Absorption and Variable Costing, and Inventory Management

Performance of Profit Centers: Variable, 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.
 Must 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.

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.
 Fixed overhead is an inventoriable cost.

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.
 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.

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. Yet variable
costing can supply vital cost information for decision making and control, information not supplied by
absorption costing. For internal application, variable costing is an important managerial tool.

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.
Computing Inventory Cost Under Absorption Costing 8.1

It shows how to compute inventory cost under absorption costing

Notice that the inventory cost computed under absorption costing is the traditional product cost used for
external financial statements and for GAAP. Each unit includes all variable manufacturing costs as well as
a portion of fixed factory overhead.
Computing Inventory Cost Under Variable Costing 8.2

It shows how to calculate inventory cost under variable costing. When comparing Cornerstone 8-1 and 8-2,
we can see that the only difference between the two approaches is the treatment of fixed factory overhead.

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.

As the slide illustrates, in a pictorial form, the unit product cost under absorption costing is always greater
than the unit product cost under variable costing since the only difference between the two approaches is
the treatment of fixed factory overhead.

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.
Preparing An Absorption Costing Income Statement 8.3

It shows how to develop cost of goods sold and income statements for absorption costing. As we see in
Cornerstone 8-3, the cost of goods sold includes some but not all fixed factory overhead. Total fixed factory
overhead is $250,000 ($25 X 10,000 units produced). However, only $200,000 ($25 X 8,000 units sold) of
fixed overhead was expensed in cost of goods sold.
Preparing a Variable-Costing Income Statement 8.4
It shows how to prepare a variable-costing income statement. When you compare Cornerstone 8-3 and 8-
4, notice that operating income under absorption costing is $500,000 whereas operating income under
variable costing is only $450,000. This is because $50,000 of current period product cost in fixed factory
overhead went into ending inventory under absorption costing.

Production, Sales, and Income Relationships

The relationship between variable-costing income and absorption-costing income changes as the
relationship between production and sales changes. If more is sold than was produced, variable-costing
income is greater than absorption-costing. Selling more than was produced means that beginning inventory
and units produced are being sold. Under absorption costing, units coming out of inventory have attached
to them fixed overhead from a prior period. Variable-costing income is greater than absorption-costing
income by the amount of fixed overhead flowing out of beginning inventory.

Evaluating Profit-Center Managers

 The evaluation of managers is often tied to the profitability of the units that they control.
 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.

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.

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.

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.
Preparing a Segmented Income Statement 8.5

It shows how to prepare a segmented income statement where the segments are product lines.

It shows that both products have large positive contribution margins ($180,000 for MP3 players and
$125,500 for DVD players). Both products are providing revenue above variable costs that can be used to
help cover the firm’s fixed costs.

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.

Comparison of Segmented Income Statement With and Without Allocated Common Fixed Expense

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.
Here in Panel B of the exhibit, 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. The profit contribution each
segment makes, toward covering a firm’s common fixed costs is called 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.

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.

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.
Traditional Reasons for Carrying Inventory

Economic Order Quantity: The Traditional Model

 Once a company decides to carry inventory, two basic questions must be addressed:
 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:

Calculating Ordering Cost, Carrying Cost, and Total Inventory-Related Cost 8.6

The cost of carrying inventory can be computed for any organization that carries inventories, including
retail, service, and manufacturing organizations. CORNERSTONE 8-6 illustrates the application for a
service organization and shows how to calculate total ordering cost, carrying cost, and inventory cost. Note
that the total carrying cost for the year is figured by multiplying the average number of units on hand by the
cost of carrying one unit in inventory for a year.
Average Inventory
 The average amount in inventory is the maximum plus the minimum divided by two.
Average Inventory = (Max amount + Min amount)
2

What is the average number of units on hand? Given the policy of ordering say 1,000 units at a time, the
maximum number on hand would be 1,000 units—the amount on hand just after an order is delivered.
Ideally, the minimum amount on hand would be zero, the amount the company has just moments before
the new order arrives. Therefore, the average amount in inventory is the maximum plus the minimum
divided by two.

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).
 Since EOQ is the quantity that minimizes total inventory-related costs, a formula for computing it is:
The square root of the product of two times the cost of placing one order times the ratio of annual demand
for the item in units and the cost of carrying one unit in inventory for a year.

Calculating Economic Order Quantity (EOQ) 8.7

It shows how to use the EOQ formula.

Look carefully at Cornerstone 8-7. Notice that at the EOQ, the carrying cost equals the ordering cost. This
is always true for the simple EOQ model described here. Now compare Cornerstone 8-7 with Cornerstone
8-6. The EOQ of 500 is less costly than an order quantity of 1,000 ($1,000 vs. $1,250).

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

Calculating The Reorder Point When Usage Is Known with Certainty 8.8

It shows how to calculate the reorder point when usage is known with certainty.

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 daily usage – Average daily usage) x Lead Time

Calculating Safety Stock and the Reorder Point with Safety Stock 8.9
It shows how to calculate safety stock and the reorder point with safety stock.

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.

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.
 Fast-food restaurants, like McDonald’s, use this type of pull system to control their finished goods
inventory.

Comparing Just-in-Time and Traditional 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.

Comparing JIT and Traditional Inventory 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.
Comparing JIT and Traditional Inventory 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.

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.