Cost Chapter 9

comparing income statement for multiple years 3

-BI + COGM = COGS + EI -instead of original absorption formula, can do absorption op income - variable op income = fixed manu costs inventoried in units produced absorption - fixed manu in COGS absorption -managers take pressure to reduce inventory- use just in time production -as inventory reduced, op income dif of variable and absorption become immaterial

absorption costing and performance measurement

-absorption is required inventory method for external financial reporting in most countries -absorption enables managers to increase margins/op income by producing more EI- justified when rapid growth in demand and firms want additional units to protect from shortages -managers tempted to produce inventory even when they don't anticipate consumer demand to grow- because leads to higher op income so more bonus for managers and will increase stock price so increases managers stock based compensation *but higher taxes for comp could be unethical, risky

absorption costing

-all VC manu and FC manu inventoriable, absorbs all manu costs -ex. job costing system -all nonmanu costs in value chain are period costs

how can managers increase current profits by overproducing

-all manu costs tied to products, units that we don't sell absorb full manu costs- absorption- every unit absorbs total manu costs per unit- total variable and fixed manu for EI -managers can reduce per unit FC by producing more units- if don't sell units, then they go to bal sheet -FC per unit decreases when you produce more -when COGS down then NI increasing -manipulating op income by overproducing -makes yourself look better in short term by overproducing -costs will end up in op income in long term anyways -by overproducing, COGS lower and NI higher

variable costing info

-all variable manu costs (direct and indirect) are inventoriable costs, fixed manu costs excluded from inventoriable costs- they are period -imprecise because variable non manu costs are treated as period -called direct costing -considers MOH VC as inventoriable but excludes direct marketing costs- imprecise

advantages of absorption costing

-already GAAP-fufills GAAP requirements -treat all manu costs as product costs- use for long term to set prices- helps in long term for strategic decisions, use unit manu costs to set prices

chart dif variable and absorption

-are fixed manu costs inventoried: no for V and yes for A -is there a production volume variance: no for V and yes for A -are classifications between variable and fixed costs routinely made: yes for V and infrequently for A -what are the effects on cost volume profit relationship (for a given level of fixed costs and a given CM per unit): driven by unit level of sales for V and driven by unit level sales/unit level of production/chosen denominator level look at chart

how can managers increase current profits

-by overproducing -over production means: production > (sales + optimal EI)

absorption costing and performance measurement 2

-comps use variable costing for internal reporting to reduce undesirable incentives to build up inventory *important for short run decision making -comps can use both methods- VC short run/performance eval and absorption for long run decisions -most orgs use absorption, but a lot use variable as secondary

comparing variable and absorption

-dif for VC and absorption is accounting for fixed manu costs: for variable fixed manu are period and for absorption fixed manu are inventoriable

profit centers

-evaluated based on profits which are computed according to GAAP rules

chart dif variable and absorption 2

-how do changes in unit inventory levels affect op income: *for production equal=sales: equal for both V and A *for production > sales: V is lower and A is higher *for production < sales: V is higher and A is lower

disadvantages of absorption costing

-incentives for managers to overproduce

comparison of alternative inventory costing methods 2

-managers have to allocate costs related to manu and non manu -indirect costs that are incident/necessary to production/manu is inventoriable for tax purposes only if it is treated as inventoriable for the purposes of financial reporting -full absorption method

absorption: undesirable build up of inventory

-op income changes when production levels change -called producing for inventory ---> increases EI in next year to increase the years op income by producing for inventory -limits to how much inventory can be increased over time because of physical constraints- reduces likelihood of incurring absorption undesirable effects -managers have incentive to move costs in/out of inventory to manage op income under absorption -top managers should implement checks and balances

absorption formula info

-op income same if no change in EI -if sales= production (no change EI) then income under variable and absorption is the same -absorption always higher income when inventory increasing, opposite if inventory decreasing

variable costing and the effect of sales production on op income

-period to period changes in op income under variable costing is driven solely by changes in quantity of units actually sold -chang in variable op income= CM per unit x change in quantity of units sold -absorption enables managers to increase op income by increasing unit level of sales and producing more units

throughput costing

-some argue that only DM are truly variable in output -throughput costing/super variable costing= extreme form variable costing where only DM costs are included as inventoriable costs- all of there costs are costs of the period in which they are incurred, variable DM and MOH are period -revs - all DM cost of goods sold -only DM cost per unit inventoriable -largest amount of expenses in current periods income statement -less incentive to produce for inventory especially than absorption and also variable -not as widely used

variable costing

-treats all fixed manu costs as period costs to be expensed in the period incurred -a method of costing in which only variable manu costs are included as inventoriable costs (not GAAP) -can't do variable costing for managers and for financial reporting because not GAAP so have to have 2 sets of books

absorption v variable: differences

-under absorption, fixed manu costs are inventoriable are expensed in the period goods are sold -under variable costing, fixed manu costs are treated as period costs and expensed in the period incurred -fixed manu costs will eventually be expensed under both methods- the dif is the timing of the expense*******

problem with variable costing: classifying fixed v variable overhead

-under both absorption and variable, managers have an incentive to defer costs by getting more costs into EI rather than COGS in current period -to defer costs under variable costing, managers can classify more overhead as variable rather than fixed so that variable costs per unit increases

comparison of alternative inventory costing methods

-variable controversial because of how it affects external reporting *people who think it should be used for this say that fixed manu costs is more closely related to the capacity to produce than to actual production of specific units so FC expensed -if support absorption for external, say inventories should carry fixed a fixed manu cost component because VC manu costs and fixed manu costs necessary to produce goods *both types of costs inventoried *for external, comps follow GAAP that all manu costs inventoriable

comparing income statements 2

-variable manu cost: for variable and absorption is inventoriable -fixed manu costs: for variable it is period and absorption it is inventoriable- divide by number of units -if inventory levels change, op income will differ between the 2 methods because of the dif in accounting for fixed manu costs *if same number of units produced and sold, same NI because inventory levels unchanged

absorption v variable: similarities

-variable manu costs are inventoriable and expensed in period goods are sold

comparing income statements

-variable uses CM income statement format -absorption uses gross margin format -absorption does not need to differentiate between VC and FC -op income higher under absorption because not all fixed manu costs expensed

comparing income statement for multiple years

-whenever production differs from denominator level, there is a production volume variance- calc by doing fixed manu rate x dif in actual v denominator level -denominator level is budgeted- dif between actual fixed manu total v budgeted fixed manu total -due to production volume variance, absorption will be lower even though sold more -production volume variance does not occur under variable costing

comparing income statement for multiple years 2

-why do variable and absorption have dif op income numbers: *if inventory increases during a period, less op income will be reported under variable than absorption *if inventory decreases, more op income reported under variable than absorption *dif due to moving fixed manu costs into inventories as inventories increase and moving fixed manu costs out of inventories ad inventories decrease under absorption

to reduce over production, 3 ways to modify the performance evaluation system

1. inventory holding charge against profit (common, easy to calc): charge segments of your comp inventory charges 2. change (lengthen) the period used to evaluate performance 3. use variable costing- managers can still overproduce but they will not benefit personally as over-production under variable costing will not increase current op income- most common- do CM income statement- fixed manu cost is a period cost not product cost

3 reasons many comps use absorption costing for internal accounting

1. it is cost effective and less confusing for managers to use one common method of inventory costing for both internal and external and performance eval 2. it can help prevent managers from taking actions that make their performance measure look good but that hurt the income they report to shareholders 3. it measures the cost of all manu resources, whether variable or fixed, necessary to produce inventory *many comps use inventory costing info for long run decisions, such as pricing and choosing a product mix *for these long run decisions, inventory costs should include both variable and fixed costs

FG t chart

D BI D COGM D EI C COGS

absorption formula

absorption OI - variable OI = fixed manu costs in EI - fixed manu costs in BI

absorption: undesirable build up of inventory: ways in which a manager can produce for inventory that may not be easy to detect (3)

look at pg.340

proposals for revising performance eval

look at pg.340 -top management would want to see production equal to sales and relatively stable levels of inventory- report for each product manufactured and sold