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Introduction to Management Accounting

Winter 2013

Teri Shearer

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ABSORPTION AND VARIABLE COSTINGINVENTORY MANAGEMENT

Chapter 8

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Absorption versus Variable costing

Recall that under Absorption costing, all manufacturing costs

must be treated as product costs and inventoried until the

related product is sold. This includes direct materials, direct

labour, variable overhead andfixed overhead

Absorption costing is required for financial reporting and for

tax reporting

Variable costing treats fixed manufacturing costs as period costs

to be deducted from income (expensed) in the period incurred

Under Variable costing, only direct materials, direct labour, and

variable overhead flow through the inventory accounts. Fixed

overhead is treated as an expense

Variable costing is useful for many internal purposes

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Inventory costs under Absorption Costing and Variable Costing

Information:Units in beginning inventory

Units produced

Units sold ($300 per unit)

Variable costs per unit:

Direct materials

Direct labour

Variable overhead

Fixed costs:Fixed overhead per unit produced

Fixed selling and administrative

0

10,000

8,000

$50

$100

$50

$25

$100,000

Example:

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Example, continued

Calculate units in Ending Inventory:

0

10,000

8,000

2,000

Finished Goods Inventory

Beg. Balance

Produced

Sold

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Cost of Ending InventoryAbsorption costing

Direct materials $ 50

Direct labour

Variable overheadFixed overhead

Unit product cost

100

50

$225

25

Value of ending inventory = 2,000 $225 = $450,000

Per unit

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Cost of Ending InventoryVariable costing

Direct materials

Direct labour

Variable overhead

Unit product cost

$ 50

100

50

$200

2,000 $200 = $400,000

When there are units in ending inventory, variable costing resultsin a lower ending inventory value than absorption costing

Only variable

costs

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Absorption costing Income Statement

Cost of goods

sold

Absorption

unit product

costUnits sold=

$225= 8,000

= $1,800,000

$50 + $100 + $50 + $25

First calculate Cost of Goods Sold:

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Absorption costing Income Statement, continued

Sales ($300 8,000)

Less: Cost of goods sold

Gross Margin

Less: Selling and administrative expenses

$2,400,000

1,800,000

$ 600,000

100,000

Net Income $ 500,000

Fixed selling and

administrative costs.

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Variable costing Income Statement

Cost of goods

sold

Variable unit

product costUnits sold=

$200= 8,000

= $1,600,000

$50 + $100 + $50

First calculate Cost of Goods Sold:

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Variable costing Income Statement, continued

Sales ($300 8,000)

Less variable expenses:

Variable cost of goods sold

$2,400,000

1,600,000

Contribution margin $ 800,000

Less fixed expenses:

Fixed overhead $250,000

350,000Fixed selling and administrative 100,000

$ 450,000Net Income

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Reconciling Absorption and Variable costing

If Production > Sales then Absorption income >

Variable income If Production < Sales then Absorption income Sales so Abs NI > Var NI by the $50,000 offixed overhead that was deferred in inventory underAbsorption costing

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Segmented Income Statements

Segment is a subunit of a company

divisions

departments

product lines

customer classes

Fixed expenses are broken down into twocategories:

direct fixed expenses directly traceable to a segment

common fixed expenses jointly caused by two or more segments

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Segment margin

Sales

Variable Cost of Goods Sold

Variable Selling Expense

Contribution Margin

Direct fixed overhead

Direct selling and administrative

Segment Margin

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Example: Segmented Income Statement

Information:

Sales

Variable cost of goods sold

Direct fixed overhead

150,000

20,000

MP3 Players DVD Players

$400,000 $290,000

200,000

30,000

Sales commissions, 5% of sales Direct fixed selling and administrative expense estimated:

$10,000 for the MP3 line

$15,000 for the DVD line

Common fixed overhead est., $100,000

Common selling and administrative est., $20,000

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Example, continued

Sales

Variable cost of goods soldVariable selling expense

(150,000)

MP3 Players DVD Players$400,000 $290,000

(200,000)(20,000)

Total$690,000

(350,000)

5% $290,000

(14,500)

Sales commissions = 5% of Sales

5% $400,000

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Example, continued

SalesVariable cost of goods sold

Variable selling expense

(150,000)

MP3 Players DVD Players

$400,000 $290,000(200,000)

(20,000)

Total

$690,000(350,000)

(14,500)

Contribution Margin

Less direct fixed expenses:Direct fixed overhead

Direct selling & admin.

(34,500)

$180,000 $125,500 $305,500

(30,000) (20,000) (50,000)

(10,000) (15,000) (25,000)

$140,000 $ 90,500 $230,500Segment margin

Segment margin reflects only those costs directly related to the

operation of the segment. Common costs are not included in the

segment margin

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Example, continued

Sales

Variable cost of goods soldVariable selling expense

(150,000)

MP3 Players DVD Players

$400,000 $290,000

(200,000)(20,000)

Total

$690,000

(350,000)

(14,500)

Contribution Margin

Less direct fixed expenses:

Direct fixed overhead

Direct selling & admin.

(34,500)

$180,000 $125,500 $305,500

(30,000) (20,000) (50,000)

(10,000) (15,000) (25,000)

$140,000 $ 90,500 $230,500Segment margin

Common fixed overheadCommon selling & admin.

Operating Income

(100,000)(20,000)

Less common fixed expenses:

$110,500

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Inventory Ordering and Carrying costs

Ordering costs: Costs of placing and receiving an order

Examples:

order processing costs

cost of insurance for shipment

unloading costs

Carrying costs: Costs of carrying inventory

Examples:

insurance

inventory taxes

obsolescence

opportunity cost of funds ties up in inventory, handlingcosts, and storage space

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Stockout costs

Occur when demand is not known

Costs of not having:

product available when demanded by a customer

raw materials available when needed for production

Examples: lost sales

costs of expediting orders

costs of interrupted production

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Traditional reasons for carrying inventory

To balance ordering or setup costs and carrying costs

To satisfy customer demand

To avoid shutting down manufacturing facilities because of:

Machine failure

Defective parts

Unavailable parts Late delivery of parts

To buffer against unreliable production processes

To take advantage of discounts

To hedge against future price increases

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Example: Calculating inventory related costs

Mall-o-Cars Inc. uses part X7B to repair water

pumps

10,000 units of part X7B are used each year currently purchased in lots of 1,000 units

cost of $25 to place an order

carrying cost is $2 per part per year

Information:

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Calculate number of orders per year:

10,000 parts needed per year / 1,000 parts in an order = 10

orders per year Calculate total ordering cost:

10 orders per year x $25 per order = $250

Calculate total carrying cost:

Find average number of units in inventory: 1,000 when anorder comes in + 0 when order is depleted / 2: 1000 + 0 / 2 =500 units

500 average units in inventory x $2 carrying cost per unit =$1,000

Calculate total inventory-related cost: $250 ordering cost +$1,000 carrying cost = $1,250

Example, continued

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Economic Order Quantity

Number of units in the optimal size order

Minimizes total inventory-related costs

Formula:

2 CO D/CC

Cost of placing one

order

Annual demand

in units

Cost of carrying one

unit in inventory

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EOQ for Mall-o-Cars Example

(2 $25 10,000) /$2=

= 500,000/2

= 500 units

Economic Order Quantity:

At the EOQ, total carrying costs and total order costs are equal

(in this case, $500 each, for total inventory costs of $1,000)

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Re-order point

Point in time when a new order should be placed

Function of: EOQ

Lead time

Rate at which inventory is used

Example: Mall-o-Cars Inc. 10,000 units of Part X7B are used each year

Used at a rate of 40 parts per day

Takes 5 days from time of order to arrival of order

Re-order point = 40 parts per day x 5 days lead time = 200;Mall-o-Cars should re-order when its inventory reaches 200units

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Safety stock and re-order point with safety stock

Mall-o-Cars Inc. uses Part X7B to repair water pumps 10,000 units of Part X7B are used each year

Used at an average rate of 40 parts per day

But some days as many as 50 parts are used

Takes 5 days from the time of order to the arrival of the order Safety stock = (max daily usage avg daily usage) x lead time

(50 max 40 avg) x 5 days = 50

Re-order point with safety stock:

Re-order point without safety stock plus safety stock = 200 + 50= 250, OR

Max daily usage x lead time = 50 x 5 days = 250

Example:

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Just-in-time production systems

Product pulled through production process by

present demand rather than on a fixed schedule based

on anticipated demand

Each operation produces only what is necessary to

satisfy the demand of the succeeding operation Reduces all inventories to very low levels

Reduces inventory carrying costs

Makes production very sensitive to supplier delays,production stoppages, etc.