Inventory Costing

and
Capacity Analysis

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1. Identify what distinguishes variable costing
from absorption costing
2. Compute income under variable costing and
absorption costing and explain the
difference in income
3. Understand how absorption costing can
provide undesirable incentives for
managers to build up inventory
4. Differentiate throughput costing from
variable costing and absorption costing

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5. Describe the various capacity concepts that
firms can use in absorption costing
6. Examine the key factors managers use to
choose a capacity level to compute the
budgeted fixed manufacturing cost rate
7. Understand other issues that play an
important role in capacity planning and
control

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The inventory
costing system that
is chosen
determines which
manufacturing costs
are treated as
inventoriable costs.
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The denominator-
level capacity
choice focuses on
the cost allocation
base used to set
budgeted fixed
manufacturing cost
rates.
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 Variable costing—a method of inventory
costing in which all variable manufacturing
costs (direct and indirect) are included as
inventoriable costs. (Also known as direct
costing)
 Absorption costing—a method of inventory
costing in which all variable and fixed
manufacturing costs are included as
inventoriable costs. You can say that
inventory “absorbs” all manufacturing costs.
 Throughput costing—only direct materials are
capitalized; all other costs are expensed.
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 Operating income will differ between
absorption and variable costing.
 The amount of the difference represents the
amount of fixed manufacturing costs
capitalized as inventory under absorption
costing and expensed as a period cost under
variable costing.
 If inventory levels change, operating income
will differ between the two methods because
of the difference in accounting for fixed
manufacturing costs.
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Absorption costing is the required inventory
method for external financial reporting in
most countries. Also preferred because:
 It is cost-effective and less confusing.
 It can help prevent managers from taking
actions that make their performance
measure look good but that hurt the
income they report to shareholders.
 It measures the cost of all manufacturing
resources (variable or fixed) necessary to
produce inventory.

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 One unfavorable attribute of absorption
costing is that it enables managers to
increase margins and, therefore, operating
income, by producing more ending
inventory.
 Producing for inventory can be justified
when rapid growth is forecasted, but
should not be undertaken simply to boost
profits.
 To reduce an undesirable buildup of
inventory, companies can use variable
costing for internal reporting purposes
including performance measurement.

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To reduce the undesirable effects of absorption
costing, management can:
 Focus on careful budgeting and inventory
planning.
 Incorporate an internal carrying charge for
inventory
 Change (lengthen) the period used to evaluate
performance.
 Include nonfinancial as well as financial variables
in the measures to evaluate performance.
(compare ratio of ending/beginning inventory to
ratio of units produced/sold)

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 Throughput costing (super-variable costing) is a
method of inventory costing in which only direct
material costs are included as inventory costs.
All other product costs are treated as period
expenses.
 Throughput margin equals revenues minus all
direct material cost of the goods sold.

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We have concluded the discussion of inventory
costing and will begin capacity analysis.

Given a firm’s level of spending on fixed

manufacturing costs, what capacity level
should managers and accountants use to
compute the fixed manufacturing cost per
unit?

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Spending on fixed manufacturing costs enables
firms to obtain the scale or capacity needed to
satisfy the expected market demand from
customers. Determining the “right” amount of
spending, or the appropriate level of capacity, is
one of the most strategic and most difficult
decisions managers face.

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Spending on fixed manufacturing costs enables
firms to obtain the scale or capacity needed to
satisfy the expected market demand from
customers. Determining the “right” amount of
spending, or the appropriate level of capacity, is
one of the most strategic and most difficult
decisions managers face.
Too much capacity means firms will incur the
cost of unused capacity; having too little means
that demand from some customers may be
unfulfilled.
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 The choice of the capacity level used to
allocate budgeted fixed manufacturing costs
to products can greatly affect operating
income.
 Four different capacity levels can be used as
the denominator to compute the budgeted
fixed manufacturing cost rate:
 Theoretical capacity
 Practical capacity
 Normal capacity utilization
 Master-budget capacity utilization
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 Theoretical capacity is the level of capacity
based on producing at full efficiency all the
time.
 It is theoretical in the sense that it does not
allow for any slowdowns due to plant
maintenance, shutdown periods or
interruptions because of downtime.
 In the real world, theoretical capacity levels
are unattainable but they represent the ideal
goal of capacity utilization a company can
aspire to.
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Practical capacity is the level of capacity that
reduces theoretical capacity by considering
unavoidable operating interruptions like
maintenance and holiday shutdowns.

Engineering and human resource factors are

important when estimating theoretical or
practical capacity.

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Both theoretical and practical capacity
measure capacity levels in terms of what a
plant can supply.
Normal Capacity Utilization and Master-Budget
Capacity Utilization, in contrast, measure
capacity levels in terms of demand for the
output of the plant.
It is possible and even likely that budgeted
demand will be below production capacity
levels.

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 Normal capacity utilization is the level of
capacity utilization that satisfies average
customer demand over a period that is long
enough to consider seasonal, cyclical and
trend factors.
 Master-budget capacity utilization is the
level of capacity utilization that managers
expect for the current budget period which is
typically one year.

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The choice of capacity level can have a huge
impact on budgeted fixed manufacturing cost
per unit as shown here:

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The choice of denominator-level capacity to
use may differ based on the purpose for which
the choice is being made. Some of those
purposes include:
1. Product costing and capacity management
2. Pricing
3. Performance evaluation
4. External reporting
5. Tax requirements

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 For product costing and capacity
management, using practical capacity as the
denominator level sets the cost of capacity
at the cost of supplying the capacity,
regardless of demand for the capacity.
 Highlighting the cost of capacity acquired
but not used directs managers’ attention
toward managing unused capacity.
 In contrast, using either of the capacity
levels based on demand hides the amount of
unused capacity.
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 To understand the best choice for pricing
decisions, let’s look first at the downward
demand spiral for a company. It is the
continuing reduction in the demand for its
products that occurs when competitor prices
are not met, demand drops further and the
fixed costs are spread over fewer units,
resulting in greater and greater costs per
unit.
 Practical capacity, by contrast, is a more
stable measure. It calculates the fixed cost
rate based on capacity available rather than
capacity used to meet demand.
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 Unused capacity adds costs to products.
 Mid-level managers have no control over
those costs but do have control over prices.
 Should the marketing managers be held
accountable for the manufacturing overhead
costs unrelated to their potential customer
base? (practical capacity vs master-budget
capacity utilization)
 Where there are large differences between
practical capacity and master-budget
capacity utilization, that difference is often
classified as planned unused capacity.
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 The magnitude of the favorable/unfavorable
production-volume variance under absorption
costing is affected by the choice of the
denominator level used to calculate the
budgeted fixed manufacturing cost per unit.
 Recall from Chapter 4 that the production-
volume variance can be disposed of three
ways:
 Adjusted allocation-rate approach (recalculate at
year end)
 Proration approach (spread to Work-In-Process,
Finished Goods and Cost of Goods Sold)
 Write-off to Cost of Goods Sold.
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The objective in choosing the method to
dispose of the production-volume variance is
to write-off the portion of the variance that
represents the cost of capacity not used to
support the production of output during the
period.
That objective is also helpful in determining
which capacity should be used to develop the
budgeted fixed manufacturing cost per unit.

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 The IRS permits the use of practical capacity
to calculate budgeted fixed manufacturing
costs per unit AND allows for the write-off of
the production-volume variance generated
this way.
 The tax benefit can be significant

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A few other factors should be taken into
account when planning capacity levels and in
deciding how best to control and assign
capacity costs. They are:
1. Difficulty of obtaining demand-side
denominator-level concepts
2. Difficulty of forecasting fixed
manufacturing costs
3. Capacity issues for nonmanufacturing parts
of the value chain
4. In ABC Costing, a capacity level must be
chosen for each cost driver
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TERMS TO LEARN PAGE NUMBER REFERENCE
Absorption costing Page 330
Direct costing Page 329
Downward demand spiral Page 346
Master-budget capacity Page 344
utilization
Normal capacity utilization Page 344
Practical capacity Page 344
Super-variable costing Page 341
Theoretical capacity Page 343
Throughput costing Page 341
Variable costing Page 329

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