Chapter 9 Income Effects of Denominator Level on Inventory Valuation ...
Chapter 9 Income Effects of Denominator Level on Inventory Valuation Notes Denominator Levels: A Complex Decision with Complex Effects • •
• •
each of the four choices for denominator level constrains output produced through either supply or demand capacity the first two denominator-level choices constrain output because of the supply that can be provided by existing capacity: o theoretical capacity is amount of output theoretically possible if there were never any delays or interruptions in production o practical capacity is the amount of output practically possible after taking into account required idle time for maintenance, safety inspections, holidays, and other relevant factors theoretical capacity is always greater than practical capacity because practical capacity excludes volume lost through idle time the following two denominator-level choices constrain output produced because of the existing demand level for the output: o normal capacity is level of output that will satisfy average customer demand over a time period and complies with GAAP o master-budget capacity is the level of output that will satisfy customer demand for a single budget cycle and complies with Canada Revenue Agency (CRA) for tax purposes
Supply: Theoretical Capacity or Practical Capacity? • • • • • • • •
theoretical capacity is based on the production of output at full efficiency all the time no idle time results in highest possible supply-side denominator level, lowest fixed overhead cost rate and inventory valuation if, however, actual production is less than theoretical capacity because there is no demand or production is interrupted, the production-volume variance will be high and indicates the cost of idle productive capacity practical capacity is the capacity concept that reduces theoretical capacity for unavoidable operating interruptions this type of scheduled idle capacity is often called off-limits idle capacity strategically, companies might schedule off-limits idle capacity to comply with regulations and safety legislation an important job for the production manager is to schedule setups to minimize non-productive idle capacity this type of capacity is not off-limits because it can be minimized with either excellent scheduling or deployed in other ways
Demand: Normal Capacity or Master-Budget Capacity? • • • • • • •
normal capacity utilization is the capacity concept based on the level of capacity utilization that satisfies average customer demand over a period (say, of two or three years) that includes seasonal, cyclical, or other trend factors master-budget capacity utilization is the capacity concept based on the anticipated level of capacity utilization for the next operating budget period of a month, a quarter, or a year they key difference is the time period under consideration, long (normal) or short (master) term these two denominator levels will differ when an industry has cyclical periods of high and low demand or when management believes that the budgeted production for the coming period is unrepresentative of “long-term” demand GAAP external reporting requires the use of normal capacity in the denominator taking into account off-limits idle capacity unallocated overhead (variance) is recognized in the time period incurred GAAP also permits the use of actual production level if it is not materially different from normal capacity
Effects on Reporting, Costing, Pricing, and Evaluation Product Pricing: the Downward Demand Spiral
• •
downward demand spiral a progressive reduction in sales and production that leads to an increase in the fixed overhead rate; as sales decrease, the realized quantity in the denominator of any fixed overhead cost rate decreases but the fixed cost pool is constant; diminishing sales must bear higher costs per unit, which leads to diminishing sales managers who use reported unit costs in a mechanical way to set prices are less likely to promote a downward demand spiral when they use practical capacity concepts than when they use the normal capacity or master-budget capacity-utilization concepts
Performance Evaluation • • • •
normal capacity utilization is often used as a basis for long-term plans the normal capacity utilization depends on the time span selected and the forecasts made for each year; however, normal capacity utilization is an average that provides no meaningful feedback to the manager for a particular year master-budget capacity utilization, rather than normal capacity utilization or practical capacity, is what should be used for evaluating a manager’s performance in current year because master budget is principal short-run planning and control tool managers feel more obligated to reach the levels specified in the master budget, which should have been carefully set in relation to the maximum opportunities for sales in the current year
Capacity Costs and Denominator-Level Issues • • •
the choice of any denominator level introduces rigidity into the budgeting and costing system standard cost systems do not recognize fluctuations and uncertainty, therefore, the managers must make a choice despite their knowledge that they will almost certainly be wrong challenging issues also arise in measuring the numerator, the fixed-cost pool
Denominator Level and Inventory Valuation Absorption and Variable Inventory Valuation Assumptions
•
absorption costing (or full absorption costing) a method of inventory valuation in which inventory “absorbs” both variable and fixed manufacturing costs as inventoriable costs, but all nonmanufacturing costs are classified as period costs
•
a variety of costs such as tax, insurance premiums, and amortization of manufacturing plant and equipment will be included in the fixed overhead cost rate assigned to each unit remaining in inventory the important event transferring costs of production from the inventory on the balance sheet to COGS expense is a sale
•
•
variable costing method of inventory valuation in which variable manufacturing costs are included as inventoriable costs; all fixed and all nonmanufacturing costs are classified as period costs expensed during specific time period they are incurred the key distinguishing factors of these two valuation policies are: o classification of fixed manufacturing overhead as an inventoriable (COGS) or a period cost o the classification of variable nonmanufacturing overhead as an inventoriable (COGS) or period cost o the event that triggers recognition of fixed overhead expense o the timing of expensing fixed manufacturing overhead
•
•
direct costing inaccurately describes the inventory costing (valuation) method called variable costing
• •
critics of absorption costing have made a variety of proposals for revising how managers are evaluated their proposals include the following: 1) Change the accounting system. Both variable and throughput costing reduce incentives of managers to build up inventory.
Proposals for Revising Performance Evaluation
2) 3) 4) 5)
Careful budgeting and inventory planning to reduce management’s freedom to build up excess inventory. Incorporate a carrying charge for inventory in the internal accounting system. Change the time period used to evaluate performance. By evaluating performance over a 3-to-5-year period, the incentive to take short-run actions that reduce long-term income is reduced. Include nonfinancial as well as financial variables in the measures used to evaluate performance.
Throughput: Super-Variable Costing • throughout costing (or super-variable costing) a costing method that treats all costs except variable direct materials as period costs that are expensed when they are incurred; only variable direct materials costs are inventoriable when innovation cycles are very short, obsolescence can occur almost overnight and the assumption that unsold production is unlikely to produce future benefit may be appropriate
•
Overview of Three Costing Policies CostingThroughput
Variable Costing
Absorption Costing
Actual Costing
Normal Costing
Variable Direct Materials
Actual prices × Actual quantity of inputs used
Actual prices × Actual quantity of inputs used
Variable Direct Conversion Costs
Actual prices × Actual quantity of inputs used
Actual prices × Actual quantity of inputs used
Variable Manufacturing Overhead Costs
Actual variable overhead rate × Actual quantity of cost-allocation bases used
Budgeted variable overhead rates × Actual quantity of cost-allocation bases used
Fixed Direct Manufacturing Costs
Actual prices × Actual quantity of inputs used
Actual prices × Actual quantity of inputs used
Fixed Manufacturing Overhead Costs
Actual fixed overhead rates × Actual quantity of costallocation bases used
Budgeted fixed overhead rates × Actual quantity of cost-allocation bases used
Standard Costing Standard prices × Standard quantity of inputs allowed for actual output achieved Standard prices × Standard quantity of inputs allowed for actual output achieved Standard variable overhead rate × Standard quantity of cost-allocation bases allowed for actual output achieved Standard prices × Standard quantity of inputs allowed for actual output achieved Standard fixed overhead rates × Standard quantity of cost-allocation bases allowed for actual output achieved
Production under Each Cost Policy • •
the formula for computing the breakeven point with variable costing is a special case of the target operating income formula: Q = (Total fixed costs + Target operating income) / Contribution margin per unit Q = Number of units sold to earn the target operating income if absorption costing is used, the required number of units sold to achieve a specific target operating income is not unique because of the number of variables involved in the formula: Q = {Total fixed costs + Total operating income + [Fixed manufacturing cost rate × (Breakeven sales in units – Units produced)]} / Contribution margin per unit
•
extra term added under absorption costing is:
[Fixed manufacturing costs × (Breakeven sales in units – Units produced)]
• • • • • •
this captures additional amount of target operating income in numerator due to absorption costing moving fixed manufacturing costs to inventory from COGS under variable costing for all units produced that exceed the breakeven sales quantity the breakeven point is defined as the quantity for which the target operating income is $0 this formula shows that under absorption costing there is still a unique breakeven point for each quantity of units produced there is also an inverse relationship between the quantity of units produced and the required quantity of units sold to breakeven the higher the quantity of units produced, the higher the level of fixed manufacturing overhead costs absorbed into finished goods inventory and the higher the COGS; while the period costs remain unchanged, therefore, the quantity of units that must be sold to cover these costs too (and break even) will decrease the breakeven point under absorption costing depends on—(1) fixed costs, (2) contribution margin per unit, (3) unit level of sales, (4) unit level of production, and (5) overhead cost rate
Decision Points 1. What are the various capacity levels a company can use to calculate budgeted fixed manufacturing cost rate?
2.
3. 4. 5.
Capacity levels can be measured in terms of what a plant can supply—theoretical capacity or practical capacity. Capacity can also be measured in terms of demand for the output of a plant—normal capacity utilization or master-budget capacity utilization. When the chosen capacity level exceeds the actual production level, there will be an unfavourable production-volume variance; when the chosen capacity level is less than the actual production level, there will be a favourable production-volume variance. What are the major factors managers consider when choosing the capacity level to compute the budgeted fixed overhead cost rate? The major factors managers consider when choosing the capacity level to compute the budgeted fixed manufacturing cost per unit are (a) the effect on product costing and capacity management, (b) the effect on pricing decisions, (c) the effect on performance evaluation, (d) the effect on financial statements, (e) regulatory requirements, and (f) difficulties in forecasting chosen capacity-level concepts. How do level of sales and level of production affect operating income under variable costing and absorption costing? Under variable costing, operating income is driven by the unit level of sales. Under absorption costing, operating income is driven by the unit level of production, as well as by the unit level of sales. How does throughput costing differ from variable costing and absorption costing? Throughput costing treats all costs except direct materials as costs of the period in which they are incurred. Throughput costing results in a lower amount of manufacturing costs being inventoried than either variable or absorption costing. How is a breakeven calculation affected by using absorption costing? The target operating income at breakeven is $0 and there is no unique solution because a number of values change at the same time, including fixed costs, contribution margin per unit, sales quantity, production quantity, and the overhead cost rates. Many values for these factors can combine to give an operating income of $0.
• •
each of the four choices for denominator level constrains output produced through either supply or demand capacity the first two denominator-level choices constrain output because of the supply that can be provided by existing capacity: o theoretical capacity is amount of output theoretically possible if there were never any delays or interruptions in production o practical capacity is the amount of output practically possible after taking into account required idle time for maintenance, safety inspections, holidays, and other relevant factors theoretical capacity is always greater than practical capacity because practical capacity excludes volume lost through idle time the following two denominator-level choices constrain output produced because of the existing demand level for the output: o normal capacity is level of output that will satisfy average customer demand over a time period and complies with GAAP o master-budget capacity is the level of output that will satisfy customer demand for a single budget cycle and complies with Canada Revenue Agency (CRA) for tax purposes
Supply: Theoretical Capacity or Practical Capacity? • • • • • • • •
theoretical capacity is based on the production of output at full efficiency all the time no idle time results in highest possible supply-side denominator level, lowest fixed overhead cost rate and inventory valuation if, however, actual production is less than theoretical capacity because there is no demand or production is interrupted, the production-volume variance will be high and indicates the cost of idle productive capacity practical capacity is the capacity concept that reduces theoretical capacity for unavoidable operating interruptions this type of scheduled idle capacity is often called off-limits idle capacity strategically, companies might schedule off-limits idle capacity to comply with regulations and safety legislation an important job for the production manager is to schedule setups to minimize non-productive idle capacity this type of capacity is not off-limits because it can be minimized with either excellent scheduling or deployed in other ways
Demand: Normal Capacity or Master-Budget Capacity? • • • • • • •
normal capacity utilization is the capacity concept based on the level of capacity utilization that satisfies average customer demand over a period (say, of two or three years) that includes seasonal, cyclical, or other trend factors master-budget capacity utilization is the capacity concept based on the anticipated level of capacity utilization for the next operating budget period of a month, a quarter, or a year they key difference is the time period under consideration, long (normal) or short (master) term these two denominator levels will differ when an industry has cyclical periods of high and low demand or when management believes that the budgeted production for the coming period is unrepresentative of “long-term” demand GAAP external reporting requires the use of normal capacity in the denominator taking into account off-limits idle capacity unallocated overhead (variance) is recognized in the time period incurred GAAP also permits the use of actual production level if it is not materially different from normal capacity
Effects on Reporting, Costing, Pricing, and Evaluation Product Pricing: the Downward Demand Spiral
• •
downward demand spiral a progressive reduction in sales and production that leads to an increase in the fixed overhead rate; as sales decrease, the realized quantity in the denominator of any fixed overhead cost rate decreases but the fixed cost pool is constant; diminishing sales must bear higher costs per unit, which leads to diminishing sales managers who use reported unit costs in a mechanical way to set prices are less likely to promote a downward demand spiral when they use practical capacity concepts than when they use the normal capacity or master-budget capacity-utilization concepts
Performance Evaluation • • • •
normal capacity utilization is often used as a basis for long-term plans the normal capacity utilization depends on the time span selected and the forecasts made for each year; however, normal capacity utilization is an average that provides no meaningful feedback to the manager for a particular year master-budget capacity utilization, rather than normal capacity utilization or practical capacity, is what should be used for evaluating a manager’s performance in current year because master budget is principal short-run planning and control tool managers feel more obligated to reach the levels specified in the master budget, which should have been carefully set in relation to the maximum opportunities for sales in the current year
Capacity Costs and Denominator-Level Issues • • •
the choice of any denominator level introduces rigidity into the budgeting and costing system standard cost systems do not recognize fluctuations and uncertainty, therefore, the managers must make a choice despite their knowledge that they will almost certainly be wrong challenging issues also arise in measuring the numerator, the fixed-cost pool
Denominator Level and Inventory Valuation Absorption and Variable Inventory Valuation Assumptions
•
absorption costing (or full absorption costing) a method of inventory valuation in which inventory “absorbs” both variable and fixed manufacturing costs as inventoriable costs, but all nonmanufacturing costs are classified as period costs
•
a variety of costs such as tax, insurance premiums, and amortization of manufacturing plant and equipment will be included in the fixed overhead cost rate assigned to each unit remaining in inventory the important event transferring costs of production from the inventory on the balance sheet to COGS expense is a sale
•
•
variable costing method of inventory valuation in which variable manufacturing costs are included as inventoriable costs; all fixed and all nonmanufacturing costs are classified as period costs expensed during specific time period they are incurred the key distinguishing factors of these two valuation policies are: o classification of fixed manufacturing overhead as an inventoriable (COGS) or a period cost o the classification of variable nonmanufacturing overhead as an inventoriable (COGS) or period cost o the event that triggers recognition of fixed overhead expense o the timing of expensing fixed manufacturing overhead
•
•
direct costing inaccurately describes the inventory costing (valuation) method called variable costing
• •
critics of absorption costing have made a variety of proposals for revising how managers are evaluated their proposals include the following: 1) Change the accounting system. Both variable and throughput costing reduce incentives of managers to build up inventory.
Proposals for Revising Performance Evaluation
2) 3) 4) 5)
Careful budgeting and inventory planning to reduce management’s freedom to build up excess inventory. Incorporate a carrying charge for inventory in the internal accounting system. Change the time period used to evaluate performance. By evaluating performance over a 3-to-5-year period, the incentive to take short-run actions that reduce long-term income is reduced. Include nonfinancial as well as financial variables in the measures used to evaluate performance.
Throughput: Super-Variable Costing • throughout costing (or super-variable costing) a costing method that treats all costs except variable direct materials as period costs that are expensed when they are incurred; only variable direct materials costs are inventoriable when innovation cycles are very short, obsolescence can occur almost overnight and the assumption that unsold production is unlikely to produce future benefit may be appropriate
•
Overview of Three Costing Policies CostingThroughput
Variable Costing
Absorption Costing
Actual Costing
Normal Costing
Variable Direct Materials
Actual prices × Actual quantity of inputs used
Actual prices × Actual quantity of inputs used
Variable Direct Conversion Costs
Actual prices × Actual quantity of inputs used
Actual prices × Actual quantity of inputs used
Variable Manufacturing Overhead Costs
Actual variable overhead rate × Actual quantity of cost-allocation bases used
Budgeted variable overhead rates × Actual quantity of cost-allocation bases used
Fixed Direct Manufacturing Costs
Actual prices × Actual quantity of inputs used
Actual prices × Actual quantity of inputs used
Fixed Manufacturing Overhead Costs
Actual fixed overhead rates × Actual quantity of costallocation bases used
Budgeted fixed overhead rates × Actual quantity of cost-allocation bases used
Standard Costing Standard prices × Standard quantity of inputs allowed for actual output achieved Standard prices × Standard quantity of inputs allowed for actual output achieved Standard variable overhead rate × Standard quantity of cost-allocation bases allowed for actual output achieved Standard prices × Standard quantity of inputs allowed for actual output achieved Standard fixed overhead rates × Standard quantity of cost-allocation bases allowed for actual output achieved
Production under Each Cost Policy • •
the formula for computing the breakeven point with variable costing is a special case of the target operating income formula: Q = (Total fixed costs + Target operating income) / Contribution margin per unit Q = Number of units sold to earn the target operating income if absorption costing is used, the required number of units sold to achieve a specific target operating income is not unique because of the number of variables involved in the formula: Q = {Total fixed costs + Total operating income + [Fixed manufacturing cost rate × (Breakeven sales in units – Units produced)]} / Contribution margin per unit
•
extra term added under absorption costing is:
[Fixed manufacturing costs × (Breakeven sales in units – Units produced)]
• • • • • •
this captures additional amount of target operating income in numerator due to absorption costing moving fixed manufacturing costs to inventory from COGS under variable costing for all units produced that exceed the breakeven sales quantity the breakeven point is defined as the quantity for which the target operating income is $0 this formula shows that under absorption costing there is still a unique breakeven point for each quantity of units produced there is also an inverse relationship between the quantity of units produced and the required quantity of units sold to breakeven the higher the quantity of units produced, the higher the level of fixed manufacturing overhead costs absorbed into finished goods inventory and the higher the COGS; while the period costs remain unchanged, therefore, the quantity of units that must be sold to cover these costs too (and break even) will decrease the breakeven point under absorption costing depends on—(1) fixed costs, (2) contribution margin per unit, (3) unit level of sales, (4) unit level of production, and (5) overhead cost rate
Decision Points 1. What are the various capacity levels a company can use to calculate budgeted fixed manufacturing cost rate?
2.
3. 4. 5.
Capacity levels can be measured in terms of what a plant can supply—theoretical capacity or practical capacity. Capacity can also be measured in terms of demand for the output of a plant—normal capacity utilization or master-budget capacity utilization. When the chosen capacity level exceeds the actual production level, there will be an unfavourable production-volume variance; when the chosen capacity level is less than the actual production level, there will be a favourable production-volume variance. What are the major factors managers consider when choosing the capacity level to compute the budgeted fixed overhead cost rate? The major factors managers consider when choosing the capacity level to compute the budgeted fixed manufacturing cost per unit are (a) the effect on product costing and capacity management, (b) the effect on pricing decisions, (c) the effect on performance evaluation, (d) the effect on financial statements, (e) regulatory requirements, and (f) difficulties in forecasting chosen capacity-level concepts. How do level of sales and level of production affect operating income under variable costing and absorption costing? Under variable costing, operating income is driven by the unit level of sales. Under absorption costing, operating income is driven by the unit level of production, as well as by the unit level of sales. How does throughput costing differ from variable costing and absorption costing? Throughput costing treats all costs except direct materials as costs of the period in which they are incurred. Throughput costing results in a lower amount of manufacturing costs being inventoried than either variable or absorption costing. How is a breakeven calculation affected by using absorption costing? The target operating income at breakeven is $0 and there is no unique solution because a number of values change at the same time, including fixed costs, contribution margin per unit, sales quantity, production quantity, and the overhead cost rates. Many values for these factors can combine to give an operating income of $0.
