Chapter 8 Absorption and Variable Costing and Inventory

Chapter 8: Absorption and Variable Costing, and Inventory Management Cornerstones of Managerial Accounting, 4 e © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Learning Objectives 1. Explain the difference between absorption and variable costing. 2. Prepare segmented income statements. 3. Discuss inventory management under the economic order quantity and just-in-time (JIT) models. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Measuring the Performance of 1 Profit Centers by Using Variable and Absorption Income Statements ► Many companies consist of separate business units called profit centers. ► It is important for these companies to determine both the overall performance of the business and the performance of the individual profit centers. ► Therefore, it is important to develop a segmented income statement for each profit center. ► Two methods of computing income have been developed: ►one based on variable costing and ►the other based on full or absorption costing. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Absorption Costing ► Absorption costing assigns all manufacturing costs to the product. ► Direct materials, direct labor, variable overhead, and fixed overhead define the cost of a product. ► Under this method, fixed overhead is assigned to the product through the use of a predetermined fixed overhead rate and is not expensed until the product is sold. ► In other words, fixed overhead is an inventoriable cost. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Variable Costing ►Variable costing stresses the difference between fixed and variable manufacturing costs. ►Variable costing assigns only variable manufacturing costs to the product; these costs include direct materials, direct labor, and variable overhead. ►Fixed overhead is treated as a period expense and is excluded from the product cost. ►Under variable costing, fixed overhead of a period is seen as expiring that period and is charged in total against the revenues of the period. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Comparison of Variable and Absorption Costing Methods Generally accepted accounting principles (GAAP) require absorption costing for external reporting. The Financial Accounting Standards Board (FASB), the Internal Revenue Service (IRS), and other regulatory bodies do not accept variable costing as a product-costing method for external reporting. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Inventory Valuation ►Inventory is valued at product or manufacturing cost. ►Under absorption costing, that product cost includes direct materials, direct labor, variable overhead, and fixed overhead. ►Under variable costing, the product cost includes only direct materials, direct labor, and variable overhead. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Cornerstone 8 -1 Computing Inventory Cost Under Absorption Costing © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Cornerstone 8 -1 Computing Inventory Cost Under Absorption Costing (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Cornerstone 8 -2 Computing Inventory Cost Under Variable Costing © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Cornerstone 8 -2 Computing Inventory Cost Under Variable Costing (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Comparison of Variable and Absorption Costing Methods The only difference between the two approaches is the treatment of fixed factory overhead. As a result, the unit product cost under absorption costing is always greater than the unit product cost under variable costing. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Income Statements Using Variable and Absorption Costing ►Because unit product costs are the basis for cost of goods sold, the variable and absorption -costing methods can lead to different operating income figures. ►The difference arises because of the amount of fixed overhead recognized as an expense under the two methods. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Cornerstone 8 -3 Preparing An Absorption Costing Income Statement © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Cornerstone 8 -3 Preparing An Absorption Costing Income Statement (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Cornerstone 8 -4 Preparing a Variable-Costing Income Statement © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Cornerstone 8 -4 Preparing a Variable-Costing Income Statement (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Production, Sales, and Income Relationships The relationship between variable-costing income and absorption-costing income changes as the relationship between production and sales changes. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Evaluating Profit-Center Managers ► The evaluation of managers is often tied to the profitability of 1 the units that they control. ► In general terms, if income performance is expected to reflect managerial performance, then managers have the right to expect the following: ► As sales revenue increases from one period to the next, all other things being equal, income should increase. ► As sales revenue decreases from one period to the next, all other things being equal, income should decrease. ► As sales revenue remains unchanged from one period to the next, all other things being equal, income should remain unchanged. ► Variable costing ensures that the above relationships hold; however, absorption costing may not. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Segmented Income Statements Using Variable Costing ► Variable costing is useful in preparing segmented income statements because it gives useful information on variable and fixed expenses. ► A segment is a subunit of a company of sufficient importance to warrant the production of performance reports. ► Segments can be divisions, departments, product lines, customer classes, and so on. ► In segmented income statements, fixed expenses are broken down into two categories: ► direct fixed expenses and ► common fixed expenses. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Direct Fixed Expenses ►Direct fixed expenses are fixed expenses that are directly traceable to a segment. ►These are sometimes referred to as avoidable fixed expenses or traceable fixed expenses because they vanish if the segment is eliminated. ►For example, if the segments were sales regions, a direct fixed expense for each region would be the rent for the sales office. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Common Fixed Expenses ►Common fixed expenses are jointly caused by two or more segments. ►These expenses persist even if one of the segments to which they are common is eliminated. ►For example, depreciation on the corporate headquarters building or the salary of the CEO would be a common fixed expense for most large companies. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 8 -5 Preparing a Segmented Income Statement © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Cornerstone 8 -5 Preparing a Segmented Income Statement (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 You Decide Using Segmented Income Statements to Make Decisions You are the Financial Vice President for Folsom Company, which sells three products, Alpha, Beta, and Gamma. You have just received the income statement shown in Panel A of the next slide. Clearly, Gamma is unprofitable. In fact, the company is losing $13, 740 a year on Gamma. Should you drop Gamma? Will income go up if you do? Take a closer look at the income statement. Notice that both the direct fixed costs and the allocated common fixed costs are subtracted from each segment’s contribution margin. This is misleading; it seems that dropping any segment would result in losing the operating income associated with the segment. However, if one segment is dropped, the allocated common fixed costs will remain. A more useful income statement is presented in Panel B of the next slide. Here, the segment margin for all three products is positive, as is overall income. While Gamma is not as profitable as Alpha and Beta, it is profitable. Dropping Gamma will result in a decrease in operating income of $12, 000, the amount of the segment margin. Separating the direct fixed costs from the common fixed costs, and focusing on the segment margin, will give a truer picture of a segment’s profitability. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Comparison of Segmented Income Statement With and Without Allocated Common Fixed Expense © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Decision Making for Inventory Management ►Inventory can definitely affect operating income. ►In addition to the product cost of inventory, there are other types of costs that relate to inventories of raw materials, work in process, and finished goods. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Inventory-Related Costs ► If the inventory is a material or good purchased from an outside source, then these inventory-related costs are known as ordering costs and carrying costs. ► If the material or good is produced internally, then the costs are called setup costs and carrying costs. ► Ordering costs are the costs of placing and receiving an order. ► Carrying costs are the costs of keeping and storing inventory. ► Stockout costs are the costs of not having a product available when demanded by a customer or the cost of not having a raw material available when needed for production. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Traditional Reasons for Carrying Inventory © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Order Quantity: The Traditional Model 3 ► Once a company decides to carry inventory, two basic questions must be addressed: 1. 2. How much should be ordered? When should the order be placed? ► In choosing an order quantity, managers need to be concerned only with ordering and carrying costs. ► The formulas for calculating these are as follows: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 8 -6 Calculating Ordering Cost, Carrying Cost, and Total Inventory-Related Cost © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Average Inventory ►The average amount in inventory is the maximum plus the minimum divided by two. Average Inventory = (Maximum amount + Minimum amount) 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 The Economic Order Quantity ►Maintaining an order quantity equal to the average inventory may not be the best choice. Some other order quantity may produce a lower total cost. ►The objective is to find the order quantity that minimizes the total cost. ►The number of units in the optimal size order quantity is called the economic order quantity (EOQ). © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 The Economic Order Quantity (continued) ►Since EOQ is the quantity that minimizes total inventoryrelated costs, a formula for computing it is: © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cornerstone 8 -7 3 Calculating Economic Order Quantity (EOQ) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 8 -7 Calculating Economic Order Quantity (EOQ) (continued) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Reorder Point ► Knowing when to place an order (or setup for production) is also an essential part of any inventory policy. ► The reorder point is the point in time when a new order should be placed (or setup started). ► It is a function of the EOQ, the lead time, and the rate at which inventory is used. Lead time is the time required to receive the economic order quantity once an order is placed or a setup is started. ► Knowing the rate of usage and lead time allows us to compute the reorder point that accomplishes these objectives: Reorder point = Rate of usage x Lead time © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cornerstone 8 -8 3 Calculating The Reorder Point When Usage Is Known with Certainty © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Safety Stock ►Safety stock is extra inventory carried to serve as insurance against changes in demand. ►Safety stock is computed by multiplying the lead time by the difference between the maximum rate of usage and the average rate of usage: Safety stock = Maximum Average x Lead time daily usage © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Cornerstone 8 -9 Calculating Safety Stock and the Reorder Point with Safety Stock © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Economic Order Quantity and Inventory Management ► The EOQ model is very useful in identifying the optimal trade-off between inventory ordering costs and carrying costs. ►It also is useful in helping to deal with uncertainty by using safety stock. ► The historical importance of the EOQ model in many American industries can be better appreciated by understanding the nature of the traditional manufacturing environment. ►This environment has been characterized by the mass production of a few standardized products that typically have a very high setup cost. ► The high setup cost encouraged a large batch size. ►Thus, production runs for these firms tended to be quite long, and the excess production was placed in inventory. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Just-in-Time Approach to Inventory Management ►The just-in-time (JIT) approach maintains that goods should be pulled through the system by present demand rather than being pushed through on a fixed schedule based on anticipated demand. ►The material or subassembly arrives just in time for production to occur so that demand can be met. ►Many fast-food restaurants, like Mc. Donald’s, use this type of pull system to control their finished goods inventory. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Comparing Just-in-Time and Traditional 3 Inventory Approaches: Ordering Costs ►In a traditional system, inventory resolves the conflict between ordering or setup costs and carrying costs by selecting an inventory level that minimizes the sum of these costs. ►In a JIT environment, however, ordering costs are reduced by developing close relationships with suppliers. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Comparing JIT and Traditional Inventory 3 Approaches: Uncertainty in Demand ►According to the traditional view, inventories prevent shutdowns caused by machine failure, defective material or subassembly, and unavailability of a raw material or subassembly. ►JIT solves these three problems by emphasizing total preventive maintenance and total quality control and by building the right kind of relationship with suppliers. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Comparing JIT and Traditional Inventory 3 Approaches: Lower Cost of Inventory ►Traditionally, inventories are carried so that a firm can take advantage of quantity discounts and hedge against future price increases of the items purchased. ►The objective is to lower the cost of inventory. ►JIT achieves the same objective without carrying inventories, through long-term contracts with a few chosen suppliers located as close to the production facility as possible to establish more extensive supplier involvement. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Limitations of Just-in-Time Approach ► JIT does have limitations. ► It is often referred to as a program of simplification—yet this does not imply that JIT is simple or easy to implement. ► It requires time for building sound relationships with suppliers. ► Insisting on immediate changes in delivery times and quality may not be realistic and may cause difficult confrontations between a company and its suppliers. ► Reductions in inventory buffers may cause a regimented workflow and high levels of stress among production workers. ► It requires careful and thorough planning and preparation. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.