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CHAPTER 15: ALTERNATIVE INVENTORY VALUATION METHODS

MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES

By Dennis Caplan PART 4: DETERMINING THE COST OF INVENTORY
CHAPTER 15: ALTERNATIVE INVENTORY VALUATION METHODS Chapter Contents:
Introduction Absorption Costing Variable Costing Absorption Costing and Variable Costing Compared Income Statement Presentation Absorption Costing and Generally Accepted Accounting Principles The Value Chain Throughput Costing

Introduction:
This chapter addresses the question: What costs are capitalized as the cost of inventory? In other words, what costs constitute the debit balance on the balance sheet for inventory, and the debit balance on the income statement for cost of goods sold? The answer to this question determines the extent to which the matching principle is honored for production costs. The following table illustrates three alternative rules for determining which costs are capitalized. All three are used in managerial accounting practice. The three methods are absorption costing, variable costing, and throughput costing. The colored bars identify the costs that each method capitalizes as inventory. Absorption Costing Variable Costing Throughput Costing

t Category

acturing overhead uring overhead cturing costs

Cost Classification Direct, variable costs Direct, variable costs Indirect, variable costs Indirect, fixed costs Direct and indirect, variable and fixed.

As the table indicates, non-manufacturing costs are never capitalized as part of the cost of inventory. The three methods differ with respect to their treatment of one or more categories of manufacturing costs, but they all agree that non-manufacturing costs should not be debited as part of the cost of inventory. For external financial reporting under Generally Accepted Accounting Principles, as well as for tax reporting, companies are
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required to use absorption costing (also called full costing). Hence, there is no choice from the above table for external financial reporting. For internal reporting purposes, survey data suggests that approximately half of manufacturing companies use absorption costing and approximately half use variable costing. Throughput costing is a relatively recent phenomenon, and does not seem to be used extensively yet.

Absorption Costing:
The theoretical justification for absorption costing is to honor the matching principle for all manufacturing costs. Fixed manufacturing overhead costs are only incurred with the expectation that the resources represented by these costs will be used in the production of inventory. Hence, these costs should be matched against the revenue generated from the sale of that inventory. Absorption costing requires computing an overhead rate for applying all manufacturing overhead to units produced during the period (or else two overhead rates, one for variable manufacturing overhead and one for fixed manufacturing overhead; or else multiple overhead rates if the company uses activity-based costing). There are important issues related to choosing the denominator in the overhead rate for fixed manufacturing overhead, which are discussed in the next chapter of this book.

Variable Costing:
The theoretical justification for variable costing is that fixed manufacturing overhead (FMOH) will be incurred in the short-run regardless of how much inventory is produced. In many companies, even if a factory is idle, a significant portion of the FMOH is unavoidable in the short run. For this reason, FMOH is treated as a period expense. Variable costing used to be called direct costing with some frequency, but less so today. Direct costing is a particularly confusing name, because the implication is that only direct manufacturing costs are capitalized, whereas in fact, variable manufacturing overhead is also capitalized. Even the name variable costing is perhaps less than ideal, because not all variable costs are capitalized: non-manufacturing costs are not capitalized as part of the cost of inventory under any circumstances. Under variable costing, the cost of ending inventory consists of direct manufacturing costs (usually materials and labor) and variable manufacturing overhead. Hence, these are the costs for which variable costing honors the matching principle, and nothing else is capitalized as part of the cost of inventory.

Absorption Costing and Variable Costing Compared:

The only difference between absorption costing and variable costing is the treatment of fixed manufacturing overhead (FMOH). Under absorption costing, FMOH is allocated to units produced, so that there is a little bit of FMOH included in the cost of every unit of inventory. Under variable costing, FMOH is treated as a period expense, appearing on the income statement as a lump-sum in the period incurred. Comparing income under absorption costing to income under variable costing, the following observations can be made: When there are beginning and ending inventories, absorption costing and variable costing will generally result in different inventory valuations for beginning inventory, different inventory valuations for ending inventory, and different net incomes, but it is possible for the inventory balances and net income to be the same under the two methods. If beginning and ending inventory levels are zero, absorption costing and variable costing will always result in the same net income. If beginning inventory is zero and ending inventory is positive, absorption costing will always result in higher net income than variable costing, and a higher valuation for ending inventory. If beginning inventory is positive and ending inventory is zero, absorption costing will always result in lower net income than variable costing, and a higher valuation for beginning inventory. When inventory levels are increasing from period-end to period-end, as would be expected when the
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company is growing, absorption costing will generally result in higher ending inventory valuations than variable costing, and also higher net income in each period. The reason is that absorption costing postpones recognizing ever-increasing amounts of fixed manufacturing overhead on the income statement, because increasing amounts of fixed manufacturing overhead are capitalized as ending inventory. Over the life of the company (or from any point in time at which there is zero inventory to any other point in time at which there is zero inventory), the sum of net income over all periods must be equal under the two methods. The difference between absorption costing and variable costing is only a timing difference: the question of when fixed manufacturing overhead is taken to the income statement.

Income Statement Presentation:

Absorption costing, variable costing and throughput costing are each associated with an income statement format: Absorption costing uses a gross margin income statement, which starts with revenues and subtracts cost of goods sold to derive gross margin, then subtracts non-manufacturing costs to derive operating income. Virtually every income statement presented in connection with external financial reporting uses a gross margin format. Gross margin income statements separate manufacturing costs from non-manufacturing costs, which is helpful for certain types of analyses. Variable costing uses a contribution margin income statement, which starts with revenues and subtracts variable costs (variable manufacturing costs related to units sold, plus all variable non-manufacturing costs) to derive contribution margin, then subtracts all fixed costs (manufacturing and non-manufacturing) to derive operating income. Contribution margin income statements facilitate cost-volume-profit analysis. It should be emphasized that under variable costing, not all variable costs appear on the income statement in the period incurred. Variable manufacturing costs that have been incurred to make inventory that hasnt been sold yet appear on the balance sheet as part of the cost of finished goods inventory. Throughput costing starts with revenues and subtracts direct material costs associated with units sold to derive throughput margin, then subtracts all other costs. These income statement formats do not define the costing methods. The costing methods are defined by which manufacturing costs are capitalized, as indicated in the table at the beginning of this chapter. It is possible, for example, to cost inventory and determine net income using the rules of absorption costing, but to then present the data in a contribution margin format by making certain reclassifications.

Absorption Costing and Generally Accepted Accounting Principles:

GAAP on the issue of absorption costing is old, and consequently, a little vague. Neither the Financial Accounting Standards Board, nor its predecessor, the Accounting Principles Board, has specifically addressed absorption costing in a broad-based way. Rather, each board incorporated GAAP that existed at the time the board was founded. Using this genealogy, GAAP for absorption costing can be traced at least as far back as Accounting Research Bulletin (ARB) No. 43, issued in 1953 by the Committee on Accounting Procedure (the predecessor to the Accounting Principles Board). Key provisions of ARB No. 43, Chapter 4 on inventory pricing, include the following: A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues. - ARB 43, Chapter 4, Statement No. 2 As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. - ARB 43, Chapter 4,
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Statement No. 3 The definition of cost as applied to inventories is understood to mean acquisition and production cost, and its determination involves many problems. Under some circumstances, items such as idle facility expense may be so abnormal as to require treatment as current period charges rather than as a portion of the inventory cost. - ARB 43, Chapter 4 Discussion of Statement No. 3 There is evidence that some companies take advantage of the flexibility that arises from the vagueness in GAAP to treat a portion of fixed manufacturing overhead as a period cost. The extent to which companies deviate from textbook absorption costing has been examined in two articles that appeared in Management Accounting, one by Michael Schiff (February 1987) and one by Steve Landekich (March 1973). An example of fixed overhead that some companies treat as a period expense, which has theoretical support from ARB 43, is factory depreciation related to excess manufacturing capacity. Another example, that seems justified by materiality and expediency rather than on theoretical grounds, is the decision not to allocate corporate service department costs. However, despite the exceptions found by Landekich and Schiff, it seems that most manufacturing companies honor the matching principle for most fixed manufacturing overhead costs for external financial reporting purposes.

The Value Chain:

The value chain is the sequence of activities that add value in a company. The following table provides a typical list of activities in the value chain of a manufacturing firm, although some manufacturers might outsource some of these activities. Value Chain for a Manufacturing Firm Research and development Manufacturing Marketing Distribution Sales Customer service For many industries, manufacturing costs constitute the majority of costs incurred in the value chain. For companies in these industries, the decision to capitalize most or all manufacturing costs as inventory, and to run these costs through the income statement when the related inventory is sold, provides the benefits of the matching principle that are discussed in introductory financial accounting courses. However, there are some industries in which manufacturing costs are small relative to one or more of the other activities in the value chain. For example, pharmaceutical companies incur large research and development (R&D) costs. Under all three costing methods that are discussed in this chapter, R&D does not become a part of the cost of inventory. In most situations, R&D is expensed when incurred for financial reporting purposes, which clearly fails to honor the matching principle in a significant way. Large expenditures are incurred and taken to the income statement for many years before any revenue is realized for that drug, and then after the drug is approved by the Food and Drug Administration, revenue is generated for many years with no directly-related offsetting R&D expenditures. The actual manufacturing cost of the drug can be quite small relative to the R&D expenditures that were incurred to bring the drug to market. Of course, the situation is somewhat more complicated for large pharmaceutical companies, because there are numerous drugs at various stages in their lifecycles, so that R&D on some projects offset revenue from drugs for which the R&D is already complete, and also, there are many R&D projects that never result in a saleable product. Another industry in which manufacturing costs are small relative to some of the other activities in the value chain is the soft drink industry. The ingredients and processes used in the manufacture of soft drinks are fairly inexpensive, and there are few barriers to entry. Consequently, soft drink companies spend large amounts on marketing and advertising. These marketing efforts are anticipated to provide long-term benefits by turning consumers into life-long Coca-Cola or Pepsi drinkers.
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However, these costs are not capitalized as part of the cost of inventory or as any other type of asset; rather, they are expensed when incurred (subject to the usual accrual accounting practices).

Throughput Costing:
Also called super-variable costing, throughput costing is a relatively new development. Throughput costing treats all costs as period expenses except for direct materials. In other words, the matching principle is honored only for direct materials. A company should probably meet two criteria before it chooses throughput costing. The first criterion relates to the nature of the manufacturing process. Throughput costing only makes sense for companies engaged in a manufacturing process in which most labor and overhead are fixed costs. Assembly-line and continuous processes that are highly automated are most likely to meet this criterion. For example, thirty factory employees might be required to work a given shift, regardless of whether the machinery is set at full capacity or less. The second criterion is that management prefers cost accounting information that is helpful for short-term, incremental analysis, such as whether the company should accept a one-time special sales order at a reduced sales price. In this respect, a companys choice of throughput costing is a logical extension of the companys choice of variable costing over absorption costing. Eliyahu Goldratt, who developed the theory of constraints, advocates throughput costing in his popular business novel The Goal. Although throughput costing has not gained wide acceptance, Goldratts support for it has been influential.

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