CHAPTER 9

INVENTORY COSTING AND CAPACITY ANALYSIS

9-18 (40 min.) Variable and absorption costing, explaining operating-income differences.

1. Key inputs for income statement computations are:

January February March

Beginning inventory 0 300 300
Production 1,000 800 1,250
Goods available for sale 1,000 1,100 1,550
Units sold 700 800 1,500
Ending inventory 300 300 50

The budgeted fixed manufacturing cost per unit and budgeted total manufacturing cost
per unit under absorption costing are:

January February March

(a) Budgeted fixed manufacturing costs $400,000 $400,000 $400,000
(b) Budgeted production 1,000 1,000 1,000
(c)=(a)÷(b) Budgeted fixed manufacturing cost per unit $400 $400 $400
(d) Budgeted variable manufacturing cost per unit $900 $900 $900
(e)=(c)+(d) Budgeted total manufacturing cost per unit $1,300 $1,300 $1,300

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 (a) Variable Costing
January 2007 February 2007 March 2007
Revenues a
$1,750,000 $2,000,000 $3,750,000
Variable costs
Beginning inventoryb $ 0 $270,000 $ 270,000
Variable manufacturing costsc 900,000 720,000 1,125,000
1,395,000
Cost of goods available for sale 900,000 990,000
Deduct ending inventoryd (270,000) (270,000) (45,000)
Variable cost of goods sold 630,000 720,000 1,350,000
Variable operating costse 420,000 480,000 900,000
Total variable costs 1,050,000 1,200,000 2,250,000
Contribution margin 700,000 800,000 1,500,000
Fixed costs
Fixed manufacturing costs 400,000 400,000 400,000
Fixed operating costs 140,000 140,000 140,000
Total fixed costs 540,000 540,000 540,000
Operating income $ 160,000 $ 260,000 $ 960,000

a $2,500 × 700; $2,500 × 800; $2,500 × 1,500

b $? × 0; $900 × 300; $900 × 300
c $900 × 1,000; $900 × 800; $900 × 1,250
d $900 × 300; $900 × 300; $900 × 50
e $600 × 700; $600 × 800; $600 × 1,500

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 (b) Absorption Costing

January 2007 February 2007 March 2007

Revenues a
$1,750,000 $2,000,000 $3,750,000
Cost of goods sold
Beginning inventoryb $ 0 $ 390,000 $ 390,000
Variable manufacturing costsc 900,000 720,000 1,125,000
Allocated fixed manufacturing
costsd 400,000 320,000 500,000
Cost of goods available for sale 1,300,000 1,430,000 2,015,000

Deduct ending inventorye (390,000) (390,000) (65,000)

Adjustment for prod. vol. var.f 0 80,000 U (100,000) F
Cost of goods sold 910,000 1,120,000 1,850,000
Gross margin 840,000 880,000 1,900,000
Operating costs
Variable operating costsg 420,000 480,000 900,000
Fixed operating costs 140,000 140,000 140,000
Total operating costs 560,000 620,000 1,040,000
Operating income $ 280,000 $ 260,000 $ 860,000
a
$2,500 × 700; $2,500 × 800; $2,500 × 1,500
b
$?× 0; $1,300 × 300; $1,300 × 300
c
$900 × 1,000; $900 × 800; $900 × 1,250
d
$400 × 1,000; $400 × 800; $400 × 1,250
e
$1,300 × 300; $1,300 × 300; $1,300 × 50
f
$400,000 – $400,000; $400,000 – $320,000; $400,000 – $500,000
g
$600 × 700; $600 × 800; $600 × 1,500

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2. –= –
January: $280,000 – $160,000 = ($400 × 300) – $0
$120,000 = $120,000
February: $260,000 – $260,000 = ($400 × 300) – ($400 × 300)
$0 = $0
March: $860,000 – $960,000 = ($400 × 50) – ($400 × 300)
– $100,000 = – $100,000
The difference between absorption and variable costing is due solely to moving fixed manufacturing costs into inventories as
inventories increase (as in January) and out of inventories as they decrease (as in March).

9-4
9-19 (20–30 min.) Throughput costing (continuation of Exercise 9-18).

1.
January February March
Revenuesa
Direct material cost of
goods sold $ 0 $1,750,000 $2,000,000 $3,750,000
Beginning inventoryb $150,000 $ 150,000
Direct materials in goods
manufacturedc 500,000 400,000 625,000
Cost of goods available
for sale 500,000 550,000 775,000
Deduct ending inventoryd (150,000) (150,000) (25,000)
Total direct material
cost of goods sold 350,000 400,000 750,000
Throughput contribution 1,400,000 1,600,000 3,000,000
Other costs
Manufacturinge 800,000 720,000 900,000
Operatingf 560,000 620,000 1,040,000
Total other costs 1,360,000 1,340,000 1,940,000
Operating income $ 40,000 $ 260,000 $1,060,000
a
$2,500 × 700; $2,500 × 800; $2,500 × 1,500
b
$? × 0; $500 × 300; $500 × 300
c
$500 × 1,000; $500 × 800; $500 × 1,250
d
$500 × 300; $500 × 300; $500 ×50
e
($400 × 1,000) + $400,000; ($400 × 800) + $400,000; ($400 × 1,250) + $400,000
f
($600 × 700) + $140,000; ($600 × 800) + $140,000; ($600 × 1,500) + $140,000

2. Operating income under:

January February March

Absorption costing $280,000 $260,000 $860,000
Variable costing 160,000 260,000 960,000
Throughput costing 40,000 260,000 1,060,000

Throughput costing puts greater emphasis on sales as the source of operating income than does absorption or variable costing.

3. Throughput costing puts a penalty on producing without a corresponding sale in the same period. Costs other than direct materials that
are variable with respect to production are expensed when incurred, whereas under variable costing they would be capitalized as an

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inventoriable cost.

9-6
9-27 (25 min.) Capacity usage of activities, alternative denominator-level capacities.

We can use the given information to calculate the cost allocation rate per unit of cost driver, for each of the two denominator-level
capacities.

Cost allocation rate based on

Denominator-level capacity denominator-level capacity
Activity Cost Cost Driver Theoretical Practical Theoretical Practical
(1) (2) (3) (4) = (1) �(2) (5) = (1) �(3)
Machine setup $500,000 Setup hours 5,000 4,500 setup hours $100.00 $111.111 per setup hour

Material handling $200,000 Material 100,000 95,000 material $2.00 $2.105 per material
pounds pounds pound

Quality Inspection $300,000 No. of 20,000 18,000 inspections $15.00 $16.667 per inspection
inspections

1. Using the theoretical-capacity based rates computed above, the activity costs for each product are shown
in the top panel of the table below. The lower panel provides the production volume variances. For each activity,
the total activity cost is greater than the allocated activity cost, leading to an unfavorable production volume
variance.

Costs Based on Theoretical Capacity

Setup MH Inspections
Setup Material Number of (4) = (1) � (5) = (2) � (6) = (3) �
Hours Pounds Inspections $100 per $2 per $15 per
Product (1) (2) (3) setup hr. matl. lb. insp.
Beachcomber 3,200 44,000 8,500 $320,000 $ 88,000 $127,500
Hilltop 1,400 41,000 10,000 140,000 82,000 150,000
Total activity cost allocated to Beachcomber and Hilltop 460,000 170,000 277,500
Total activity cost 500,000 200,000 300,000
Production volume variance = $ 40,000 $ 30,000 $ 22,500
(Total activity cost – Total activity cost allocated) Unfavorable Unfavorable Unfavorable

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 2. Using the computed practical-capacity based rates, the activity costs for each
product and the production-volume variances are shown in the table below. The cost of
material handling is greater than the allocated material handling cost, leading to an
unfavorable production volume variance for this activity. For the other two activities, the
total activity cost is less than the allocated activity cost, leading to a favorable production
volume variance.

Costs Based on Practical Capacity

Setup MH Inspections
Setup Material Number of (7) = (1) � (8) = (2) � (9) = (3) �
Hours Pounds Inspections $111.111 per $2.105 per $16.667 per
Product (1) (2) (3) setup hour matl. lb. inspection
Beachcomber 3,200 44,000 8,500 $355,555 $ 92,620 $141,669
Hilltop 1,400 41,000 10,000 155,555 86,305 166,670
Total activity cost allocated to Beachcomber and Hilltop 511,110 178,925 308,339
Total activity cost 500,000 200,000 300,000
Production Volume Variance = $ 11,110 $ 21,075 $ 8,339
(Total activity cost – Total activity cost allocated) Favorable Unfavorable Favorable

3. Theoretical capacity, based on producing at full efficiency all the time, is usually
unattainable, and as such, it results in unrealistically small fixed manufacturing cost rates
which are inherently not very useful for any of the purposes listed. Practical capacity, on
the other hand, factors scheduled maintenance, shutdowns for holidays, training time, etc.
Used as the denominator level, the practical capacity results in more realistic fixed
manufacturing cost rates than theoretical capacity for product costing, inventory
valuation, and external reporting. In the case of pricing decisions (and the related
downward demand spiral issue), the use of practical capacity (rather than other demand-
based capacity levels) also avoids the problem of recalculating unit costs when demand
levels change. Practical capacity, being realistic and controllable in the long run, is the
best denominator level to use to focus managers’ attention sharply on excess capacity. For
performance-evaluation purposes it is best to use practical capacity—theoretical capacity
would almost always result in large, not-economically-relevant production volume
variances. For tax-reporting purposes, in the U.S., the IRS requires the use of practical
capacity as the denominator level.

9-8
9-28 (15–20 min.) Capacity usage, cost behavior, service firm.
1. Calculations based on practical capacity

Practical capacity 100,000 bills

Total variable costs $ 75,000
Total fixed costs $200,000
Budgeted variable cost per bill (Total variable costs �practical capacity) $ 0.75
Budgeted fixed cost per bill (Total fixed costs �capacity) $ 2.00
Budgeted full cost per bill $ 2.75

2.
Practical capacity 100,000 bills
Capacity used in 2007 80,000 bills
Unused capacity in units 20,000 bills
Cost of unused capacity (Unused capacity �$2 budgeted fixed cost per unit) $40,000

None of the cost of unused capacity is attributable to variable costs. Variable costs, by
definition, vary with, or adjust to, the used capacity.

3. Calculations based on new denominator level of 80,000 bills

Denominator level 80,000
Total variable costs $ 75,000
Total fixed costs $200,000
Budgeted variable cost per bill
(Total variable costs �practical capacity) $ 0.75
Budgeted fixed cost per bill
(Total fixed costs �new capacity) $ 2.50
Budgeted full cost per bill $ 3.25

Note that the budgeted variable cost per bill is still $0.75 because the variable cost
of $75,000 was budgeted based on the practical capacity level of 100,000 bills.

4. A&S Security pays $3 per bill processed. It was a profitable customer at the
practical capacity of 100,000 units (payment per bill is greater than the full cost of $2.75
per bill), but it is not a profitable customer at the 80,000 units denominator capacity (full
cost is now $3.25 per bill). But, A&S work is 40% of the business. Losing it would mean
a downward spiral. Possible actions (medium-to-long term) are as follows:
 first conduct studies to ensure that 80,000 bills is the correct practical capacity
for the company
 pare down fixed costs (if 4 employees can do the job for fixed costs of
$160,000, then for a denominator capacity of 80,000 bills, the fixed cost per
bill will once again be $2.00)
 study the competition—if their prices are lower, how are they doing it?
 discuss with A&S—gradually raise prices
 raise prices and offer a value-added proposition to A&S which is relatively
“costless” to Finn & Sawyer (usually hard to do this).

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