CHAPTER 9. EFFECTS OF DENOMINATOR LEVEL ON ...
CHAPTER 9. EFFECTS OF DENOMINATOR LEVEL ON INVENTORY VALUATION
Capacity choice -> denominator level -> price and cost Denominator levels: a complex decision w/ complex effects -
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Supply level constraints: a. Theoretical capacity: no delays b. Practical capacity: w/ idle time Demand level constraints: a. Normal capacity: over specified time satisfying average customer b. Master capacity: satisfy customer demand for budget cycle for tax purposes
These affect balance sheet and income statement Note: DOL increases for mechanization and DOL decreases for labour intensive Manager’s decisions: a. acquire all capacity 1. 2. 3. 4. 5. 6.
b. make acquisition
Choose the budge period Compute the fixed overhead cost allocation rate(s) Select benchmark, standard or budgeted cost allocation base quantities Select homogenous inputs for other fixed cost allocation bases Analyze and select homogenous cost pools Analyze and select capacity alternative to use in production-volume cost allocation base: a. Capacity supply ( theoretical > practical) i. Capacity management ii. Inventory value iii. Product cost (COGM) iv. Product price ( full absorption) b. Capacity demand ( normal > = master budget) i. Performance evaluation ii. Internal variance ( fixed overhead) iii. External governance iv. Financial reporting
The decision framework and denominator choice If actual production is less than theoretical capacity because there is no demand or production is interrupted, the production-volume variance will be high and indicated opportunity cost of idle productive capacity. This is a non-value added cost for which a customer will not pay. Practical capacity reduces theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holidays, safety inspections and so on. This type of scheduled idle capacity is often called off-limits idle capacity. Practical capacity is not constant over the life of the equipment. Process redesign can improve labour efficiency, wait time for materials and scheduling which would increase practical capacity
Note: often, the difference between theoretical and practical capacity is off-limits idle capacity. Downtime : setups – non productive idle capacity: this is not off limits because it can be minimized with excellent scheduling or used to accomplish other value-added activities. Note: excess non- productive capacity can be used in other revenue- generating ways until demand growth accelerates (designing new products to fill unused capacity or leasing out unused capacity to others). Increased demand by customers may not only be for the product but for the services customized to their needs. Difference between the two demand level: time period- long for normal and short for master Effects on reporting, costing, pricing and evaluation Production volume variance= (denominator level in output units – actual output units) x budgeted fixed manufacturing overhead rate per output unit Page 8 : income statement effects of alternative denominator levels Product costing: For internal cost and price control: Practical capacity is often used to calculate the budgeted fixed manufacturing cost, but not appropriate for marketing functions . Budgeted fixed manufacturing cost refers to cost of supplying the capacity Product pricing: the downward demand spiral Progressive reduction in capacity use, which leads to an increase in the fixed overhead rate- i.e. realized quanitity in the master- budget denominator of any fixed overhead cost rate decreases but the fixed cost pool remains constant A decrease in sales would lead to higher per unit fixed manufacturing overhead cost which would in turn push the price up and lead to further decline in sales. Performance evaluation: Normal capacity utilization is an averge that provides no meaningful feedback to the marketing manager for a particular year. Master budget – principal short run planning and control tool. Differences between practical capacity and master budget capacity utilization is known as planned unused capacity. Capacity costs and denominator-level issues Problems come in measuring the fixed cost pool Capacity cost also arises in non-manufaturing cost/ service sector companies. Affects ABC costing rates
Denominator level and inventory valuation 1. Absorption and variable inventory valuation assumptions: Absorption costing/ full absorption costing: inventory absorbs both variable and fixed manufacturing cost as inventoriable cost but classifies all non-manufacturing costs as period costs which is excluded Variable costing : only variable manufacturing costs are included as inventoriable costs. All fixed and all non manufacturing costs are classified as period costs expensed during the specific time they are incurred. Important: transferring costs of production to balance sheet/ fixed cost of production from inventory on b.s to income statement
Note: a. Denominator level for the static budget be used to calculate the pro forma fixed overhead rate. b. Cost included in cost of goods sold is inventoriable, included in period cost are non inventoriable. c. Capitalizing means acquisition costs are recorded as asset on the balance sheet when incurred ( both absorption costing and variable costing capitalize all fixed cost-manufacturing and non manufacturing cost) d. Variable costing is not direct costing 2. Explaining differences in operating income: If inventory level increases: -
Ending inventory under absorption costing > variable costing Period cost in absorption< variable Operating income in absorption costing> variable costing
Formula : (AC operating income) – (VC operating income) = (FMC in ending inventory) – (FMC in beginning inventory) = (units produced – units sold) x (budgeted FMC rate) = (ending inventory in units – beginning inventory in units) x (budgeted FMC rate) ( for absorption costing) Change in operating income = contribution margin x change in unit sales level Ex 9-7 page 21 : how to show changes in absorption costing and variable costing 3. 4. a. b. c.
Performance evaluation: undesirable buildup of inventories Proposals for revising performance evaluation: Change the accounting system: to variable or through put Careful budgeting and inventory planning Incorporate a carrying charge for inventory
d. Change the time period used to evaluate performance e. Include nonfinancial as well as financial variable in the measures used to evaluate performance.
Throughput: super-variable costing Also known as super-variable costing treats all costs except variable direct matierals as period costs that are expensed when they are incurred. -
Reduces incentive to build up inventories
Overview of three costing policies : page 25 Variable and through put costing are not permitted for external reporting
Productivity under each cost policy Under variable costing: Breakeven point Q = (total fixed cost + target operating income )/ CM per unit Under absorption costing: Q = { total FC + target OI + [ FMC rate x ( breakeven sales in units – units produced)]}/ CM per unit
Capacity choice -> denominator level -> price and cost Denominator levels: a complex decision w/ complex effects -
-
Supply level constraints: a. Theoretical capacity: no delays b. Practical capacity: w/ idle time Demand level constraints: a. Normal capacity: over specified time satisfying average customer b. Master capacity: satisfy customer demand for budget cycle for tax purposes
These affect balance sheet and income statement Note: DOL increases for mechanization and DOL decreases for labour intensive Manager’s decisions: a. acquire all capacity 1. 2. 3. 4. 5. 6.
b. make acquisition
Choose the budge period Compute the fixed overhead cost allocation rate(s) Select benchmark, standard or budgeted cost allocation base quantities Select homogenous inputs for other fixed cost allocation bases Analyze and select homogenous cost pools Analyze and select capacity alternative to use in production-volume cost allocation base: a. Capacity supply ( theoretical > practical) i. Capacity management ii. Inventory value iii. Product cost (COGM) iv. Product price ( full absorption) b. Capacity demand ( normal > = master budget) i. Performance evaluation ii. Internal variance ( fixed overhead) iii. External governance iv. Financial reporting
The decision framework and denominator choice If actual production is less than theoretical capacity because there is no demand or production is interrupted, the production-volume variance will be high and indicated opportunity cost of idle productive capacity. This is a non-value added cost for which a customer will not pay. Practical capacity reduces theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holidays, safety inspections and so on. This type of scheduled idle capacity is often called off-limits idle capacity. Practical capacity is not constant over the life of the equipment. Process redesign can improve labour efficiency, wait time for materials and scheduling which would increase practical capacity
Note: often, the difference between theoretical and practical capacity is off-limits idle capacity. Downtime : setups – non productive idle capacity: this is not off limits because it can be minimized with excellent scheduling or used to accomplish other value-added activities. Note: excess non- productive capacity can be used in other revenue- generating ways until demand growth accelerates (designing new products to fill unused capacity or leasing out unused capacity to others). Increased demand by customers may not only be for the product but for the services customized to their needs. Difference between the two demand level: time period- long for normal and short for master Effects on reporting, costing, pricing and evaluation Production volume variance= (denominator level in output units – actual output units) x budgeted fixed manufacturing overhead rate per output unit Page 8 : income statement effects of alternative denominator levels Product costing: For internal cost and price control: Practical capacity is often used to calculate the budgeted fixed manufacturing cost, but not appropriate for marketing functions . Budgeted fixed manufacturing cost refers to cost of supplying the capacity Product pricing: the downward demand spiral Progressive reduction in capacity use, which leads to an increase in the fixed overhead rate- i.e. realized quanitity in the master- budget denominator of any fixed overhead cost rate decreases but the fixed cost pool remains constant A decrease in sales would lead to higher per unit fixed manufacturing overhead cost which would in turn push the price up and lead to further decline in sales. Performance evaluation: Normal capacity utilization is an averge that provides no meaningful feedback to the marketing manager for a particular year. Master budget – principal short run planning and control tool. Differences between practical capacity and master budget capacity utilization is known as planned unused capacity. Capacity costs and denominator-level issues Problems come in measuring the fixed cost pool Capacity cost also arises in non-manufaturing cost/ service sector companies. Affects ABC costing rates
Denominator level and inventory valuation 1. Absorption and variable inventory valuation assumptions: Absorption costing/ full absorption costing: inventory absorbs both variable and fixed manufacturing cost as inventoriable cost but classifies all non-manufacturing costs as period costs which is excluded Variable costing : only variable manufacturing costs are included as inventoriable costs. All fixed and all non manufacturing costs are classified as period costs expensed during the specific time they are incurred. Important: transferring costs of production to balance sheet/ fixed cost of production from inventory on b.s to income statement
Note: a. Denominator level for the static budget be used to calculate the pro forma fixed overhead rate. b. Cost included in cost of goods sold is inventoriable, included in period cost are non inventoriable. c. Capitalizing means acquisition costs are recorded as asset on the balance sheet when incurred ( both absorption costing and variable costing capitalize all fixed cost-manufacturing and non manufacturing cost) d. Variable costing is not direct costing 2. Explaining differences in operating income: If inventory level increases: -
Ending inventory under absorption costing > variable costing Period cost in absorption< variable Operating income in absorption costing> variable costing
Formula : (AC operating income) – (VC operating income) = (FMC in ending inventory) – (FMC in beginning inventory) = (units produced – units sold) x (budgeted FMC rate) = (ending inventory in units – beginning inventory in units) x (budgeted FMC rate) ( for absorption costing) Change in operating income = contribution margin x change in unit sales level Ex 9-7 page 21 : how to show changes in absorption costing and variable costing 3. 4. a. b. c.
Performance evaluation: undesirable buildup of inventories Proposals for revising performance evaluation: Change the accounting system: to variable or through put Careful budgeting and inventory planning Incorporate a carrying charge for inventory
d. Change the time period used to evaluate performance e. Include nonfinancial as well as financial variable in the measures used to evaluate performance.
Throughput: super-variable costing Also known as super-variable costing treats all costs except variable direct matierals as period costs that are expensed when they are incurred. -
Reduces incentive to build up inventories
Overview of three costing policies : page 25 Variable and through put costing are not permitted for external reporting
Productivity under each cost policy Under variable costing: Breakeven point Q = (total fixed cost + target operating income )/ CM per unit Under absorption costing: Q = { total FC + target OI + [ FMC rate x ( breakeven sales in units – units produced)]}/ CM per unit
