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Absorption and Variable Costing, and Inventory

Management
This chapter focuses on absorption and variable costing income statement is used to
organization information on cost behavior to facilitate performance evaluation.

LEARNING OBJECTIVES
LO1. Explain the difference between absorption and variable costing.
• Absorption costing treats fixed factory overhead as a product cost. Unit product cost
consists of direct materials, direct labor, variable factory over head, and fixed factory
overhead.
• The absorption-costing income statement groups expenses according to function:
o Production cost—cost of goods sold, including variable and fixed product cost.
o Selling expense—variable and fixed cost of selling and distributing product.
o Administrative expense—variable and fixed cost of administration.
• Variable costing treats fixed factory overhead as a period expense. Unit product cost
consists of direct materials, direct labor, and variable factory over head.
• The variable-costing income statement groups expenses according to cost behavior:
o Variable expenses of manufacturing, selling, and administration.
o Fixed expenses of manufacturing (fixed factory overhead), selling, and
administration.
• Impact of units produced and units sold on absorption-costing income and variable
costing income:
o If units produced > units sold, then absorption-costing income > variable-costing
income.
o If units produced < units sold, then absorption-costing income < variable-costing
income.
o If units produced ¼ units sold, then absorption-costing income ¼ variable-costing
income.
LO2. Prepare segmented income statements.
• Segments are subunits of a firm large enough to affect income.
o Products
o Divisions
o Geographical areas
o Any other type of important subunit
• Using a variable-costing income statement gives managers important information.
• Fixed expenses are divided into two parts.
o Direct fixed expenses (these would be eliminated if the segment is eliminated).
o Common fixed expenses (apply to two or more subunits).
• Segment margin (contribution margin minus direct fixed expense) is important for
evaluating subunits.
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LO3. Discuss inventory management under the economic order quantity and just-in-time
(JIT) models.
• EOQ balances the cost of ordering inventory with the cost of carrying inventory.
• Ordering cost is the cost of placing an order.
• Carrying cost is the cost of holding one unit in inventory for a year.
• At the EOQ, ordering cost equals carrying cost.
• Safety stock protects against running out of inventory due to uncertainty in demand.
• The EOQ approach uses inventory to solve problems:
o Uneven demand for the product
o Avoiding shutdown of factories
o Hedging against future price increases
o Taking advantage of discounts
• JIT models solve problems of uneven demand, production failures, and so on, without
using inventory.
o Long-term contracts
o Supplier relationships
o Reduce setup times to produce on demand
o Creation of manufacturing cells
o Maximizing quality and productivity

1. MEASURING THE PERFORMANCE OF PROFIT CENTERS USING

SEGMENTED INCOME STATEMENTS

A. Variable versus Absorption Costing

Profit centers are evaluated based on income (revenues minus expenses). However, how the
income is measured is important for evaluation purposes.
Two ways of calculating income are:
1. Variable costing: assigns only variable manufacturing costs to the product (direct materials,
direct labor, and variable manufacturing overhead).
2. Full or absorption costing: assigns all manufacturing costs to the product (direct materials,
direct labor, variable manufacturing overhead, and fixed manufacturing overhead).
Absorption costing is required for external financial reporting and income tax purposes.
Variable costing is used for internal reporting to management because it provides information
that is useful for planning, control, and decision making.
Product and period costs under absorption and variable costing are summarized below:
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Absorption Costing Variable Costing

Product costs: Direct Materials (DM) Direct Materials (DM)
Direct Labor (DL) Direct Labor (DL)
Variable Overhead (VOH) Variable Overhead (VOH)
Fixed Overhead (FOH)

Period costs: Variable selling Expenses Fixed Overhead (FOH)

Fixed Selling Expenses Variable Selling Expenses
Variable Administrative Expenses Fixed Selling Expenses
Fixed Administrative Expenses Variable Administrative Expenses
Fixed Administrative Expenses
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The following diagram illustrates the flow of manufacturing costs using absorption costing:
ABSORPTION COSTING
Work in Process Finished Goods Cost of Goods Sold

Direct
Materials

Direct
Labor

Variable
Manufacturing
Overhead

Fixed
Manufacturing
Overhead

The following diagram illustrates the flow of manufacturing costs using variable costing:
VARIABLE COSTING
Work in Process Finished Goods Cost of Goods Sold Period Cost

Direct
Materials

Direct
Labor

Variable
Manufacturing
Overhead

Fixed Expensed
Manufacturing as
Overhead Incurred
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B. Inventory Valuation
The main difference between the two methods relates to how fixed manufacturing overhead is
recorded.
• When using absorption costing, fixed manufacturing overhead is considered a product
cost, included in inventory and expensed when the inventory is sold. The formula is as
follows:
Absorption Costing Product Cost = Direct Materials + Direct Labor + Variable
Overhead +Fixed Overhead
• When using variable costing, fixed manufacturing overhead is considered a period cost
so thus is not included in inventory but is expensed in the period it is incurred. The
formula is as follows:
Variable Costing Product Cost = Direct Materials + Direct Labor + Variable
Overhead
The ending finished goods inventory values for absorption and variable costing will differ by the
amount of fixed manufacturing costs included in ending inventory.

C. Income Statements Using Variable and Absorption Costing

Under absorption costing, costs are classified by function as:
1. manufacturing costs (both fixed and variable)
2. selling and administrative costs (both fixed and variable).
The format used when costs are classified by function for absorption costing is:
Sales
– Cost of Goods Sold (Manufacturing Costs)
= Gross Margin
– Selling and Administrative Expenses
= Net Income

When variable costing is used, costs are classified by behavior as:

1. variable costs
• variable manufacturing
• variable selling and administrative.
2. fixed costs
• fixed manufacturing
• fixed selling and administrative.
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The format used for a variable-costing income statement follows:

Sales
– Variable Expenses:
Variable Cost of Goods Sold
Variable Selling and Administrative
= Contribution Margin
– Fixed Expenses:
Fixed Overhead
Fixed Selling and Administrative
= Net Income

D. Production, Sales, and Income Relationships

When sales equal production, income is the same under variable and absorption costing.
Production, sales, and income relationships are summarized below:
If Then
Production > Sales Absorption Net Income > Variable Net Income
Production < Sales Absorption Net Income < Variable Net Income
Production = Sales Absorption Net Income = Variable Net Income

The difference between absorption-costing income and variable-costing income results from
differences in the timing of the recognition of fixed manufacturing overhead costs as an expense.
Variable costing always recognizes the period’s fixed overhead as an expense.
Absorption costing recognizes as an expense only the fixed overhead attached to the units sold.
The difference in incomes can be calculated as the change in the number of units in inventory
multiplied by the fixed overhead rate per unit.
Absorption-Costing Variable-Costing Fixed Overhead Change in Total Units
– = ×
Income Income Rate in Inventory

Absorption-Costing Variable-Costing Fixed Overhead

– = × (Units Produced – Units sold)
Income Income Rate

E. Evaluating Profit-Center Managers

A manager’s performance is often evaluated based on the profit of the organizational units he or
she controls. In general, if a manager’s performance is evaluated based on income, then
managers have the right to expect the following (assuming all other things are equal):
1. If sales revenue increases, income should increase.
2. If sales revenue decreases, income should decrease.
3. If sales revenue remains the same, income should remain the same.
Variable costing always results in the expected association between sales and income.
Absorption income is affected by the level of inventory and does not always result in the expected
association between sales and income.
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2. SEGMENTED INCOME STATEMENTS USING VARIABLE COSTING

A segment is a subunit of an organization and can be a division, product line, sales territory, or
plant.
Segmented reporting is the process of preparing financial performance reports for segments
within a firm.
Segment reports can be prepared for any level of the organization: division, product line, plants
within a division, and so on.
Segmented reports prepared using variable costing produce better evaluations and decisions
than those prepared on an absorption-costing basis.
A comparison of the formats for a variable-costing income statement and a segmented income
statement using variable costing follows:
Variable-Costing Income Statement Variable-Costing Segmented Income Statement
Sales Sales
– Variable Expenses: – Variable Expenses:
Variable Cost of Goods Sold Variable Cost of Goods Sold
Variable Selling and Administrative Variable Selling and Administrative
= Contribution Margin = Contribution Margin
– Direct Fixed Expenses:
Direct Fixed Overhead
– Fixed Expenses: Direct Selling and Administrative
Fixed Overhead = Segment Margin (or Product Margin)
Fixed Selling and Administrative – Common Fixed Expenses:
Common Fixed Overhead
Common Selling and Administrative
= Net Income = Net Income

Direct fixed expenses are fixed costs that are directly traceable to a particular segment and
arise because of the existence of that segment.
Direct fixed expenses are avoidable because they would be eliminated or avoided if the
segment is eliminated.
Common fixed expenses are fixed costs that benefit more than one segment and are not
directly traceable to a particular segment. An example of a common fixed cost would be the
corporate president’s salary.
Common fixed costs continue to be incurred even if one of the segments is eliminated.
The segment contribution margin (sales less variable costs) provides information useful in
making short-run operating decisions such as accepting or rejecting orders at special prices.
Segment margin is the segment contribution margin remaining after covering the direct fixed
costs of the segment. Segment margin is the amount the segment contributes toward covering
the firm’s common fixed costs and generating profit. Thus, variable costing enables manage-
ment to evaluate each segment’s contribution to overall firm performance.
The segment margin (sales less variable costs less direct fixed costs) provides information
useful in assessing the long-run profitability of a segment.
If a segment does not affect the sales of other segments, the segment margin is the amount by
which the firm’s profits would change if the segment were eliminated.
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3. DECISION MAKING FOR INVENTORY MANAGEMENT

A. Inventory-Related Costs
Ordering costs are the costs of placing and receiving an order. Examples include the clerical
costs of processing an order, the cost of insurance for shipment, and unloading costs.
Setup costs are the costs of preparing equipment and facilities for production. Examples include
wages of idled production workers, lost income from idled production facilities, and the costs of
test runs (labor, materials, and overhead).
Carrying costs are the costs of carrying inventory, such as storage and handling costs, the
opportunity cost of funds invested in inventory, and insurance and taxes on the inventory.
Since both ordering costs and setup costs are costs of acquiring inventory, they are treated in
the same manner.
Stockout costs are the costs associated with having insufficient amounts of inventory. Stockout
costs include:
• lost sales (both current and future)
• costs of expediting (overtime or increased transportation costs)
• costs of interrupted production

B. Traditional Reasons for Holding Inventory

Traditional reasons for holding inventories are:
• to balance ordering or setup costs and carrying costs
• to satisfy customer demand (meet delivery dates)
• to avoid shutting down manufacturing facilities due to machine failure, defective or
unavailable parts, and/or late delivery of parts.
• to buffer against unreliable production processes
• to take advantage of discounts
• to hedge against future price increases.

C. Economic Order Quantity: The Traditional Inventory Model

An inventory policy addresses two questions:
• How much inventory should be ordered (or produced)?
• When should the order be placed (or the setup performed)?

Order Quantity and Total Ordering and Carrying Costs

The order quantity used should minimize the total cost of ordering and carrying inventory.
Total Inventory-Related Costs = Ordering Cost + Carrying Cost
= PD/Q + CQ /2
where CO = the cost of placing and receiving an order (or the setup cost for a production
run)
D = the known annual demand
Q = quantity (the number of units ordered each time an order is placed or the lot
size for a production run)
CC = the cost of carrying one unit of stock for one year
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The economic order quantity is the order quantity that minimizes the total cost.

D. Computing EOQ
The economic order quantity is calculated as:

EOQ = 2PD/C
The EOQ is the order size that results in ordering costs equaling carrying costs.
The economic order quantity model can also be used to determine the most economical size of
a production run. The only difference is that setup costs for starting a production run are
substituted for ordering costs.

E. Reorder Point
When to order (or setup for production) is an essential part of any inventory policy.
Reorder point is the point in time when a new order should be placed. It is a function of the
EOQ, 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
setup is started.
Reorder point is calculated as:
Reorder Point = Rate of Usage X Lead Time

F. EOQ and Inventory Management

The traditional approach to inventory management is called a just-in-case system.
The traditional manufacturing environment uses mass production of a few standardized
products that typically have a very high setup cost. The high setup cost encourages a large
batch size and long production runs. Diversity is viewed as being costly and is avoided.

G. Just-In-Time Approach to Inventory Management

Competitive pressures have led many firms to abandon the EOQ model in favor of a just-in-time
(JIT) approach to manufacturing and purchasing. JIT offers increased cost efficiency and
simultaneously has the flexibility to respond to customer demands for better quality and more
variety.
JIT (just-in-time) manufacturing is a demand-pull system. Products are produced only when
demanded by customers.
JIT purchasing occurs when parts and materials arrive just in time to be used in production.
Differences between JIT and traditional manufacturing are summarized on the following page.
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Manufacturing Systems

JIT Traditional

System: ◼ pull-through system based on demand ◼ push-through system

Inventory ◼ suppliers deliver parts just in time to be ◼ higher levels of inventory than JIT
effects: used in production
◼ inventory used as a buffer because of
◼ uses a few suppliers with long-term delayed reaction time
contracts
◼ greater number of suppliers with short-
term contracts

Plant layout: ◼ manufacturing cells consist of a set ◼ departmental structure with machines
of machines that produce a particular performing similar functions are located
product or product family together in a department
◼ multiskilled labor where workers are ◼ specialized labor where workers operate
trained to operate all machines within a specific machine
the cell
◼ requires less space and reduces lead
times

Grouping of ◼ service departments providing support ◼ service departments providing support

employees: services, such as materials stores, are services are centralized
reassigned to work with manufacturing
cells ◼ a central stores location handles
materials
◼ cell workers perform more of support
services, such as setup and preventive ◼ a central purchasing department places
maintenance all purchase orders for materials

Employee ◼ increased employee participation, which ◼ less participation by employees in

empowerment: increases productivity and cost efficiency management of organization
◼ input from employees is sought ◼ managers act as supervisors

◼ managers act as facilitators to develop

people and skills

Total quality ◼ poor quality cannot be tolerated without ◼ acceptable quality level (AQL) permits
control: inventories defects to occur as long as they do not
exceed a certain level
◼ quest for defective-free products

Traceability of ◼ uses more direct tracing of overhead ◼ relies more on driver tracing and
overhead costs: costs and less driver tracing and allocation
allocation
◼ use of manufacturing cells results in more
costs being directly traceable to products
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