Cornerstones: of Managerial Accounting, 6e

CORNERSTONES
of Managerial Accounting, 6e
CHAPTER 8:
ABSORPTION AND VARIABLE
COSTING, AND INVENTORY
MANAGEMENT
Cornerstones of Managerial
Accounting, 6e
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Learning Objectives
1. Explain the difference between absorption and
variable costing.
2. Prepare segmented income statements.
3. Discuss inventory management under the
economic order quantity and just-in-time (JIT)
models.
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. LO-1
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.
LO-1
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. LO-1
Variable Costing
 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.
LO-1
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.
LO-1
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.
LO-1
Cornerstone 8.1
Computing Inventory Cost
Under Absorption Costing
LO-1
Cornerstone 8.1
Under Absorption Costing (cont.)
LO-1
Cornerstone 8.2
Under Variable Costing
LO-1
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.
LO-1
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.
LO-1
Cornerstone 8.3
Preparing An Absorption Costing Income
Statement
LO-1
Cornerstone 8.4
Preparing a Variable-Costing Income
Statement
LO-1
Production, Sales, and Income Relationships
The relationship between variable-costing income and

absorption-costing income changes as the relationship
between production and sales changes.
LO-1
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.
LO-1
Evaluating Profit-Center
Managers (cont.)
 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.
LO-1
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. LO-2
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.
LO-2
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.
LO-2
Cornerstone 8.5
Preparing a Segmented Income Statement
LO-2
Cornerstone 8.5
Preparing a Segmented Income Statement
(cont.)
LO-2
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?
LO-2
Using Segmented Income Statements
to Make Decisions (cont.)
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.
LO-2
Comparison of Segmented
Income Statement With and Without
Allocated Common Fixed Expense
LO-2
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.
LO-3
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.
LO-3
Inventory-Related 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.
LO-3
Traditional Reasons
for Carrying Inventory
LO-3
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.
LO-3
Economic Order Quantity:
The Traditional Model (cont.)
 The formulas for calculating these are as follows:
LO-3
Cornerstone 8.6
Calculating Ordering Cost, Carrying Cost, and Total
Inventory-Related Cost
LO-3
Cornerstone 8.6
Calculating Ordering Cost, Carrying Cost, and Total
Inventory-Related Cost
LO-3
Average Inventory
 The average amount in inventory is the maximum
plus the minimum divided by two.
Average Inventory = (Max amount + Min amount)
2
LO-3
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).
LO-3
The Economic Order
Quantity (cont.)
 Since EOQ is the quantity that minimizes total
inventory-related costs, a formula for computing it
is:
LO-3
Cornerstone 8.7
Calculating Economic Order Quantity (EOQ)
LO-3
Cornerstone 8.7
Calculating Economic Order Quantity (EOQ)
LO-3
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.
LO-3
Reorder Point (cont.)
 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
LO-3
Cornerstone 8.8
Calculating The Reorder Point When Usage Is
Known with Certainty
LO-3
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 - Average x Lead time

daily usage daily usage
LO-3
Cornerstone 8.9
Calculating Safety Stock and
the Reorder Point with Safety Stock
LO-3
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.
LO-3
Economic Order Quantity and
Inventory Management (cont.)
 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.
LO-3
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.
LO-3
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.
LO-3
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.
LO-3
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.
LO-3
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.
LO-3
Limitations of Just-in-Time
Approach (cont.)
 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.
LO-3

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CORNERSTONES

Generally accepted accounting principles (GAAP) require absorption costing for

The only difference between the two approaches is the

The relationship between variable-costing income and

You are the Financial Vice President for Folsom Company,

Should you drop Gamma? Will income go up if you do?

Reorder point = Rate of usage X Lead time

Safety stock = Maximum - Average x Lead time

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