chapter 8 w13
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Introduction to Management Accounting
Winter 2013
Teri Shearer
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ABSORPTION AND VARIABLE COSTINGINVENTORY MANAGEMENT
Chapter 8
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Absorption versus Variable costing
Recall that under Absorption costing, all manufacturing costs
must be treated as product costs and inventoried until the
related product is sold. This includes direct materials, direct
labour, variable overhead andfixed overhead
Absorption costing is required for financial reporting and for
tax reporting
Variable costing treats fixed manufacturing costs as period costs
to be deducted from income (expensed) in the period incurred
Under Variable costing, only direct materials, direct labour, and
variable overhead flow through the inventory accounts. Fixed
overhead is treated as an expense
Variable costing is useful for many internal purposes
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Inventory costs under Absorption Costing and Variable Costing
Information:Units in beginning inventory
Units produced
Units sold ($300 per unit)
Variable costs per unit:
Direct materials
Direct labour
Variable overhead
Fixed costs:Fixed overhead per unit produced
Fixed selling and administrative
0
10,000
8,000
$50
$100
$50
$25
$100,000
Example:
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Example, continued
Calculate units in Ending Inventory:
0
10,000
8,000
2,000
Finished Goods Inventory
Beg. Balance
Produced
Sold
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Cost of Ending InventoryAbsorption costing
Direct materials $ 50
Direct labour
Variable overheadFixed overhead
Unit product cost
100
50
$225
25
Value of ending inventory = 2,000 $225 = $450,000
Per unit
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Cost of Ending InventoryVariable costing
Direct materials
Direct labour
Variable overhead
Unit product cost
$ 50
100
50
$200
2,000 $200 = $400,000
When there are units in ending inventory, variable costing resultsin a lower ending inventory value than absorption costing
Only variable
costs
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Absorption costing Income Statement
Cost of goods
sold
Absorption
unit product
costUnits sold=
$225= 8,000
= $1,800,000
$50 + $100 + $50 + $25
First calculate Cost of Goods Sold:
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Absorption costing Income Statement, continued
Sales ($300 8,000)
Less: Cost of goods sold
Gross Margin
Less: Selling and administrative expenses
$2,400,000
1,800,000
$ 600,000
100,000
Net Income $ 500,000
Fixed selling and
administrative costs.
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Variable costing Income Statement
Cost of goods
sold
Variable unit
product costUnits sold=
$200= 8,000
= $1,600,000
$50 + $100 + $50
First calculate Cost of Goods Sold:
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Variable costing Income Statement, continued
Sales ($300 8,000)
Less variable expenses:
Variable cost of goods sold
$2,400,000
1,600,000
Contribution margin $ 800,000
Less fixed expenses:
Fixed overhead $250,000
350,000Fixed selling and administrative 100,000
$ 450,000Net Income
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Reconciling Absorption and Variable costing
If Production > Sales then Absorption income >
Variable income If Production < Sales then Absorption income Sales so Abs NI > Var NI by the $50,000 offixed overhead that was deferred in inventory underAbsorption costing
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Segmented Income Statements
Segment is a subunit of a company
divisions
departments
product lines
customer classes
Fixed expenses are broken down into twocategories:
direct fixed expenses directly traceable to a segment
common fixed expenses jointly caused by two or more segments
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Segment margin
Sales
Variable Cost of Goods Sold
Variable Selling Expense
Contribution Margin
Direct fixed overhead
Direct selling and administrative
Segment Margin
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Example: Segmented Income Statement
Information:
Sales
Variable cost of goods sold
Direct fixed overhead
150,000
20,000
MP3 Players DVD Players
$400,000 $290,000
200,000
30,000
Sales commissions, 5% of sales Direct fixed selling and administrative expense estimated:
$10,000 for the MP3 line
$15,000 for the DVD line
Common fixed overhead est., $100,000
Common selling and administrative est., $20,000
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Example, continued
Sales
Variable cost of goods soldVariable selling expense
(150,000)
MP3 Players DVD Players$400,000 $290,000
(200,000)(20,000)
Total$690,000
(350,000)
5% $290,000
(14,500)
Sales commissions = 5% of Sales
5% $400,000
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Example, continued
SalesVariable cost of goods sold
Variable selling expense
(150,000)
MP3 Players DVD Players
$400,000 $290,000(200,000)
(20,000)
Total
$690,000(350,000)
(14,500)
Contribution Margin
Less direct fixed expenses:Direct fixed overhead
Direct selling & admin.
(34,500)
$180,000 $125,500 $305,500
(30,000) (20,000) (50,000)
(10,000) (15,000) (25,000)
$140,000 $ 90,500 $230,500Segment margin
Segment margin reflects only those costs directly related to the
operation of the segment. Common costs are not included in the
segment margin
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Example, continued
Sales
Variable cost of goods soldVariable selling expense
(150,000)
MP3 Players DVD Players
$400,000 $290,000
(200,000)(20,000)
Total
$690,000
(350,000)
(14,500)
Contribution Margin
Less direct fixed expenses:
Direct fixed overhead
Direct selling & admin.
(34,500)
$180,000 $125,500 $305,500
(30,000) (20,000) (50,000)
(10,000) (15,000) (25,000)
$140,000 $ 90,500 $230,500Segment margin
Common fixed overheadCommon selling & admin.
Operating Income
(100,000)(20,000)
Less common fixed expenses:
$110,500
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Inventory Ordering and Carrying costs
Ordering costs: Costs of placing and receiving an order
Examples:
order processing costs
cost of insurance for shipment
unloading costs
Carrying costs: Costs of carrying inventory
Examples:
insurance
inventory taxes
obsolescence
opportunity cost of funds ties up in inventory, handlingcosts, and storage space
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Stockout costs
Occur when demand is not known
Costs of not having:
product available when demanded by a customer
raw materials available when needed for production
Examples: lost sales
costs of expediting orders
costs of interrupted production
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Traditional reasons for carrying inventory
To balance ordering or setup costs and carrying costs
To satisfy customer demand
To avoid shutting down manufacturing facilities because of:
Machine failure
Defective parts
Unavailable parts Late delivery of parts
To buffer against unreliable production processes
To take advantage of discounts
To hedge against future price increases
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Example: Calculating inventory related costs
Mall-o-Cars Inc. uses part X7B to repair water
pumps
10,000 units of part X7B are used each year currently purchased in lots of 1,000 units
cost of $25 to place an order
carrying cost is $2 per part per year
Information:
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Calculate number of orders per year:
10,000 parts needed per year / 1,000 parts in an order = 10
orders per year Calculate total ordering cost:
10 orders per year x $25 per order = $250
Calculate total carrying cost:
Find average number of units in inventory: 1,000 when anorder comes in + 0 when order is depleted / 2: 1000 + 0 / 2 =500 units
500 average units in inventory x $2 carrying cost per unit =$1,000
Calculate total inventory-related cost: $250 ordering cost +$1,000 carrying cost = $1,250
Example, continued
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Economic Order Quantity
Number of units in the optimal size order
Minimizes total inventory-related costs
Formula:
2 CO D/CC
Cost of placing one
order
Annual demand
in units
Cost of carrying one
unit in inventory
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EOQ for Mall-o-Cars Example
(2 $25 10,000) /$2=
= 500,000/2
= 500 units
Economic Order Quantity:
At the EOQ, total carrying costs and total order costs are equal
(in this case, $500 each, for total inventory costs of $1,000)
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Re-order point
Point in time when a new order should be placed
Function of: EOQ
Lead time
Rate at which inventory is used
Example: Mall-o-Cars Inc. 10,000 units of Part X7B are used each year
Used at a rate of 40 parts per day
Takes 5 days from time of order to arrival of order
Re-order point = 40 parts per day x 5 days lead time = 200;Mall-o-Cars should re-order when its inventory reaches 200units
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Safety stock and re-order point with safety stock
Mall-o-Cars Inc. uses Part X7B to repair water pumps 10,000 units of Part X7B are used each year
Used at an average rate of 40 parts per day
But some days as many as 50 parts are used
Takes 5 days from the time of order to the arrival of the order Safety stock = (max daily usage avg daily usage) x lead time
(50 max 40 avg) x 5 days = 50
Re-order point with safety stock:
Re-order point without safety stock plus safety stock = 200 + 50= 250, OR
Max daily usage x lead time = 50 x 5 days = 250
Example:
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Just-in-time production systems
Product pulled through production process by
present demand rather than on a fixed schedule based
on anticipated demand
Each operation produces only what is necessary to
satisfy the demand of the succeeding operation Reduces all inventories to very low levels
Reduces inventory carrying costs
Makes production very sensitive to supplier delays,production stoppages, etc.
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