Introduction to Management Accounting

Winter 2013 Teri Shearer

Chapter 8

ABSORPTION AND VARIABLE COSTING INVENTORY MANAGEMENT

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 and fixed 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

Inventory costs under Absorption Costing and Variable Costing

Example:

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, continued
Calculate units in Ending Inventory: Finished Goods Inventory
Beg. Balance 0 Produced 10,000

8,000 Sold

2,000

Cost of Ending Inventory Absorption costing

Per unit

Direct materials Direct labour Variable overhead

$ 50 100 50 25 $225

Fixed overhead Unit product cost

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

Cost of Ending Inventory Variable costing

Direct materials Direct labour Variable overhead Unit product cost

Only variable costs

$ 50 100 50 $200

2,000 $200 = $400,000

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

Absorption costing Income Statement

First calculate Cost of Goods Sold:

Cost of goods = sold

Absorption unit product cost $225

Units sold

=
$50 + $100 + $50 + $25

8,000

$1,800,000

Absorption costing Income Statement, continued

Sales ($300 8,000)

$2,400,000 1,800,000
$ 600,000 100,000

Less: Cost of goods sold

Gross Margin Less: Selling and administrative expenses

Net Income
Fixed selling and administrative costs.

$ 500,000

Variable costing Income Statement

First calculate Cost of Goods Sold:

Cost of goods = sold

Variable unit product cost $200 $1,600,000

Units sold

=
$50 + $100 + $50

8,000

Variable costing Income Statement, continued

Sales ($300 8,000) Less variable expenses: Variable cost of goods sold Contribution margin Less fixed expenses: Fixed overhead Fixed selling and administrative $250,000 100,000

$2,400,000 1,600,000 $ 800,000

350,000

Net Income

$ 450,000

Reconciling Absorption and Variable costing If Production > Sales then Absorption income > Variable income If Production < Sales then Absorption income < Variable income If Production = Sales then Absorption income = Variable income The difference between the two income numbers is the amount of fixed overhead deferred in ending inventory under absorption costing Prod > Sales so Abs NI > Var NI by the $50,000 of fixed overhead that was deferred in inventory under Absorption costing

Segmented Income Statements Segment is a subunit of a company

divisions departments product lines customer classes

Fixed expenses are broken down into two categories:

direct fixed expenses
directly traceable to a segment

common fixed expenses

jointly caused by two or more segments

Segment margin Sales Variable Cost of Goods Sold Variable Selling Expense Contribution Margin Direct fixed overhead Direct selling and administrative Segment Margin

Example: Segmented Income Statement

Information: Sales Variable cost of goods sold Direct fixed overhead MP3 Players $400,000 200,000 30,000 DVD Players $290,000 150,000 20,000

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

Example, continued

MP3 Players

DVD Players

Total

Sales Variable cost of goods sold Variable selling expense

$400,000 (200,000) (20,000)

$290,000 (150,000) (14,500)

$690,000 (350,000)

5% $290,000
Sales commissions = 5% of Sales 5% $400,000

Example, continued
MP3 Players DVD Players Total

Sales Variable cost of goods sold Variable selling expense

Contribution Margin Less direct fixed expenses: Direct fixed overhead Direct selling & admin. Segment margin

$400,000 (200,000) (20,000)

$180,000 (30,000) (10,000) $140,000

$290,000 (150,000) (14,500)

$125,500 (20,000) (15,000) $ 90,500

$690,000 (350,000) (34,500)

$305,500 (50,000) (25,000) $230,500

Segment margin reflects only those costs directly related to the operation of the segment. Common costs are not included in the segment margin

Example, continued
MP3 Players DVD Players Total

Sales Variable cost of goods sold Variable selling expense Contribution Margin Less direct fixed expenses: Direct fixed overhead Direct selling & admin. Segment margin Less common fixed expenses: Common fixed overhead Common selling & admin. Operating Income

$400,000 (200,000) (20,000) $180,000 (30,000) (10,000) $140,000

$290,000 (150,000) (14,500) $125,500 (20,000) (15,000) $ 90,500

$690,000 (350,000) (34,500) $305,500 (50,000) (25,000) $230,500

(100,000) (20,000) $110,500

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, handling costs, and storage space

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

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

Example: Calculating inventory related costs

Information:

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

Example, continued
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 an order 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

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

EOQ for Mall-o-Cars Example

Economic Order Quantity:
=

(2 $25 10,000) /$2

500,000/2 = 500 units

At the EOQ, total carrying costs and total order costs are equal (in this case, $500 each, for total inventory costs of $1,000)

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 200 units

Safety stock and re-order point with safety stock

Example:

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

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.