

Revenues: $1.20 × 49,056,000 $58,867,200Variable costs Beginning inventory $ 0 Variable manuf. cost: $0.20 × 54,750,000 10,950,000 Cost of goods available for sale 10,950,000 Deduct ending inventory: $0.20 × 5,694,000 1,138,800 Variable cost of goods sold 9,811,200 Variable marketing costs: $0.07 × 49,056,000 3,433,920 Adjust for variable-cost variance 0 Total variable costs 13,245,120 Contribution margin 45,622,080Fixed costs Fixed manufacturing costs 7,358,400 Fixed R&D 4,905,600 Fixed marketing 19,622,400 Total fixed costs 31,886,400 Operating income $13,735,680

9-17

922 (Cont’d.)

Absorption costing:

Revenues: $1.20 × 49,056,000 $58,867,200Costs of goods sold Beginning inventory $ 0 Variable manuf. cost: $0.20 × 54,750,000 10,950,000 Fixed manuf. costs: $0.15 × 54,750,000 8,212,500 Cost of goods available for sale 19,162,500 Deduct ending inventory: $0.35 × 5,694,000 (1,992,900)

Adjust for manuf. variances a (854,100 ) Cost of goods sold 16,315,500 Gross margin 42,551,700Operating costs Variable marketing costs: $0.07 × 49,056,000 3,433,920 Fixed R&D 4,905,600 Fixed marketing 19,622,400 Adjustment for operating cost variances 0 Total operating costs 27,961,920 Operating income $14,589,780 a Production - volume variance = (0.15 × 54,750,000 units) – $7,358,4000 = $854,100F

3. The difference of $854,100 is due to:

=

= ($0.15 × 5,694,000) $0= $854,100

9-18

9-23 (20-30 min.) Comparison of actual-costing methods.

The numbers are simplified to ease computations. This problem avoids standard costing and its complications.

1. Variable-costing income statements:

2003 2004Sales

Production1,000 units1,400 units

SalesProduction

1,200 units1,000 units

Revenues ($3 per unit) $3,000 $3,600Variable costs:

Beginning inventoryVariable cost of goods manufacturedCost of goods available for sale

Deduct ending inventorya

$ 0 700

700 (200 )

$ 200 500

700 (100 )

Variable cost of goods soldVariable operating costs Variable costs

Contribution marginFixed costs

Fixed manufacturing costsFixed operating costs Total fixed costs

Operating income

500 1,000

700 400

1,500 1,500

1,100 $ 400

600 1,200

700 400

1,800 1,800

1,100 $ 700

a Unit inventoriable costs:Year 1: $700 ÷ 1,400 = $0.50 per unit; $0.50 × (1400 – 1000)Year 2: $500 ÷ 1,000 = $0.50 per unit; $0.50 × (400 + 1,000 – 1,200)

9-19

9-23 (Cont'd.)

2. Absorption-costing income statements:

2003 2004Sales

Production1,000 units1,400 units

SalesProduction

1,200 units1,000 units

Revenues ($3 per unit)Cost of goods sold:

Beginning inventoryVariable manufacturing costsFixed manufacturing costsa

Cost of goods available for saleDeduct ending inventoryb

$ 0 700

700 1,400

(400 )

$3,000

$ 400500

700 1,600

(240 )

$3,600

Cost of goods soldGross marginOperating costs:

Variable operating costsFixed operating costs

Total operating costsOperating income

1,000 400

1,000 2,000

1,400 $ 600

1,200 400

1,360 2,240

1,600 $ 640

a Fixed manufacturing costs:Year 1: $700 ÷ 1,400 = $0.50 per unitYear 2: $700 ÷ 1,000 = $0.70 per unit

b Unit inventoriable costs:Year 1: $1,400 ÷ 1,400 = $1.00 per unit; $1.00 × (1400 – 1000)Year 2: $1,200 ÷ 1,000 = $1.20 per unit $1.20 × (400 + 1,000 – 1,200)

9-20

9-23 (Cont'd.)

3. 2003 2004Variable Costing:

Operating income $400 $700Ending inventory 200 100

Absorption Costing:Operating income $600 $640Ending inventory 400 240Fixed manuf. overhead

• in beginning inventory 0 200• in ending inventory 200 140

=

Year 1: $600 – $400 = $0.50 × 400 – $0= $200

Year 2: $640 – $700 = ($0.70 × 200) – ($0.50 × 400)= –$60

The difference in reported operating income is due the amount of fixed manufacturing overhead in the beginning and ending inventories. In Year 1, absorption costing has a higher operating income of $200 due to ending inventory having $200 more in fixed manufacturing overhead than does beginning inventory. In Year 2, variable costing has a higher operating income of $60 due to ending inventory under absorption costing having $60 less in fixed manufacturing overhead than does beginning inventory.

4. a. Absorption costing is more likely to lead to inventory build-ups than variable costing. Under absorption costing, operating income in a given accounting period is increased by inventory buildup, because some fixed manufacturing costs are accounted for as an asset (inventory) instead of as a cost of the period of production.

b. Although variable costing will counteract undesirable inventory build-ups, other measures can be used without abandoning absorption costing. Examples include:(1) careful budgeting and inventory planning,(2) incorporating a carrying charge for inventory,(3) changing the period used to evaluate performance to be long-term,(4) including nonfinancial variables that measure inventory levels in performance

evaluations.

9-21

9-24 (10 min.) Capacity management, denominator-level capacity concepts.

1. d2. c, d3. d4. a5. c6. a, b7. a8. b9. c, d10. b11. a, b

9-25 (25 min.) Denominator-level problem

1. Budgeted fixed manufacturing overhead costs rates:

DenominatorLevel Capacity

Concept

Budgeted FixedManufacturingOverhead per

Period

BudgetedCapacity

Level

Budgeted FixedManufacturingOverhead Cost

RateTheoretical $ 3,800,000 2,880 $ 1,319.44Practical 3,800,000 1,800 2,111.11Normal 3,800,000 1,000 3,800.00Master-budget 3,800,000 1,200 3,166.67

The rates are different because of varying denominator-level concepts. Theoretical and practical capacity levels are driven by supply-side concepts, i.e,. “how much can I produce?” Normal and master-budget capacity levels are driven by demand-side concepts, i.e,. “how much can I sell?” (or “how much should I produce?”)

2. In order to incorporate fixed manufacturing costs into unit product costs, fixed manufacturing costs have to be unitized for inventory costing. Absorption costing is the method used for tax reporting to the IRS and for financial reporting using generally accepted accounting principles.

The choice of a denominator level becomes relevant under absorption costing because fixed costs are accounted for along with variable costs at the individual product level. Variable and throughput costing account for fixed costs as a lump sum, expensed in the period incurred.

3. The variances that arise from use of the theoretical or practical level concepts will signal that there is a divergence between the supply of capacity and the demand for capacity. This is useful input to managers. As a general rule, however, it is important not to place undue reliance on the production volume variance as a measure of the economic costs of unused capacity.

9-22

9-25 (Cont’d.)

4. Under a cost-based pricing system, the choice of a master-budget level denominator will lead to high prices when demand is low (more fixed costs allocated to the individual product level), further eroding demand; conversely it will lead to low prices when demand is high, forgoing profits. This has been referred to as the downward demand spiral—the continuing reduction in demand that occurs when the prices of competitors are not met and demand drops, resulting in even higher unit costs and even more reluctance to meet the prices of competitors. The positive aspect of the master-budget denominator level is that it indicates the price at which all costs per unit would be recovered to enable the company to make a profit. Master-budget denominator level is also a good benchmark against which to evaluate performance.

9-26 (30 min.)Variable and absorption costing and breakeven points.

1. Production = Sales + Ending Inventory - Beginning Inventory= 242,400 + 24,800 32,600= 234,600 cases

2. Breakeven point in cases:a. Variable Costing:

QT =

QT =

QT =

QT = 224,400 cases

b. Absorption costing:

Fixed manuf. cost rate = $3,753,600 ÷ 234,600 = $16 per case

QT =

QT =

QT =

9-23

9-26 (Cont’d.)

QT =

46 QT 16 QT = $6,568,800

30 QT = $6,568,800

QT = 218,960 cases.

3. If grape prices increase by 25%, the cost of grapes per case will increase from $16 in 2004 to $20 in 2005. This will decrease the unit contribution margin from $46 in 2004 to $42 in 2005.

a. Variable Costing:

QT =

= 245,772 cases (rounded up)

b. Absorption Costing:

QT =

$42 QT = $6,568,800 + $16 QT

$26 QT = $6,568,800

QT = 252,647 cases (rounded up)

9-24

9-27 (15 min.) ABC and capacity usage.

1. Rate per Unit ofActivity Cost Driver

Machine setup $500,000 activity costs ÷ 5,000 setup-hours = $100 per setup-hour

Material handling $200,000 activity costs ÷ 100,000 poundsof material = $2 per pound

Cost Allocation:

Machine setupDaska (3,000 setup-hours × $100) $300,000Kothi (1,500 setup-hours × $100) 150,000Total machine setup costs allocation $450,000

Material handlingDaska (40,000 pounds × $2) $ 80,000Kothi (50,000 pounds × $2) 100,000Total material handling costs allocation $180,000

2. Cost of unused capacity:

Machine setup ($500,000 – $450,000) $ 50,000Material handling ($200,000 – $180,000) 20,000Total cost of unused capacity $ 70,000

9-25

9-28 (15 min.) ABC and capacity usage.

1. Activity Rate per Unit of Cost DriverPower $200,000 activity costs ÷ 50,000

kilowatt hours = $4 per kilowatt hour

Quality inspection $300,000 activity costs ÷ 10,000 inspections = $30 per inspection

Cost allocation:

PowerTulsa (10,000 kilowatt hours × $4) $ 40,000Okla (35,000 kilowatt hours × $4) 140,000Total power costs allocation $180,000

Quality inspectionTulsa (5,000 inspections × $30) $150,000Okla (4,000 inspections × $30) 120,000Total quality inspection costs allocation $270,000

2. Cost of unused capacity:

Power ($200,000 – $180,000) $ 20,000Quality inspection ($300,000 – $270,000) 30,000Total cost of unused capacity $ 50,000

9-26

9-29 (25 min.) Cost behavior, activity-based costing, capacity usage.

1. Budgeted fixed rate per bill processed:($30,000 × 5) ÷ (6,000 × 5) = $5.00

Budgeted variable rate per bill processed:($22,500) ÷ (6,000 × 5) = 0.75

Budgeted rate per bill processed = $5.75

2. Capacity available, 6,000 bills × 5 employees 30,000 bills

3. Capacity available = Capacity used + Unused capacity

Unused capacity = Capacity available – Capacity used= 30,000 bills – 26,000 bills= 4,000 bills

4. Cost of capacity supplied = Cost of capacity used + Cost of unused capacity

For fixed costs,$150,000 = ($5 × 26,000 bills) + ($5 × 4,000 bills)

= $130,000 + $20,000Fixed cost resources have costs of unused capacity when all the fixed cost capacity is not

used to produce products or services.For variable costs,

Cost of capacity supplied = $0.75 × 26,000 bills = $19,500Cost of capacity used = $0.75 × 26,000 bills = $19,500

There is no unused capacity for variable costs. Variable cost resources are only acquired when they are used.

9-27

9-30 (40 min.) Variable costing versus absorption costing.1. Absorption Costing:

Mavis Company Income StatementFor the Year Ended December 31, 2004

Revenues (540,000 × $5.00) $2,700,000Cost of goods sold:

Beginning inventory (30,000 × $3.70a) $ 111,000Variable manufacturing costs (550,000 × $3.00) 1,650,000Fixed manuf. costs (550,000 × $0.70) 385,000Cost of goods available for sale 2,146,000Deduct ending inventory (40,000 × $3.70) 148,000 Cost of goods sold (at std. costs) 1,998,000

Gross margin (at standard costs) 702,000

Deduct adjustment for variances (50,000b × $0.70) 35,000Gross margin 667,000Operating costs:

Variable operating costs (540,000 × $1) 540,000Fixed operating costs 120,000Adjustment for variances 0 Total operating costs 660,000

Operating income $ 7,000a $3.00 + ($7.00 ÷ 10) = $3.00 + $0.70 = $3.70b [(10 × 60,000) – 550,000)] = 50,000 units

2. Variable Costing: Mavis Company Income Statement

For the Year Ended December 31, 2004

Revenues $2,700,000Variable costs:

Beginning inventory (30,000 × $3.00) $ 90,000Variable manufacturing costs (550,000 × $3.00) 1,650,000Cost of goods available for sale 1,740,000 Deduct ending inventory (40,000 × $3.00) 120,000Variable manufacturing cost of goods sold 1,620,000Variable operating costs 540,000 Total variable costs (at std. cost) 2,160,000Adjustment for variances 0 Total variable costs 2,160,000

Contribution margin 540,000Fixed costs:

Fixed manufacturing overhead costs 420,000Fixed operating costs 120,000Adjustment for fixed cost variances 0 Total fixed costs 540,000

9-28

Operating income $ 0

9-30 (Cont’d.)

3. The difference in operating income between the two costing methods is:

=

$7,000 – $0 = [(40,000 × $0.70) – (30,000 × $0.70)]$7,000 = $28,000 – $21,000$7,000 = $7,000

The absorption-costing operating income exceeds the variable costing figure by $7,000 because of the increase of $7,000 during 2004 of the amount of fixed manufacturing costs in ending inventory vis-a-vis beginning inventory.

4.

5. Absorption costing is more likely to lead to buildups of inventory than does variable costing. Absorption costing enables managers to increase reported operating income by building up inventory which reduces the amount of fixed manufacturing overhead included in the current period's cost of goods sold.

Ways to reduce this incentive include:(a) Careful budgeting and inventory planning,(b) Change the accounting system to variable costing or throughput costing,(c) Incorporate a carrying charge for carrying inventory,(d) Use a longer time period to evaluate performance than a quarter or a year, and(e) Include nonfinancial as well as financial measures when evaluating management performance.

9-29

9-31 (10-20 min.) Breakeven under absorption costing (continuation of Problem 9-30).

1. The unit contribution margin is $5 – $3 – $1 = $1. Total fixed costs ($540,000) divided by the unit contribution margin ($1.00) equals 540,000 units. Therefore, under variable costing 540,000 units must be sold to break even.

2. If there are no changes in inventory levels, the breakeven point can be the same, 540,000 units, under both variable costing and absorption costing. However, as the chapter demonstrates, under absorption costing, the breakeven point is not unique; operating income is a function of both sales and production. Some fixed overhead is "held back" when inventories rise (10,000 units × $0.70 = $7,000), so operating income is positive even though sales are at the breakeven level as commonly conceived.

=

Let N = Breakeven sales in units

N =

N =

$0.30N = $155,000

N = 516,667 units (rounded)

Therefore, under absorption costing, when 550,000 units are produced, 516,667 units must be sold for the income statement to report zero operating income.

Proof of 2004 breakeven point:

Gross margin, 516,667 units × ($5.00 – $3.70) $671,667Output level MOH variance, as before $ 35,000Marketing and administrative costs: Variable, 516,667 units × $1.00 516,667 Fixed 120,000 671,667Operating income $ 0

9-30

9-31 (Cont’d.)

3. If no units are sold, variable costing will show an operating loss equal to the fixed manufacturing costs, $420,000 in this instance. In contrast, the company would break even under absorption costing, although nothing was sold to customers. This is an extreme example of what has been called "selling fixed manufacturing overhead to inventory."

A final note: We find it helpful to place the following comparisons on the board, keyed to the three parts of this problem:

1. Breakeven = f (sales)2. Breakeven = f (sales and production)3. Breakeven = f (0 units sold and 540,000 units produced), an extreme case

9-32 (40 min.) The All-Fixed Company in 2004.

This problem always generates active classroom discussion.

1. The treatment of fixed manufacturing overhead in absorption costing is affected primarily by what denominator level is selected as a base for allocating fixed manufacturing costs to units produced. In this case, is 10,000 tons per year, 20,000 tons, or some other denominator level the most appropriate base?

We usually place the following possibilities on the board or overhead projector and then ask the students to indicate by vote how many used one denominator level versus another. Incidentally, discussion tends to move more clearly if variable-costing income statements are discussed first, because there is little disagreement as to computations under variable costing.

a. Variable-Costing Income Statement:

2003 2004 TogetherRevenues (and contribution margin) $300,000 $300,000 $600,000Fixed costs:Manufacturing costs $280,000Operating costs 40,000 320,000 320,000 640,000Operating income $ (20,000) $ (20,000) $ (40,000)

b. Absorption-Costing Income Statement:

The ambiguity about the 10,000- or 20,000-unit denominator level is intentional. IF YOU WISH, THE AMBIGUITY MAY BE AVOIDED BY GIVING THE STUDENTS A SPECIFIC DENOMINATOR LEVEL IN ADVANCE.

Alternative 1. Use 20,000 units as a denominator; fixed manufacturing overhead per unit is $280,000 20,000 = $14.

9-31

9-32 (Cont’d.)

2003 2004  Together

Revenues $300,000 $ 300,000 $600,000 Manufacturing costs at $14 280,000 -- 280,000Deduct ending inventory 140,000 --   -- Cost of goods sold 140,000 140,000* 280,000Underallocated manuf. overhead-- output level variance -- 280,000 280,000Operating costs 40,000 40,000 80,000 Total costs 180,000 460,000 640,000 Operating income $120,000 $(160,000 ) $( 40,000 )

* Inventory carried forward from 2003 and sold in 2004.

Alternative 2.Use 10,000 units as a denominator; fixed manufacturing overhead per unit is $280,000 10,000 = $28.

2003 2004  Together

Revenues $300,000 $300,000 $600,000 Manufacturing costs at $28 560,000 -- 560,000Deduct ending inventory 280,000 -- -- Cost of goods sold 280,000 280,000* 560,000Underallocated manuf. overhead-- output level variance -- 280,000 --Overallocated manuf. overhead -- output level variance (280,000) -- --Operating costs 40,000 40,000 80,000 Total costs 40,000 600,000 640,000Operating income $260,000 $(300,000) $ (40,000)

*Inventory carried forward from 2003 and sold in 2004.

Note that operating income under variable costing follows sales and is not affected by inventory changes.

Note also that students will understand the variable-costing presentation much more easily than the alternatives presented under absorption costing.

2. = =

= 10,667 tons per year or 21,333 for two years.

9-32

9-33

9-32 (Cont’d.)

If the company could sell 667 more tons per year at $30 each, it could get the extra $20,000 contribution margin needed to break even.

Most students will say that the breakeven point is 10,667 tons per year under both absorption costing and variable costing. The logical question to ask a student who answers 10,667 tons for variable costing is: "What operating income do you show for 2003 under absorption costing?" If a student answers $120,000 (alternative 1 above), or $260,000 (alternative 2 above), ask: "But you say your breakeven point is 10,667 tons. How can you show an operating income on only 10,000 tons sold during 2003?"

The answer to the above dilemma lies in the fact that operating income is affected by both sales and production under absorption costing.

Given that sales would be 10,000 tons in 2003, solve for the production level that will provide a breakeven level of zero operating income. Using the formula in the chapter, sales of 10,000 units, and a fixed manufacturing overhead rate of $14 (based on $280,000 ÷ 20,000 units denominator level = $14):

Let P = Production level

=

10,000 tons =

$300,000 = $320,000 + $140,000 – $14P$14P = $160,000 P = 11,429 units (rounded)

Proof:Gross margin, 10,000 × ($30 – $14) $160,000Output level variance, (20,000 – 11,429) × $14 $120,000Marketing and administrative costs 40,000 160,000Operating income $ 0

9-34

9-32 (Cont’d.)

Given that production would be 20,000 tons in 2003, solve for the breakeven unit sales level. Using the formula in the chapter and a fixed manufacturing overhead rate of $14 (based on a denominator level of 20,000 units):

Let N = Breakeven sales in units

N =

N =

$30N = $320,000 + $14N – $280,000$16N = $40,000N = 2,500 unitsProof:

Gross margin, 2,500 × ($30 – $14) $40,000Output level MOH variance $ 0Marketing and administrative costs 40,000 40,000Operating income $ 0

We find it helpful to put the following comparisons on the board:

Variable costing breakeven = f(sales)= 10,667 tons

Absorption costing breakeven = f(sales and production)= f(10,000 and 11,429)= f(2,500 and 20,000)

3. Absorption costing inventory cost: Either $140,000 or $280,000 at the end of 2003 and zero at the end of 2004.

Variable costing: Zero at all times. This is a major criticism of variable costing and focuses on the issue of the definition of an asset.

3. Operating income is affected by both production and sales under absorption costing. Hence, most managers would prefer absorption costing because their performance in any given reporting period, at least in the short run, is influenced by how much production is scheduled near the end of a period.

9-35

9-33 (25-35 min.) Comparison of variable costing and absorptioncosting.

1. Operating income is a function of both sales and production under absorption costing, whereas it is a function only of sales under variable costing. Therefore, inventory changes can have dramatic effects on operating income under absorption costing. In this case, the severe decline in inventory has resulted in enormous fixed costs from beginning inventory being charged against 2003 operations.

2. The income statement deliberately contains an ambiguity about whether the fixed manufacturing overhead of $1,000,000 is the budgeted or actual amount. Of course, it must be the budgeted amount, because the spending variance and the output level variance are shown separately. Therefore:

= –

$400,000 = $1,000,000 – Allocated

Allocated = $600,000, which is 60% of denominator level

3. Note that the answer to (3) is independent of (2). The difference in operating income of $315,000 ($600,000 – $285,000) is explained by the release of $315,000 of fixed manufacturing costs when the inventories were decreased during 2003:

Fixed Manuf. Absorption Variable Overhead

Costing Costing in InventoryInventories: December 31, 2002 $1,650,000 $1,320,000 $330,000 December 31, 2003 75,000 60,000 15,000 Release of fixed manuf. costs $315,000

The above schedule in this requirement is a formal presentation of the equation:

=

($285,000 – $600,000) = ($15,000 – $330,000)= – $315,000

9-36

9-33 (Cont’d.)

Alternatively, the presence of fixed manufacturing overhead costs in each income statement can be analyzed:

Absorption costing, Fixed manuf. costs in cost of goods sold ($4,575,000 − $3,660,000) $ 915,000 Production-volume variance 400,000

1,315,000Variable costing, fixed manuf. costs charged to expense 1,000,000 Difference in operating income explained $ 315,000

Although it is not required, the following supplementary analysis may clarify the relationships (all amounts are at standard costs):

Absorption VariableCosting Costing

Inventory, December 31, 2002 $1,650,000 $1,320,000Cost of goods manufactured* 3,000,000 2,400,000 Available for sale 4,650,000 3,720,000Inventory, December 31, 2003 75,000 60,000 Cost of goods sold $4,575,000 $3,660,000

*Computed from the other data, which are given.

4. a. Absorption costing is more likely to lead to inventory buildups than variable costing. Under absorption costing, operating income in a given accounting period is increased because some fixed manufacturing overhead is accounted for as an asset (inventory) instead of an expense (fixed cost written off during the current period).

b. Although variable costing will counteract undesirable inventory buildups, other measures can be used without abandoning absorption costing. Examples include budget targets and nonfinancial measures of performance such as maintaining specific inventory levels, inventory turnovers, delivery schedules, and equipment maintenance schedules.

9-37

9-34 (25-30 min.) Alternative denominator-level concepts.

1.Denominator-

LevelConcept

Budgeted FixedManufacturing

Overheadper Period

BudgetedDenominator

Level

Budgeted FixedManufacturing

OverheadCost Rate

Theoretical capacityPractical capacityNormal capacity utilizationMaster-budget utilization(a) Jan.–June 2003(b) July–Dec. 2003

$42,000,00042,000,00042,000,000

21,000,00021,000,000

5,256,0003,500,0002,800,000

1,120,0001,680,000

$ 7.9912.0015.00

18.7512.50

The differences arise for several reasons:

a. The theoretical and practical capacity concepts emphasize supply factors, while normal capacity utilization and master-budget utilization emphasize demand factors.

b. The two separate six-month rates for the master-budget utilization concept differ because of seasonal differences in budgeted production.

2. Theoretical capacity is based on the production of output at maximum efficiency for 100% of the time.

Practical capacity--reduces theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holidays and other days, and so on.

For each of the three determinants of capacity in Lucky Larger's plant, practical capacity is less than theoretical capacity:

BarrelsPer Hour

(1)

WorkingHours

Per Day(2)

Working Days

Per Yea(3)

Capacity(4)=(1) × (2) × (3)

Theoretical capacityPractical capacity

600500

2420

365350

5,256,0003,500,000

3. The smaller the denominator, the higher the amount of overhead costs capitalized for inventory units. Thus, if the plant manager wishes to be able to "adjust" plant operating income by building inventory, master-budget utilization or possibly normal capacity utilization would be preferred.

9-38

9-35 (30 min.) Operating income effects of alternative denominator-level concepts (continuation of Problem 9-34).

1. Solution Exhibit 9-35 reports the operating income for each denominator-level concept. Computations include:

Denominator-Level

Concept

VariableManufacturing

Cost*

Budgeted FixedManufacturing

OverheadCost Rate

TotalManufacturing

Costs

Theoretical capacityPractical capacityNormal capacity

$46.3046.3046.30

$ 7.9912.0015.00

$54.2958.3061.30

* $120,380,000 ÷ 2,600,000 = $46.30 per barrel

The total fixed manufacturing overhead variance (spending variance plus production-volume variance) for each denominator-level concept is:

(a) Theoretical capacity: $40,632,000 – ($7.99 × 2,600,000)$40,632,000 – $20,774,000 = $19,858,000 U

(b) Practical capacity: $40,632,000 – ($12.00 × 2,600,000)$40,632,000 – $31,200,000 = $ 9,432,000 U

(c) Normal utilization: $40,632,000 – ($15.00 × 2,600,000)$40,632,000 – $39,000,000 = $ 1,632,000 U

Illustration of operating income differences:

Practical – Theoretical: $13,848,000 – $13,046,000 = $ 802,000Normal – Practical: $14,448,000 – $13,848,000 = $ 600,000Normal – Theoretical: $14,448,000 – $13,046,000 = $1,402,000

The difference in operating income across the three denominator-level concepts is due solely to differences in fixed manufacturing overhead included in the ending 200,000 barrels of inventory:

Theoretical capacity: 200,000 × $ 7.99 = $1,598,000$802,000 difference

Practical capacity: 200,000 × $12.00 = $2,400,000$600,000 difference

Normal capacity: 200,000 × $15.00 = $3,000,000

2. Given the data in this question, the theoretical capacity concept reports the lowest operating income and thus (other things being equal) the lowest tax bill for 2003. Lucky Larger benefits by having deductions as early as possible. The theoretical capacity denominator-level concept maximizes the deductions for manufacturing costs.

9-39

9-40

9-35 (Cont’d.)

3. The IRS may restrict the flexibility of a company in several ways.a. Restrict the denominator-level concept choice.b. Restrict the cost line items that can be expensed rather than inventoried.c. Restrict the ability of a company to use shorter write-off periods or more accelerated

write-off periods for inventoriable costs.d. Require proration or allocation of variances to represent actual costs and actual capacity

used.

SOLUTION EXHIBIT 9-35

TheoreticalCapacity

PracticalCapacity

NormalUtilization

Revenues ($68 × 2,400,000)Cost of goods sold:Beginning inventoryVariable manufacturing costs,

$46.30 × 2,600,000Fixed manufacturing overhead costs,

$7.99, $12, $15 × 2,600,000Cost of goods available for saleEnding inventory,

$54.29, $58.30, $61.30 × 200,000Total cost of goods sold (at budgeted costs)Adjustment for variances

$163,200,000

0

120,380,000

20,774,000 141,154,000

10,858,000 130,296,000

19,858,000 a

$163,200,000

0

120,380,000

31,200,000 151,580,000

11,660,000 139,920,000

9,432,000 a

$163,200,000

0

120,380,000

39,000,000 159,380,000

12,260,000 147,120,000

1,632,000 a

Cost of goods soldGross marginOther costsOperating income

150,154,000 13,046,000 0 $ 13,046,000

149,352,000 13,848,000 0 $ 13,848,000

148,752,000 14,448,000 0 $ 14,448,000

a See the answer to requirement 1 for computation. The variances are the difference between actual fixed manufacturing overhead costs and fixed manufacturing overhead costs allocated to products. Thus, the variances are the sum of the fixed overhead spending variance and the production-volume variance.

9-41

9-36(20 min.) Downward demand spiral.

1. Budgeted variable manufacturing costs per unit $200Allocated fixed manufacturing overhead costs per unit 100 a Budgeted total manufacturing costs per unit 300Markup (100% × $300) 300Budgeted selling price $600

a $1,000,000 ÷ 10,000 units = $100 per unit

2. Budgeted variable manufacturing costs per unit $200Allocated fixed manufacturing overhead costs per unit 125 b Budgeted total manufacturing costs per unit 325Markup (100% × $325) 325Revised budgeted selling price $650

b $1,000,000 ÷ 8,000 units = $125 per unit

3. Considering that the market is highly competitive, raising the selling price, in an attempt to recover fixed manufacturing overhead costs, will make Pismo Company less competitive. Pismo’s higher selling price would likely make it lose its customers to the competitors. This is the classic syndrome of the start of a downward demand spiral. Pismo Company should use its practical capacity to allocate fixed manufacturing overhead costs. If an upturn is expected, Pismo should keep its excess capacity. Otherwise, it should either lease or get rid of the excess capacity in order to bring down its fixed manufacturing overhead costs to the demand level.

9-42

9-37 (20-35 min.) Effects of denominator-level concept choice.

1. Normal capacity utilization. Givens denoted*

Actual CostsIncurred

(1)

Same BudgetedLump Sum

(as in Static Budget)Regardless ofOutput Level

(2)

Flexible Budget:Same Budgeted

Lump Sum(as in Static Budget)

Regardless ofOutput Level

(3)

Allocated:Budgeted Input

Allowed for Actual Output

× Budgeted Rate(4)

$130,000 $120,000* $120,000*70,000 hrs.* × $2.00a

= $140,000$10,000 U* $20,000 F*

Spending variance Never a variance Prodn. volume variance

=

– $20,000 = ($120,000 – X)X = $140,000

= = $2 per machine-hour

Denominator level = = 60,000 machine-hours

9-43

9-37 (Cont’d.)

2. Practical capacity. Givens denoted*

Actual CostsIncurred

(1)

Same Lump Sum(as in Static Budget)

Regardless ofBudgeted Output

Level(2)

Flexible Budget:Same Lump Sum

(as in Static Budget)Regardless of

Budgeted Output Level

(3)

Allocated:Budgeted Input

Allowed for Actual Output

× Budgeted Rate(4)

$130,000 $120,000* $120,000*70,000* × $1.20a

= $84,000$10,000 U* $36,000 U*

Spending variance Never a variance Prodn. volume variance

=

$36,000 = ($120,000 – X) X = $84,000

= = $1.20 per machine-hour

Denominator level = = 100,000 machine-hours

3. To maximize operating income, the executive vice president would favor using normal capacity utilization rather than practical capacity. Why? Because normal capacity utilization is a smaller base than practical capacity, resulting in any year-end inventory having a higher unit cost. Thus, less fixed manufacturing overhead would become a 2003 expense as part of the production-volume variance if normal capacity utilization were used as the denominator level.

9-44

9-38 (30 min.) Denominator volume, production volume variance.

1. Budgeted Budgeted Budgeted FixedFixed Denominator Manufacturing

Denominator-Level Manufacturing Level (in Overhead RateCapacity Concept Overhead Machine Hours) Per Machine-Hour

(1) (2) (3) (4) = (2) ÷ (3)Theoretical capacity $10,500,000 2,100,000 $5.0Practical capacity 10,500,000 1,500,000 7.0Normal capacity utilization 10,500,000 1,312,500 8.0Master-budget capacity utilization 10,500,000 1,000,000 10.5

2.Production volume variance = – ×

Theoretical capacity: Production volume variance = (2,100,000 – 1,100,000) $5.0 = $5,000,000 U

Practical capacity: Production volume variance = (1,500,000 – 1,100,000) × $7.0 = $2,800,000 U

Normal capacity utilization: Production volume variance = (1,312,500 – 1,100,000) × $8 = $1,700,000 U

Master budget capacity utilization: Production volume variance = (1,000,000 – 1,100,000) × $10.5 = $1,050,000 F

9-45

9-39 (20 min.) Cost allocation, downward demand spiral.

1. =

$1.50 =

Budgeted denominator level == 2,920,000 meals

WHM is using budgeted usage as its denominator level for calculating the budgeted fixed costs per meal in 2004.

2. Alternative denominator levels include:a. Capacity available. The data in the problem note that the facility can serve 3,650,000

meals a year. With this denominator level, there will be budgeted unused capacity, which could be recorded as a separate line in the cost report for the Santa Monica facility.

b. Budgeted usage of capacity. With the 2004 budgeted usage of 2,920,000 meals, the fixed costs charge is $1.50 per meal. The marketplace is signaling that WHM's own central food-catering facility is not providing value for the costs charged. If Jenkins decides to raise prices to recover fixed costs from a declining demand base, he will likely encounter the downward demand spiral:

BudgetedDenominator

(1)

Variable Costper Meal

(2)

Fixed Costper Meal

$4,380,000 ÷ (1)(3)

Total Costper Meal

(4)

3,650,0002,920,0002,550,0002,000,000

$3.803.803.803.80

$1.201.501.722.19

$5.005.305.525.99

Jenkins might adopt a contribution margin approach, which means viewing the $3.80 variable cost as the only per-unit cost and the $4,380,000 as a fixed cost. Alternatively, Jenkins could use practical capacity to cost the meals and work to reduce costs of unused capacity.

9-46

9-39 (Cont’d.)

3. Three factors managers should consider in pricing decisions:a. Customers. Jenkins is facing customers who are dissatisfied with both the cost and the

quality of the meal service. Three of the 10 hospitals have already elected to use an outside canteen service.

b. Competitors. For the three hospitals terminating use of the Santa Monica facility, at least one competitor is more cost-effective. The seven remaining hospitals likely will be very interested in how this competitor performs at the three hospitals.

c. Costs. Jenkins should consider ways to reduce both the variable costs per meal and the fixed costs.

9-40 (20 min.) Cost allocation, budgeted rates, ethics (continuation of Problem 9-39).

1. Hospitals are charged a budgeted variable cost rate and an allocation of budgeted fixed costs. By overestimating budgeted meal counts, the denominator of the budgeted fixed cost rate is larger, and hence the amount charged to individual hospitals is lower. Consider 2004 where the budgeted fixed cost rate of $1.50 is computed as follows:

= $1.50 per meal

Suppose in 2004, hospital administrators "inflated" their budgeted meal count by 20%: The budgeted fixed cost rate for 2004 rate would have been

= $1.25 per meal

Hence, by deliberately overstating budgeted meal count demand, they could reduce the costs charged per meal in 2004. The use of budgeted meals as the denominator means the central food-catering facility bears the risk of demand overestimates.

2. Evidence that could be collected include:

(a) Budgeted meal-count estimates and actual meal-count figures each year for each hospital controller. Over an extended time period, there should be a sizable number of both underestimates and overestimates. Controllers could be ranked on both their percentage of overestimation and the frequency of their overestimation.

(b) Look at the underlying demand estimates by patients at individual hospitals. Each hospital controller has other factors (such as hiring of nurses) that give insight into their expectations of future meal-count demands. If these factors are inconsistent with the meal-count demand figures provided to the central food-catering facility, explanations should be sought.

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9-40 (Cont’d.)

3. (a) Highlight the importance of a corporate culture of honesty and openness. WHM could institute a Code of Ethics that highlights the upside of individual hospitals providing honest estimates of demand (and the penalties for those who do not).

(b) Have individual hospitals contract in advance for their budgeted meal count. Unused amounts would be charged to each hospital at the end of the accounting period. This approach puts a penalty on hospital administrators who overestimate demand.

(c) Use an incentive scheme that has an explicit component for meal-count forecasting accuracy. Each meal-count “forecasting error” would reduce the bonus by $0.05. Thus, if a hospital bids for 292,000 meals and actually uses 200,000 meals, its bonus would be reduced by$0.05 × (292,000 – 200, 000) = $4,600.

9-41 (60 min.) Absorption, variable, and throughput costing.

1.

(a) =

=

= $125 per standard assembly hour or $2,500per vehicle

(b) Direct materials per unit $ 6,000Direct manufacturing labor per unit 1,800Variable manufacturing overhead per unit 2,000Fixed manufacturing overhead per unit 2,500Total manufacturing cost per unit $12,300

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9-41 (Cont’d.)

2. Amounts in thousands. Absorption CostingJanuary February March

Revenues ($16,000 × 2,000; 2,900; 3200)Cost of goods sold

Beginning inventoryVariable manufacturing costs ($9.8 × 3,200; 2,400; 3800)Fixed manufacturing costs ($2.5 × 3,200; 2,400; 3,800)Cost of goods available for saleDeduct ending inventory ($12.3 × 1,200; 700; 1,300) Cost of goods sold (at standard cost)Adjustment for manuf. variancesa

Total cost of goods soldGross marginMarketing costsOperating income

Inventory Details (Units)Beginning inventoryProductionGoods available for saleSalesEnding inventory

Inventory Details ($12,300 per unit)Beginning inventory ($12,300 per unit)Ending inventory ($1,000s)

$32,000

031,360

8,000 39,360

14,760 24,600

500 F 24,100

7,900 0 $ 7,900

0 3,200 3,200

2,000 1,200

$ 0$14,760

$46,400

14,76023,520

6,000 44,280

8,610 35,670

1,500 U 37,170

9,230 0 $ 9,230

1,200 2,400

3,600 2,900 700

$14,760$ 8,610

$51,200

8,61037,240

9,500 55,350

15,990 39,360

2,000 F 37,360 13,840

0 $13,840

700 3,800 4,500

3,200 1,300

$ 8,610$15,990

Computation of Bonus January February MarchOperating income× 0.5%

$7,900,000$ 39,500

$9,230,000$46,150

$13,840,000$ 69,200

aProduction–volume variances = (Denomination level – Production) × Budgeted rate January: (3,000 – 3,200) × $2,500 per vehicle = $500,000 F February: (3,000 – 2,400) × $2,500 per vehicle = $1,500,000 U March: (3,000 – 3,800) × $2,500 per vehicle = $2,000,000 F

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9-41 (Cont’d.)

3. Amounts in thousands Variable Costing January February March

RevenuesVariable Costs

Beginning inventoryVariable manuf. costs ($9.80 × 3,200; 2,400, 3,800)Cost of goods available for saleDeduct ending inventory ($9.80 ×1,200; 700, 1,300)Variable COGSVariable marketing costsVariable costs (at standard cost)Adjustment for variances Total variable costs

Contribution marginFixed costs

Fixed manuf. overhead costsFixed marketing costsFixed costs (at standard cost)Adjustment for variances Total fixed costs

Operating income

Inventory details ($9,800 per unit)Beginning inventory (units)Ending inventory (units)Beginning inventory ($000s)Ending inventory ($000s)

$32,000

0 31,360 31,360

11,760 19,600

0 19,600 0 19,600 12,400

7,500 0

7,500 0 7,500 $ 4,900

01,200

$0$11,760

$46,400

11,760 23,520 35,280

6,860 28,420

0 28,420 0 28,420 17,980

7,500 0

7,500 0 7,500 $10,480

1,200700

$11,760$ 6,860

$51,200

6,860 37,240 44,100

12,740 31,360

0 31,360 0 31,360 19,840

7,500 0

7,500 0 7,500 $12,340

7001,300

$ 6,860$12,740

Computation of Bonus January February MarchOperating income× 0.5%

$4,900,000$ 24,500

$10,480,000$ 52,400

$12,340,000$ 61,700

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9-41 (Cont’d.)

4.January February March Total

Absorption-Costing BonusVariable-Costing BonusDifference

$39,500 24,500 $15,000

$46,150 52,400 $ (6,250 )

$69,200 61,700 $ 7,500

$154,850 138,600 $16,250

The difference between absorption and variable costing arises because of differences in production and sales:

January February March TotalProductionSalesIncrease (decrease) in inventory

3,2002,000 1,200

2,4002,900 (500 )

3,8003,200 600

9,4008,100 1,300

With absorption costing, by building for inventory, Hart can capitalize $2,500 of fixed manufacturing overhead costs per unit. This will provide a bonus payment of $12.50 (0.5% × $2,500) per unit. Operating income under absorption costing will exceed that under variable costing when production is greater than sales. Over the three-month period, the inventory buildup is 1,300 units giving a difference of $16,250 ($12.50 × 1,300) in bonus payments.

5. Amounts in thousands Throughput Costing

January February MarchRevenuesDirect material cost of goods sold

Beginning inventory ($6 × 0;1,200; 700)Direct materials ($6 × 3,200; 2,400; 3,800)Cost of goods available for saleDeduct ending inventory ($6 × 1,200; 700;1,300) Total direct material cost of good soldThroughput contribution

Other costs

Manufacturinga

$32,000

0 19,200 19,200

7,200 12,000 20,000

19,660

$46,400

7,200 14,400 21,600

4,200 17,400 29,000

16,620

$51,200

4,200 22,800 27,000

7,800 19,200 32,000

21,940

Marketing Total other costs

Operating income

0 19,660 $ 340

0 16,620 $12,380

0 21,940 $10,060

a ($3,800 3,200) + $7,500,000($3,800 2,400) + $7,500,000($3,800 3,800) + $7,500,000

Computation of Bonus January February MarchOperating income× 0.5%

$340,000$ 1,700

$12,380,000$ 61,900

$10,060,000$ 50,300

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9-41 (Cont’d.)

A summary of the bonuses paid is:

January February March TotalAbsorption CostingVariable CostingThroughput Costing

$39,50024,5001,700

$46,15052,40061,900

$69,20061,70050,300

$154,850138,600113,900

6. Alternative approaches include:(a) Careful budgeting and inventory planning,(b) Use an alternative income computation approach to absorption costing (such as variable

costing or throughput costing),(c) Use a financial charge for inventory buildup, (d) Change the compensation package to have a longer-term focus using either an external

variable (e.g., stock options) or an internal variable (e.g., five-year average income), and(e) Adopt non-financial performance targets––e.g., attaining but not exceeding present

inventory levels.

Chapter 9 Internet Exercise

The Internet exercise is available to students only on the Prentice Hall Companion Website www.prenhall.com/horngren. Students can click on Cost Accounting, 11th ed., and access the Internet Exercise for the chapter, which links to the Web site of a company or organization. The Internet Exercise on the Web will be updated periodically so that it is current with the latest information available on the subject organization's Web site. A printout copy of the Internet exercise for this chapter as of early 2002 appears below.

The solution to the Internet exercise, which will also be updated periodically, is available to instructors from the Companion Website's faculty view. To access the solution, click on Cost Accounting, 11th ed., Faculty link, and then register once to obtain your password through the online form. After the initial registration, you will have a personal login ID and password to use to log in. A printout of the solution to the Internet exercise for this chapter as of early 2002 follows. The exercise and solution provide instructors with an idea of the content of the Internet exercise for this chapter.

Internet ExerciseThe Boeing Corporation and Dell Computer Corporation both face the task of allocating fixed manufacturing costs between inventory and cost of goods sold. Go to each company's home page to learn more about its business and to access its 2000 annual reports. For Boeing, go to www.boeing.com, and click on the "investor relations" link. For Dell, go to www.dell.com and click on the "about Dell" link, followed by the "investor relations" link.

1a. Calculate gross margin, inventory turnover, and inventory as a percentage of total assets for Boeing and Dell in 1999 and 2000. Use cost of goods sold and ending inventory to calculate inventory turnover.

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Internet Exercise (Cont’d.)

1b. Did the gross margins and inventory turnover ratios at each company improve in 2000?

2. What business factors account for Dell's significantly higher inventory turnover ratio?

3. For which company is the choice of absorption costing versus variable costing likely to be a more important issue, and why?

4a. Read footnotes 1 and 9 to Boeing's financial statements, the "Summary of Significant Accounting Policies" and "Inventories." Describe the types of costs that Boeing includes in inventories. Are any costs in excess of estimated average production costs included in inventory?

4b. Do these notes suggest that Boeing uses variable costing or absorption costing to value inventory? Why?

5. Would the use of variable costing increase or decrease Boeing's inventory turnover ratio?

Solution to Internet Exercise

1a. The gross margins, inventory turnover, and inventory as a percentage of total assets are as follows.

Dell Boeing2000 1999 2000 1999

Gross margin 20.7% 22.5% 14.8% 11.5%

Inventory turnover* 51.3 51.8 6.4 7.8

Inventory/Assets 3.4% 4.0% 16.2% 18.1%

* Cost of goods sold / ending inventory

1b. Dell's gross margin decreased between 1999 and 2000, while its inventory turnover remained relatively constant. Boeing's gross margin improved between 1999 and 2000, while its inventory turnover deteriorated.

2. Dell’s build-to-order manufacturing process allows it to quickly produce customized computer systems and to achieve rapid inventory turnover. Boeing on the other hand produces commercial and military aircraft, and satellites. These require much longer production times.

3. The choice of costing method will be a more important issue for Boeing. Inventory accounts for more than 16% of Boeing's total assets compared to less than 4% for Dell. In addition, cost of goods sold accounts for a larger portion of Boeings total costs. Any overstatement of inventory or cost of goods sold will have a proportionally larger financial statement impact.

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Internet Exercise (Cont’d.)

4a. Boeing includes direct engineering, production and tooling costs, and applicable overhead in its inventoried costs for commercial aircraft and long-term contracts. As of December 31, 2000, there were no significant costs in excess of estimated average production costs included inventory.

4b. Average costs include fixed and variable production costs; thus the notes suggest that Boeing uses absorption costing to value its ending inventory.

5. Under a variable costing approach, fixed manufacturing costs would be treated as a period cost. Thus ending inventory would be lower. Cost of goods sold would be higher resulting in higher (improved) inventory turnover ratio.

Chapter 9 Video Case

The video case can be discussed using only the case writeup in the chapter. Alternatively, instructors can have students view the videotape of the company that is the subject of the case. The videotape can be obtained by contacting your Prentice Hall representative. The case questions challenge students to apply the concepts learned in the chapter to a specific business situation.

WHEELED COACH INVENTORY COSTING AND CAPACITY ANALYSIS

1. Budgeted Budgeted FixedBudgeted Fixed Denominator Manufacturing

Denominator-Level Manufacturing Level Overhead CostCapacity-Concept Overhead/Year (In Vehicles) Rate Per Vehicle Theoretical Capacity $2,000,000 3 shifts × $1,831.50

7 vehicles × 52 weeks = 1,092 vehicles

Practical Capacity $2,000,000 3 shifts × $2,666.675 vehicles × 50 weeks =750 vehicles

Normal Capacity $2,000,000 1 shift × $8,000.00 Utilization 5 vehicles ×

50 weeks =250 vehicles

Master-Budget Capacity $2,000,000 1 shift × $10,000.00 Utilization 4 vehicles ×

50 weeks =200 vehicles

Video Case (Cont’d.)

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2. Variable Budgeted Fixed TotalDenominator-Level Manufacturing MOH Manufacturing

Capacity-Concept Cost/Vehicle Cost /Vehicle Cost/ Vehicle Theoretical capacity $40,000 $1,831.50 $41,831.50Practical capacity $40,000 $2,666.67 $42,666.67Normal capacity utilization $40,000 $8,000.00 $48,000.00Master-budget capacity utilization $40,000 $10,000.00 $50,000.00

3. If Wheeled Coach does not match the price and loses the business to MedTechnix, its budgeted fixed manufacturing overhead costs would now be spread over a budgeted volume of 190 (not 200) vehicles, at a rate of $10,526 ($2,000,000/190 vehicles) instead of $10,000. MedTechnix could continue to undercut Wheeled Coach’s prices and steal more customers, further reducing the number of units over which Wheeled Coach can allocate its budgeted fixed manufacturing overhead costs. This will contribute to a downward demand spiral that may present larger problems in the future. Wheeled Coach is probably best off matching the $47,000 price that exceeds variable manufacturing costs per vehicle and, in time, working to reduce fixed manufacturing costs.

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