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Cost Accounting

Chapter 9
Inventory Costing
and
Capacity Analysis
Session 7
Prof. Jorge Merladet

Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
 Notes
Absorption $/unit $ units
standard and Jan Feb March Selling price per unit 3,500
BOP 0 100 100 Var manuf costs 950
Variable Production 1,400 1,375 1,430 Var operating costs 725
Sales 1,300 1,375 1,455 Fixed manuf costs 350 490,000
accounting EOP 100 100 75 Fixed operating costs 120,000
Crystal Clear Corporation’s actual data Standard level of production 1,400
relating to January, February, and March
Allocation ----> Deviation or variance -----------> Adjustment
2017 are as follows: February Underallocation Unfavourable variance/deviation Add cost to compensate
January February March
March Overallocation Favorourable deviation Lower cost to compensate
Unit data
Beginning entry 0 100 100
Production 1,400 1375 1430
Sales 1,300 1375 1455
Variable costs
Manufacturing $ 950
cost per unit Variable Absorption
produced
Operating cost $725
Finished goods inventory Finished goods inventory
per unit sold
Fixed costs Jan Feb March Jan Feb March
Manufacturing $490,000 $490,000 $490,000 BOP 0 95,000 95,000 BOP 0 130,000 130,000
costs + COGM 1,330,000 1,306,250 1,358,500 + COGM
Operating costs $120,000 $120,000 $120,000
- COGS 1,235,000 1,306,250 1,382,250 - COGS
= EOP 95,000 95,000 71,250 = EOP 130,000 130,000 97,500

The selling price per unit is $3,500. The Income Income

budgeted level of production used to statement Jan Feb March statement Jan Feb March
calculate the budgeted fixed Revenues 4,550,000 4,812,500 5,092,500 Revenues 4,550,000 4,812,500 5,092,500
manufacturing cost per unit is 1,400 Variable cost of goods sold: Cost of goods sold:
units. There are no price-, efficiency-, or Beginning inventory 0 95,000 95,000 Beginning inventory 0 130,000 130,000
spending variances. Any production- Variable cost of manufacturing 1,330,000 1,306,250 1,358,500 Variable cost of manufacturing 1,330,000 1,306,250 1,358,500
U O
volume variance is written off to cost of COG available for sale 1,330,000 1,401,250 1,453,500 Fixed cost of manufacturing 490,000 481,250 500,500
Deduct: ending inventory 95,000 95,000 71,250 COG available for sale 1,820,000 1,917,500 1,989,000
goods sold in the month in which it
Variable cost of goods sold: 1,235,000 1,306,250 1,382,250 Deduct: ending inventory 130,000 130,000 97,500
occurs. Variable operating costs: 942,500 996,875 1,054,875 Adj. for product-vol variance 0
U
8,750
O
-10,500
Contribution margin 2,372,500 2,509,375 2,655,375 Cost of goods sold: 1,690,000 1,796,250 1,881,000
1. Prepare income statements for Crystal Gross margin 2,860,000 3,016,250 3,211,500
Clear in January, February, and March Fixed manufacturing costs 490,000 490,000 490,000 Variable operating costs 942,500 996,875 1,054,875

2017 under (a) variable costing and (b) Fixed operating costs 120,000 120,000 120,000 Fixed operating costs 120,000 120,000 120,000
Operating income 1,762,500 1,899,375 2,045,375 Operating income 1,797,500 1,899,375 2,036,625
absorption costing.

2. Explain the difference in operating

income under variable costing and
absorption costing.
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Some key ideas

Absorption (Actual) vs. Absorption (Standard/Normal)

• Normal costing implies that a “standard cost” or “normal cost” is computed

Normal costing temporarily assumes that
FMCU will be as in the Budget, and
computes the cost per unit manufactured

• For every period, Absorption computes the FMC of the period as a manufacturing
expense, as opposed to that Absorption Standard or Normal computes as
manufacturing cost…
FMCU x units produced

• And then, when it comes to COGS, at the end of the period, needs to adjust…
Adjustment = Actual FMC – Allocated FMC

• … which is called
Production-volumen Variance

• All the cost must be recorded at closing, how do you adjust?

COGS + PVV
If we allocated less FMC than the actual value, at the end of the period we need to compute the missing part of
the cost, we will add the underallocated difference to COGS (or other methods) 24
Absorption accounting: Normal or Actual?

Direct
Fixed Manufacturing Actual
costs

Indirect costs Variable Operating Normal

Actual Figures vs Normal Figures

Actual Normal
Wait Real time Adjust to be
Budget accounting real precise
until the end of the anticipates future
month, the quarter or quantities and prices
prices known, but at end of the
the year quantities unknown
period

Account at the
end of the 1. Forecast 2. Allocate 3. Adjust
period

COGS +
real quantities, FMCbudget / Adjustment
FMCallocated=
real prices unitsbudget in the income
statement

Adjustment:
FMCUbudget x FMCactual –
FMCUbudget unitsactual
FMCallocated
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Adjustment

Adjustment = FMC actual - FMC allocated

FMC
Actual

Underallocation Overallocation
or
(=unfavourable) (=favourable)
FMC
Allocated
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Inventory costing and capacity analysis

Main learning objectives

Absorption accounting & Variable accounting

Normal accounting in Absorption – Product-Volume

Variance

Reconcile results

Denominator Issues

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Mini-case Strassen Company

Reconciling Absorption and Variable
(read p.354-363)
Bla, bla, bla…

FMCbudget / Unitsbudget = FMCU budget

$ 1 080 000 / 8 000 units = 135 $/unit

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Now let’s think of two years

2020 2021
BOP 0 2 000
Produced 8 000 5 000
Sold 6 000 6 500
EOP 2 000 500

Mini-case Strassen Company
Capacity Issues (read p.354-363)
Strassen Company has annual budgeted fixed
manufacturing costs of $1,080,000. The budgeted
variable cost per unit is $200. Strassen currently
uses absorption costing (standard costing) for
external reporting and is now debating which
denominator-level concept to use. The following
are the denominator-level options that
management has been considering:
a. Theoretical capacity—based on two shifts,
completion of twenty-five units per shift, and a 360-
day year —25  2  360 = 18,000 units.
b. Practical capacity—theoretical capacity adjusted
for unavoidable interruptions, breakdowns, and so
forth — 20  2  300 = 12,000 units.
c. Normal capacity utilization—estimated at 10,000
units.
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d. Master-budget capacity utilization— at 8,000
telescopes per year, abnormally low, because their
main competitor has been spending a lot in
advertising.
Required:
1. Calculate the budgeted fixed manufacturing
overhead cost rates under the four denominator-
level concepts.
2. What are the benefits to Strassen, of using either
theoretical capacity or practical capacity?
3. Under a cost-based pricing system, what are the
negative aspects of a master-budget denominator
level? What are the positive aspects?
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Capacity levels
For standard / normal costing

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3. Under a cost-based
pricing system, what are
Capacity Level: the negative aspects of a
master-budget
Costing & Pricing, Capacity Utilisation denominator level? What
are the positive aspects?
denominator-level concepts.
fixed manufacturing overhead

C. Budget capacity: FMCU= $/u 135. If compared with

1. Calculate the budgeted

cost rates under the four

the cost at practical capacity, allows to subdivide the

fixed cost in each unit into the cost of supplying
capacity and the cost of excess capacity.
 FMCUBudget - FMCUPractical = cost of excess capacity
 $135- $ 90 = $45 per unit
 $45 per unit x 8,000 units delivered = $360,000
 to be found as an extra cost in each of the units manufactured

D. Alternatively, at practical capacity 4,000 units not sold

if compared with the standard level.
 Each unit carries FMCUPractical = $90
 8,000 units sold, 4,000 units below standard level
 $90 per unit x 4,000 units = $360,000 of production-volume variance.
 Working at practical capacity helps identify the cost of unused capacity
2. What are the benefits to

and helps using it for other production or eliminate it. Working at master
A. Theoretical: FMCU = $/u 60, unrealistic small cost,
Strassen, of using either
theoretical capacity or

capacity, passes on the cost to pricing.

idealistic, unattainable level of capacity. Not used
practical capacity?

for pricing.

B. Practical: maximum number of units that can be E. If competitors manage capacity more effectively: risk
produced. The cost of a unit, if working and full of downward spiral.
practical capacity, that is the minimal cost of
supplying capacity. FMCU= $/u 90.
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Capacity Level:
Performance, Financial Acc & Write-off
A. Performance evaluation: a mid level marketing
manager with no say in the decision to build long-term
capacity, should assess the cost of planed unused
capacity $360,000 as something outside his/her
scope, a cost for long term growth, while the rest,
$720,000 a cost of meeting his/her demand.

Assuming the budget is met, we will produce 8,000 units, check the
variance:
B. Financial reporting: the amount passed on to
inventory or shown as a cost of the period changes.

The production-volume variance will be different for different

denominator-levels used.
 Using practical capacity the variance matches the cost of unused
capacity.
 Using budget capacity the variance is zero and the extra cost is
passed on to the cost of each unit.
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Production variance and budget

Advantages and how to account for the variance

Production-Volume Variances can be accounted for by adjusting:

1. COGS (this is the default assumption in our course)

2. EOP of Inventories (Work-in-progress & Finished goods)

3. Prorrata COGS, FG, WIP (reference figure: final balances,

overheads in final balances…)

4. Recalculating all accounts

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Absorption and Normal Costing

Advantages and disadvantages

Advantages of Absorption Advantages of Normal costing vs.

costing vs Variable Acc: Absorption:

 Required for Financial  Interim accounting is

Accounting simpler and much quicker

 All the manufacturing cost  Identifies unused capacity

of a product (fixed+var) as a cost factor

Disadvantages: Disadvantages:

x It can incentivise to x Adjustment needed at

produce for the inventory closing
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Summary Capacity levels

Also called “denominator levels” because they are used to divide FMC by #units

18 000

12 000

10 000

8 000
1. Theoretical capacity (maximum possible output)

2. Practical capacity (discounting technical and human limitations)

3. Normal capacity (average demanded quantity over the years)

4. Budget capacity (expected sales for next year)

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What we learned today
Absorption accounting, standard accounting and budgeted FCU

Product-Volume Variance: causes, sign and accounting

Variable Accounting

Reconcile differences Absorption vs Variable

Capacity levels and usage

Remember: do Big Assignment 2a

Read Ch9: p.349-354 (Absorp & Var Acc), p. 364-372 (Capacity) & p. 358-361 Automakers

Groups presenting in Session 10, start working

Everyone: read Terminus Hotel (from syllabus) & submit you two pager on BB (one per
group) before 5 pm the previous day
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