Study Guide

I. Fixed Costs and Inventory Production

A. Cost behavior can be variable or fixed in the production process. When product costs are reported
on the balance sheet, the full cost of the inventory should be conveyed. Hence, inventory costs
include fixed production costs such as salaries, depreciation, property tax, etc.
B. While it is appropriate to include fixed production costs in the value of inventory on the balance
sheet, these fixed production costs present a particular problem on the income statement. Shifts in
production volume or sales volume result in changing inventory levels. As inventory levels adjust,
prior period fixed costs are released from the balance sheet and current period fixed costs are
retained (absorbed) onto the balance sheet. This release and retention of fixed production costs
creates income effects that can lead to confusion in the organization when income is used as a
performance measure.
C. Remember from the last lesson that the production of services often results in significant inventory
costs on the balance sheet in the unbilled services (i.e., work-in-process) account. Hence, the
“fixed cost absorption” issue happens in both service organizations and manufacturing
organizations.

II. Inventory Effects on Income

A. In the last lesson we learned that costs are assigned with the following two-step process:

B. When the cost pool is fixed with respect to activity in the cost object, then the cost driver rate
is allocating indirect costs (rather than tracking direct costs) to the cost object. Using this process,
fixed production costs are allocated to products and services being produced using a fixed cost
rate.
C. Assuming that production flows in a FIFO (first-in-first-out) pattern, beginning inventory levels
represent production from the previous period and have been allocated fixed costs using the fixed
cost rate from the previous period. Conversely, ending inventory levels represent production from
the current period and have been allocated fixed costs using the current period fixed cost rate.
D. The fixed cost absorption issue on the income statement can be represented as a set of
computations involving beginning and ending inventory levels, as well as prior period and current
period fixed production cost rates.

Computations When Fixed Cost Rates are

Changing
Released Costs: (Beginning Inventory) × Prior Period Fixed Production Cost = (Decrease to
Rate Income)
+
Absorbed Costs: Ending Inventory × Current Period Fixed Production = Increase to Income
Cost Rate
 1.Because beginning inventory is the first production cost to flow from the balance sheet
onto the income statement where it becomes an expense (cost of goods sold or cost of
sales), all of the production costs (including the fixed production costs) from the prior
period are effectively being “released” from the balance sheet, which has
a decreasing effect on operating income.
2. On the other hand, ending inventory is “absorbing” current period production costs
(including fixed production costs), keeping these costs from becoming expenses on the
income statement in the current period. This has the effect of increasing operating
income.
3. The combined effect of released fixed costs and absorbed fixed costs results in a net
increase or a net decrease in operating profits and net income. Be sure to note that
whether income goes up or down is a function of the size of beginning versus ending
inventory and the size of the prior period fixed product cost rate versus the current period
rate.
E. Some organizations don't need to adjust their fixed production cost rates every year. When the
fixed production cost rate is the same this year as it was last year, a shortcut computation can be
used instead of separately computing and adding up the effects of beginning inventory and ending
inventory on income. The shortcut is demonstrated below.

Shortcut When Fixed Cost Rates are Constant

Released Costs: Inventory Decrease × Fixed Production Cost Rate = Net Decreased Income
or or
Absorbed Costs: Inventory Increase × Fixed Production Cost Rate = Net Increased Income

F. Note that either the first or the second computation in this shortcut is performed based on whether
the inventory level has decreased or increased (respectively) during the year.
III. Absorption Costing Income Statements versus Variable Costing Income Statements
A. The formats of both the absorption costing income statement and the variable costing income
statement should be familiar to you (see below).

Absorption Costing Income Statement Variable Costing Income Statement

Sales Revenue Sales Revenue
(Cost of Goods Sold) (Variable Costs)
Gross Margin Contribution Margin
(Selling & Admin Expense) (Fixed Costs)
Operating Income Operating Income

1. Absorption costing income statement is the traditional statement required for external
financial reporting. This approach tracks the full production cost of inventory to the
balance sheet and onto the income statement. As a result, this approach results in a “full
cost” valuation of inventory on the balance sheet, which is essential for accurate balance
sheet presentation. But absorption costing income statements create a troublesome
incentive in the management system.
2. Variable costing income statements are often referred to as contribution margin income
statements. The variable costing income statement approach is used to separate fixed
costs from variable costs and does not use cost rates to assign fixed production costs to
each unit of the organization's production and sales output. Instead, total fixed production
costs are fully expensed to the variable costing income statement in the period in which
 they occur. The only production costs used to value the inventory on the balance sheet are
the variable costs of production. As a result, variable costing income statements
are not allowed for external financial reporting, but they avoid the troublesome incentive
that we'll discuss below.
B. Consider the following scenario. Below are listed the sales price and production costs for Quigley
Ladders, Inc. To keep the example simple, we'll assume that sales price and production costs are
both budgeted and actual. Quigley then experienced the following sales and production volumes in
its first two years of business.

Quigley Ladders, Inc. (Original Data)

Sales price per ladder P200
Variable production cost per ladder P100
Annual fixed production costs P360,000
Units Sold Units Beginning Inventory Ending Fixed Rate per
Produced Inventory Unit
Year 1 9,000 10,000 0 1,000 P36.00
Year 2 9,000 8,000 1,000 0 P45.00

1. Note that the price, production costs, and sales volume were the same for each year. To
further simplify this example, we'll assume that Quigley has no selling and administrative
expenses.
2. Note also that Quigley produced more ladders than it needed in Year 1 and then scaled
back production in Year 2 to reduce inventory to zero. As a result, its fixed cost rate per
ladder was different in Year 1 (P360,000 ÷ 10,000 = P36) compared to Year 2 (P360,000
÷ 8,000 = P45).

C. Quigley's absorption costing income statement is presented below.

Quigley Ladders, Inc. (Absorption Costing)

Year 1 Year 2 Total
Sales revenue P1,800,000 P1,800,000 P3,600,000
Variable cost of goods sold (900,000) (900,000) (1,800,000)
Fixed costs of goods sold (324,000) (396,000) (720,000)
Operating income P576,000 P504,000 P1,080,000

1. Prices and sales volumes are constant each year, resulting in P1,800,000 in annual
revenue (P200 × 9,000 units). Variable cost of goods sold is also constant each year at
P900,000 (P100 × 9,000 units).
2. Remember, due to a different production volume of ladders in each year, that the fixed
production cost per ladder varies (P36 in Year 1 and P45 in Year 2). Fixed costs of goods
sold in Year 1 is computed as P36 × 9,000 units = P324,000. However, not all the ladders
produced in Year 1 were sold in Year 1. In Year 2 Quigley had 1,000 ladders in
beginning inventory from Year 1 and sold those ladders first. Quigley then produced
 another 8,000 ladders to support sales for the rest of Year 2. Hence, fixed costs of goods
sold in Year 2 is computed as (P36 × 1,000 units) + (P45 × 8,000 units) = P396,000.
3. It's important to see that fixed costs of goods sold on the absorption costing income
statement are treated as if fixed production costs are variable. As a result, despite the fact
that spending on fixed production costs is constant each year at P360,000 and sales
volume is constant each year at 9,000 ladders, the fixed cost of goods sold is different
each year, resulting in different operating incomes.
4. From a management perspective, it doesn't make sense that Quigley's operating income in
Year 1 is more than in Year 2. Sales prices and sales volumes are unchanged each year,
and production costs are constant at P100 per ladder (variable) plus P360,000 (total
fixed). The only factor affecting the change in Quigley's annual income is the difference
in production volume.

D. Alternatively, Quigley's variable costing (contribution margin) income statement is presented

below.

Quigley Ladders, Inc. (Variable Costing)

Year 1 Year 2 Total
Sales revenue P1,800,000 P1,800,000 P3,600,000
Variable cost of goods sold (900,000) (900,000) (1,800,000)
Contribution margin P900,000 P900,000 P1,800,000
Fixed costs of production (360,000) (360,000) (720,000)
Operating income P540,000 P540,000 P1,080,000

1. Sales revenue and variable cost of goods sold are consistent with Quigley's absorption
costing income statement. However, a fixed rate isn't used to assign fixed production
costs to the ladders produced and sold. Instead, total fixed costs are fully expensed each
year to the income statement.
2. Total operating profit for both years is P1,080,000, which is the same total operating
profit reported in Quigley's absorption costing income statement. However, as a result of
using the variable costing approach, Quigley's operating profit is constant year to year at
P540,000, which is appropriate since sales prices and volumes and production costs are
the same in each year.

E. We can reconcile the difference in Quigley's annual operating profits using the beginning and
ending inventory levels coupled with fixed production cost rates, as demonstrated below.
 Note: Monetary signs should be in PhP

1. In Year 1, Quigley's absorption costing income is P36,000 higher than its variable costing
income (P576,000 – P540,000). This is due to the fact that ending inventory in Year 1
absorbed P36,000 in fixed production costs onto the balance sheet, which reduced the
fixed costs that were expensed as cost of goods sold on the Year 1 absorption costing
income statement.
2. In Year 2, Quigley's absorption costing income is P36,000 lower than its variable costing
income (P504,000 – P540,000), which is explained by the fact that the fixed production
costs absorbed in Year 1 ending inventory are released as Year 2’s beginning inventory,
which is sold and reported on the Year 2 absorption costing income statement.

F. The situation described above, resulting in a P36,000 difference in income in each of Quigley's
two years, may not appear to be a very significant issue. Total income across both years
(P1,080,000) is the same in either case. The issue is simply a matter of timing from year to year,
and so you may be wondering how the “troubling incentive” mentioned earlier is a factor in
managing performance at Quigley Ladders, Inc.
1. It turns out that timing is quite important in performance measurement and incentives. If
the income statement used to measure and incentivize performance at Quigley is based on
absorption costing, then the reward on operating income performance will be higher in
Year 1 compared to the variable costing approach, and the reason will be because
management produced more inventory than the company sold. For most competitive
organizations, spending money to produce more than can be sold is generally not a
desirable outcome.
2. Coming into Year 2, it makes sense that management should reduce production in order
to reduce inventory. This is generally good management practice. However, reducing
inventory (i.e., producing less than is sold) is not rewarded on the absorption costing
income statement compared to the variable costing income statement. The performance
signal coming from the absorption costing income statement doesn't appear to align
management with the best interests of the organization.
IV. Troubling Incentives with Absorption Costing Income Statements
A. To demonstrate how troubling the management incentive can be with absorption costing income
statements, let's think about the pressure on management to increase operating income in Year 2.
If Quigley managers want to increase income, they obviously need to do one (or more) of three
things: increase sales price, increase sales volume, or decrease costs. But the absorption costing
income statement presents a fourth option to increase income, and that is to increase production!
B. Holding everything else constant (sales price, sales volume, and production costs), consider what
would happen if Quigley management chose to produce 12,000 ladders in Year 2 instead of 8,000
ladders. First, note below the effect on inventory and the fixed cost rate per ladder in Year 2
(differences from the original example are highlighted in yellow).

Quigley Ladders, Inc. (Changed Data)

Sales price per ladder P200
Variable production cost per P100
ladder
Annual fixed production costs P360,000
Units Sold Units Beginning Ending Fixed Rate per
Produced Inventory Inventory Unit
Year 1 9,000 10,000 0 1,000 P36.00

Year 2 9,000 12,000 1,000 4,000 P30.00

C. Using the change in the fixed cost rate for Year 2, the absorption costing income statement is
presented below along with the variable costing income statement (which is unaffected by the
fixed cost rate).

Quigley Ladders, Inc. (Absorption Costing)

Year 1 Year 2 Total
Sales revenue P1,800,000 P1,800,000 P3,600,000
Variable cost of goods sold (900,000) (900,000) (1,800,000)
Fixed costs of goods sold (324,000) (276,000) (600,000)
Operating income P 576,000 P 624,000 P1,200,000
Quigley Ladders, Inc. (Variable Costing)
Year 1 Year 2 Total
Sales revenue P1,800,000 P1,800,000 P3,600,000
Variable cost of goods sold (900,000) (900,000) (1,800,000)
Contribution margin P 900,000 P 900,000 P1,800,000
Fixed costs of production (360,000) (360,000) (720,000)
Operating income P 540,000 P 540,000 P1,080,000

D. By increasing (rather than decreasing) production and inventory by 2,000 ladders in Year 2,
managers are able to avoid a decrease in operating profit on the absorption costing income
statement. In fact, the combined income for both years will increase P120,000 on the absorption
costing income statement compared to the variable costing income statement (P1,200,000 –
P1,080,000). Again, we can reconcile this difference using beginning and ending inventory levels
coupled with the fixed production cost rates, as demonstrated below.

Note: Monetary signs should be in PhP

E. As you can see in the highlighted numbers above, the P120,000 difference in combined income
represents the Year 2 fixed production cost that has been absorbed to inventory on the balance
sheet at the end of Year 2. What happens when Quigley eventually reduces the 4,000 ladders in its
inventory? The absorbed costs will be released to the absorption costing income statement and the
reported operating income will be dramatically reduced. You can see that Quigley managers are
now “stuck” with inventory that they will be reluctant to reduce. This is the troubling incentive
 with using absorption costing income statements to plan, control, and evaluate operations within
organizations.

V. Other Computational Issues

A. There are two remaining computational issues with absorption costing income statements. First, as
illustrated earlier, there is a shortcut available to compute the effect of using absorption costing
when building income statements. This shortcut works when the fixed production cost rate per unit
is constant from year to year. We'll explore this shortcut in the practice problem at the end of this
lesson.
B. The other computational issue involves reconciling actual and applied manufacturing overhead in
the accounting system for absorption costing income statements. Most, if not all, of the fixed
production costs are found in the manufacturing overhead for the organization. Remember from
the previous lesson in both normal and standard cost accounting systems that manufacturing
overhead (MOH) is applied to the work-in-process inventory account. Actual fixed MOH costs do
not flow through the balance sheet, as demonstrated below.

1. Note that if applied MOH costs are more than actual MOH costs, then overhead has been
over-applied during the year and cost of goods sold will be too high on the income
statement. Conversely, if applied MOH is less than actual MOH, then overhead has been
under-applied and costs of goods sold will be too low.
2. To rectify the over-/under-applied overhead and adjust the income statement to report
actual costs, the difference in the manufacturing overhead account is closed out to the
cost of goods sold account (or is closed out proportionally to the inventory accounts and
the cost of goods sold account). The example used in this lesson did not have over-
/under-applied overhead. We'll explore this accounting process in the practice problem at
the end of the lesson.
 VI. Benefits and Limitations of Each System
A. Much of this lesson has focused on the limitations of using absorption costing income statements
to plan, control, and evaluate operations in organizations. However, both absorption costing
and variable costing have benefits and limitations.
B. As clearly demonstrated in this lesson, the absorption costing system creates a troubling incentive
in managers to overproduce and build inventory. On the other hand, by allocating fixed costs to
production, managers have a more complete measure of the full costs (i.e., full value) of inventory.
Financial reporting standards require a full cost valuation of inventory on the balance sheet, which
means absorption costing systems are necessary for external financial reporting.
C. Variable costing systems avoid the troubling incentive to overproduce and build inventory by not
accounting for fixed production costs as if they behave like variable costs. On the other hand, by
expensing all fixed cost spending to the income statement, inventory is undervalued on the balance
sheet. Managers need to be mindful of this undervaluation if inventory costs are used in decisions
such as pricing. Further, variable costing systems do not comply with external financial reporting
standards. Hence, organizations using variable costing systems for internal management purposes
will still need to use an absorption costing system for external financial reports.

VII. Practice Question

Return to the lesson example involving Quigley Ladders, Inc. Below are listed the sales price and
production costs for Quigley (price and costs are both budgeted and actual). Variable production costs are
all direct materials and direct labor. Fixed production costs are all manufacturing overhead (MOH).
Assume that normal production capacity for Quigley is 9,600 ladders per year and that Quigley uses this
normal production capacity to establish its fixed overhead rate at P37.50 per ladder (as shown below).
Quigley then experienced the following sales and production volumes in its first two years of business.

Quigley Ladders, Inc.

Sales price per ladder P200
Variable production cost per ladder P100
Annual fixed production costs P360,000
Normal production capacity 9,600 units
Fixed production rate per ladder P37.50
Units Sold Units Produced Beginning Inventory Ending Inventory
Year 1 9,000 10,000 0 1,000
Year 2 9,000 12,000 1,000 4,000

Requirements:
1. Quigley adjusts all of its over-/under-applied manufacturing overhead to cost of goods sold.
2. Compute Quigley's absorption costing income statement and variable costing income statement. Provide a
reconciliation between the two statements.