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Chapter 9 Income Effects of Alternative Inventory Costing Models Copyright © 2003 Pearson Education Canada Inc. Slide 7-97 Absorption Costing Absorption costing income statement • also called full costing • classify costs based on functions • inventory composed of variable and fixed production costs • net income is function of sales and production Revenue Manufacturing costs Contribution margin Marketing costs Operating income Copyright © 2003 Pearson Education Canada Inc. Pages 313 - 316 Slide 7-98 Variable Costing Variable costing income statement • also called direct costing • classify costs based on behaviour • inventory composed of variable production costs only • net income is a function of sales Revenue Variable costs Contribution margin Fixed costs Operating income Copyright © 2003 Pearson Education Canada Inc. Pages 313 - 316 Slide 7-99 Comparing the Two Income Statements • Difference in net income between a variable costing income statement and an absorption costing income statement is due to the treatment of fixed manufacturing costs • Fixed manufacturing costs are treated as a period cost under variable costing • Fixed manufacturing costs are treated as an inventoriable (product) cost under absorption costing Copyright © 2003 Pearson Education Canada Inc. Pages 316 - 318 Slide 7-100 How the Two Income Statements Differ Variable Absorption Revenue Revenue Manufacturing costs Variable costs Contribution margin Fixed costs Operating income Copyright © 2003 Pearson Education Canada Inc. Fixed Manufacturing Overhead Costs Gross margin Marketing costs Operating income Pages 316 - 318 Slide 7-101 Converting Between the Two Statements Direct operating income - absorption operating income = Fixed manufacturing costs in ending inventory - fixed manufacturing costs in beginning inventory = (200 x $16) - (0 x $16) = $3,200 or = (Units produced - units sold) x fixed manufacturing cost rate = (600 - 400) x $16 = $3,200 or = (Ending inventory units - Beginning inventory units) x fixed manufacturing cost rate = (200 units - 0 units) x $16 = $3,200 Copyright © 2003 Pearson Education Canada Inc. Pages 319 - 321 Slide 7-102 Performance Evaluation – Absorption • One of the problems with absorption costing that managers can increase operating income in the short run by increasing production independent of sales • The additional units produced absorb some of the fixed costs which are carried forward on the balance sheet rather than being expensed on the income statement • Therefore • carefully monitor inventory levels • consider a charge for the amount of inventory carried (1% x value of inventory on hand) • evaluate performance over longer periods Copyright © 2003 Pearson Education Canada Inc. Pages 321 - 324 Slide 7-103 Throughput Costing • Throughput costing (or super-variable costing) treats all costs except those related to variable direct materials as costs of the period in which they were incurred • only variable direct material costs are inventoriable • since all other production-related costs are expensed on the income statement, management is less motivated to increase inventories (shifting costs from the income statement to the balance sheet) • reducing inventory levels means less funds are tied up in inventory Copyright © 2003 Pearson Education Canada Inc. Pages 325 - 326 Slide 7-104 Capacity Concepts • Many different numbers can be used as “capacity” under absorption costing Theoretical capacity – ideal situation with 100% efficiency Practical capacity – recognize that some downtime is unavoidable Normal capacity – the average output level over a 2-3 year period Budgeted capacity – expected output for the next year Copyright © 2003 Pearson Education Canada Inc. 1,152,000 bottles 800,000 bottles 500,000 bottles 400,000 bottles Pages 328 - 333 Slide 7-105 Capacity and Absorption Costing • Using theoretical capacity or practical capacity as the denominator reduces the amount of fixed manufacturing overhead assigned to inventory and increases the production volume variance • Canada Customs and Revenue Agency (CCRA) does not allow the use of theoretical or practical capacity in determining taxable income • When considering which denominator to use keep in mind that the resultant cost information will be used for product costing and capacity management, pricing, performance evaluation, and forecasting Copyright © 2003 Pearson Education Canada Inc. Pages 328 - 333 Slide 7-106