Variable Costing Discussion Questions

Q1. What was the point of the Dead Duck Brewery illustration? (Hint: when to stop a product line or raise prices?)

Q2. Proponents of variable costing believe that having fixed cost per unit distorts the costing picture and results in inventory recessions. What is the downside of using variable costing?

Q3. What is the major difference between throughput variances and traditional flexible budget variances?

CHAPTER 9
Inventory Costing
and
Capacity Analysis
Inventory Costing Choices: Overview
• Absorption costing—product costs are
capitalized; period costs are expensed.
• Variable costing—variable product and period
costs are capitalized; fixed product and period
costs are expensed.
• Throughput costing—only direct materials are
capitalized; all other costs are expensed.
Costing Comparison
• Variable costing is a method of inventory
costing in which only variable manufacturing
costs are included as inventoriable costs.
• Absorption costing is a method of inventory
costing in which all variable manufacturing
costs and all fixed manufacturing costs are
included as inventoriable costs.
Differences in Income
• Operating income will differ between
absorption and variable costing.
• The amount of the difference represents the
amount of fixed product costs capitalized as
inventory under absorption costing, and
expensed as a period costs under variable
costing.
Comparative Income Statements
Comparative Income Statements—Three
Years
Comparative Income Effects
Are fixed product
costs inventoried?
Is there a
production-volume
variance?
Are classifications
between variable
and fixed costs
routinely made?
Variable Costing
Absorption Costing
No
Yes
No
Yes
Yes
Infrequently
Comparative Income Effects
Variable Costing
Absorption Costing
Production = Sales
Equal
Equal
Production > Sales
Lower
Higher
Production < Sales Higher Lower How do changes in unit inventory cost affect operating income if…? Comparative Income Effects What are the effects on costvolume-profit for a given level of fixed costs and a given contribution margin per unit? Variable Costing Absorption Costing Driven by: unit level of sales Driven by: Unit level of sales Unit level of production Chosen denominator level 1. 2. 3. Comparison of Alternative Inventory Costing Systems • Variable Direct Manufacturing Cost Actual Costing Actual prices X Actual quantity of inputs used Normal Costing Standard Costing Actual prices X Actual quantity of inputs used (c) 2012 Pearson Prentice Hall. All rights reserved. Standard prices X Standard quantity of inputs allowed for actual output achieved Comparison of Alternative Inventory Costing Systems • Variable Indirect Manufacturing Cost Actual Costing Normal Costing Standard Costing Actual variable indirect rates X Actual quantity of cost-allocation bases used Standard variable indirect rates X Standard quantity of cost-allocation bases allowed for actual output achieved Budgeted variable indirect rates X Actual quantity of cost-allocation bases used (c) 2012 Pearson Prentice Hall. All rights reserved. Comparison of Alternative Inventory Costing Systems • Fixed Direct Manufacturing Cost Actual Costing Actual prices X Actual quantity of inputs used Normal Costing Standard Costing Actual prices X Actual quantity of inputs used (c) 2012 Pearson Prentice Hall. All rights reserved. Standard prices X Standard quantity of inputs allowed for actual output achieved Comparison of Alternative Inventory Costing Systems • Fixed Indirect Manufacturing Cost Actual Costing Actual fixed indirect rates X Actual quantity of cost-allocation bases used Normal Costing Standard Costing Budgeted fixed indirect rates X Actual quantity of cost-allocation bases used (c) 2012 Pearson Prentice Hall. All rights reserved. Standard fixed indirect rates X Standard quantity of cost-allocation bases allowed for actual output achieved Performance Issues and Absorption Costing • Managers may seek to manipulate income by producing too many units. • Production beyond demand will increase the amount of inventory on hand. • This will result in more fixed costs being capitalized as inventory. • That will leave a smaller amount of fixed costs to be expensed during the period. • Profit increases, and potentially, so does a manger’s bonus. Inventories and Costing Methods • One way to prevent the unnecessary buildup of inventory for bonus purposes is to base manager’s bonuses on profit calculated using variable costing. • Drawback: complicated system of producing two inventory figures—one for external reporting and the other for bonus calculations. Other Manipulation Schemes Beyond Simple Overproduction • Deciding to manufacture products that absorb the highest amount of fixed costs, regardless of demand (“cherry-picking”) • Accepting an order to increase production, even though another plant in the same firm is better suited to handle that order • Deferring maintenance Management Countermeasures for Fixed Cost Manipulation Schemes • 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 Income Effects of Inventory Buildup Extreme Variable Costing: Throughput Costing • 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 operating expenses. Throughput Costing Illustrated Costing Systems Compared Example: Dead Duck Brewery Background • Brewery in CA • Specialty Brews • Existing reporting under traditional absorption costing • Direct labor traced to product lines • Products marketed through wholesale distributors • Selling and Admin costs allocated on sales dollars Background Continued • Three product line : - Dead Duck Pale Ale 1,000,000 gallons - Roadkill Red 10,000 gallons - Mallard Stout 10,000 gallons Dead Duck Brewery Traditional Income Statement For the year ended December 31, 2003 Total gallons sold: 1,000,000 DD Pale Ale Total (Per gallon) Revenue 10,000 Roadkill Red Ale Total (Per gallon) 10,000 Mallard Stout Total (Per gallon) Total $ 7,950,000 $ 7.95 $ 67,500 $ 6.75 $ 79,300 $ 7.93 $ 8,096,800 Cost of Goods Sold Direct Material Direct Labor Overhead Applied Total Cost of Goods Sold 4,200,000 300,000 1,500,000 6,000,000 4.20 0.30 1.50 6.00 32,000 3,000 15,000 50,000 3.20 0.30 1.50 5.00 43,000 3,000 15,000 61,000 4.30 0.30 1.50 6.10 4,275,000 306,000 1,530,000 6,111,000 Gross Margin 1,950,000 1.95 17,500 1.75 18,300 1.83 1,985,800 General and Administrative Administrative Marketing Depreciation Amortization Other Total General and Administrative 1,133,077 475,000 78,550 73,640 14,728 1,774,995 1.13 0.48 0.08 0.07 0.01 1.77 9,620 5,000 667 625 125 16,037 0.96 0.50 0.07 0.06 0.01 1.60 11,302 5,000 783 734 146 17,965 1.13 0.50 0.08 0.07 0.01 1.80 1,154,000 500,000 80,000 75,000 15,000 1,824,000 Net Operating Income $ 161,800 Highlights from Traditional Costing Gross Margin DD Pale Ale $1.95 per gallon Roadkill Red $1.75 per gallon Mallard Stout $1.83 per gallon Traditional Costing Tells management that DD Pale Ale costs $6.00 per gallon In a “price war”, management would view $6.00 per gallon as the price floor. Highlights from TOC • Throughput Margin - DD Pale Ale - Roadkill Red - Mallard Stout $3.75 per gallon $3.55 per gallon $3.63 per gallon All have a positive contribution margin TOC approach Tells management that DD Pale Ale costs $4.20 per gallon In a “price war”, management would view $4.20 per gallon as the price floor. Caution • In the 1960s, the adoption of variable costing vs. absorption costing lead to fierce price wars in industry • All costs become variable in the end and management’s focus only on current variable costs can lead to unfortunate choices ABC Approach Gross Margin DD Pale Ale $2.03 per gallon Roadkill Red $(2.32) per gallon Mallard Stout $(2.10) per gallon ABC Consultant’s Advice • Eliminate Roadkill Red and Mallard Stout and you will stem the loss of $38,237 and $38,965 per product line. • The net savings will be $78,202 In Reality, Economics Matter TOC tells you that the elimination of Roadkill Red and Mallard Stout will instead cause a decrease in operating profit of $31,360 The delta between the expectation of gaining $78,202 and losing an additional $31,360 is $109,562 Recap • ABC attributes a higher operating income to Dead Duck Pale Ale • TOC says that all products contribute to the fixed costs and the profit margin • Use a combination of ABC and TOC to decide if a product line should be eliminated or pricing adjusted