Class 3:

Inventory Valuation

ACCT 4200 | University of Iowa | Professor Quinto 1 / 20

 Variable and Absorption Costing
Variable costing: A method of inventory costing in which all variable
manufacturing costs (direct and indirect) are included as product costs; all fixed
manufacturing costs are excluded from product costs and are instead treated as
costs of the period in which they are incurred

Absorption costing: A method of inventory costing in which all variable

manufacturing costs and all fixed manufacturing costs are included as product
costs; that is, inventory “absorbs” all manufacturing costs

The main difference between Variable Costing and Absorption

Costing is the accounting for fixed manufacturing overhead
ACCT 4200 | University of Iowa | Professor Quinto 2 / 19
 Why Do We Need to Allocate Fixed
Manufacturing Overhead (FMOH)?
➢ Required by GAAP (and IFRS)
o Absorption Costing aka Full Costing
aka Gross Margin Format
➢ Allocation of FMOH to
individual units of each product
is required to determine the The matching
Financial Accounting
value of inventory principle states
that all expenses
o Matching principle ⇒ A product’s value must be matched
should be the sum of the costs of Direct to the revenues
Materials, Direct Labor, and the they help to
Manufacturing Overhead that it uses up generate

ACCT 4200 | University of Iowa | Professor Quinto 3 / 20

 Absorption Costing: Example
Item Amount Income Statement
Sales
Opening inventory 0
Less: Cost of goods sold
Units made 20,000
Gross margin
Units sold 17,000 Less: SG&A expenses
Selling price per unit $690 Net income (loss)
Variable materials cost per unit $295
Variable labor cost per unit $75
Variable SG&A expenses per unit sold $24 Cost of goods sold SG&A expenses

Total FMOH $2,800,000 DM Variable SG&A

Total fixed SG&A expenses $2,520,000 DL

Fixed SG&A
FMOH
SG&A expenses
Note: Costs are allocated based on number of units Cost of goods sold

ACCT 4200 | University of Iowa | Professor Quinto 4 / 20

 Absorption Costing: Example
Item Amount Balance Sheet
Inventory
Opening inventory 0
Units made 20,000
Units sold 17,000 Inventory
DM per unit
Selling price per unit $690
DL per unit
Variable materials cost per unit $295
FMOH per unit
Variable labor cost per unit $75
Inventoriable cost per unit
Variable SG&A expenses per unit sold $24
x Units in ending inventory
Total FMOH $2,800,000
Inventory cost
Total fixed SG&A expenses $2,520,000

Note: Costs are allocated based on number of units

ACCT 4200 | University of Iowa | Professor Quinto 5 / 20

 Absorption Costing: Example
Units produced FMOH
Units in FMOH allocated
Inventory, to Inventory,
3,000 , 15% $420,000 , 15%

Units in FMOH allocated

COGS, to COGS,
17,000 , 85% $2,380,000 , 85%

ACCT 4200 | University of Iowa | Professor Quinto 6 / 20

 Internal Reporting of FMOH
➢ For internal reporting purposes, a firm might use a different
method
➢ For example, a firm might immediately expense FMOH, rather
than allocating it to individual units
aka Direct Costing
o This method is known as Variable Costing
aka Contribution Margin Format
• Not permitted under GAAP

o Recognizes the non-controllability of FMOH in the short term

o May be useful from a decision-making perspective (at least in the short run)

ACCT 4200 | University of Iowa | Professor Quinto 7 / 20

 Variable Costing: Example
Item Amount Income Statement
Sales
Opening inventory 0
Less: Variable costs
Units made 20,000
Contribution margin
Units sold 17,000 Less: Fixed costs
Selling price per unit $690 Net income (loss)
Variable materials cost per unit $295
Variable labor cost per unit $75
Variable SG&A expenses per unit sold $24 Variable costs Fixed costs

Total FMOH $2,800,000 DM Fixed MOH

Total fixed SG&A expenses $2,520,000 DL Fixed SG&A

Variable SG&A Fixed costs

Note: Costs are allocated based on number of units
Drives the difference in net
Variable costs
income under Absorption
Costing vs. Variable Costing
ACCT 4200 | University of Iowa | Professor Quinto 8 / 20
 Variable Costing: Example
Item Amount Balance Sheet
Inventory
Opening inventory 0
Units made 20,000
Units sold 17,000 Inventory
DM per unit
Selling price per unit $690
DL per unit
Variable materials cost per unit $295
Inventoriable cost per unit
Variable labor cost per unit $75
x Units in ending inventory
Variable SG&A expenses per unit sold $24
Inventory cost
Total FMOH $2,800,000
Total fixed SG&A expenses $2,520,000

Note: Costs are allocated based on number of units

ACCT 4200 | University of Iowa | Professor Quinto 9 / 20

 Variable Costing: Example
Units produced FMOH
Units in FMOH allocated
Inventory, to Inventory, $0 ,
3,000 , 15% 0%

Units in FMOH allocated to

COGS, COGS, $2,800,000 ,
17,000 , 85% 100%

ACCT 4200 | University of Iowa | Professor Quinto 10 / 20

Reconciling Absorption and Variable Costing

Reconciliation
Net income under Variable Costing
Add: FMOH costs in Ending Inventory*
Less: FMOH costs in Beginning Inventory
Net income under Absorption Costing
Timing difference

*FMOH costs in Ending Inventory

Units in ending inventory
FMOH per unit
FMOH costs in Ending Inventory

ACCT 4200 | University of Iowa | Professor Quinto 11 / 20

Reconciling Absorption and Variable Costing
If Inventory … Then Why?
Increases AC net income > VC net income Under AC, we put some current-period FMOH into
(production > sales) inventory. Conversely, under VC, we expense all
current-period FMOH. Therefore, AC has less FMOH
expensed in the income statement than VC.

No change AC net income = VC net income There is no change in the amount of FMOH in
(production = sales) inventory. Therefore, the amount of FMOH expensed
in the income statement is the same under AC and VC.

Decreases AC net income < VC net income Under AC, we expense FMOH from prior periods when
(production < sales) the inventory is sold. Therefore, under AC, we expense
all current-period FMOH as well as some prior-period
FMOH. Conversely, under VC, we only expense
current-period FMOH. Consequently, AC has more
FMOH expensed in the income statement than VC.

Note: These relations may not hold 100% of the time in a multi-product company

ACCT 4200 | University of Iowa | Professor Quinto 12 / 20

 Absorption & Variable Costing: Practice
Year 1 Year 2
Bhattacharya Inc. manufactures lighting fixtures for
Beginning inventory (units) 0
sale in big-box stores such as Walmart and Home
Depot. The tabulated data pertain to its operations Units produced 2,000 1,700
in the most recent two years. Units sold 1,800

Required: Prepare an income statement for Ending inventory (units) 0

Bhattacharya Inc. using the following methods:
1) Absorption Costing Per unit
2) Variable Costing Selling price $120
Then, reconcile the two net incomes. Variable manufacturing costs $40

Hint: Assume that … Variable SG&A $30

• Overhead is allocated based on number of units FMOH $42,500
• All overhead is fixed Fixed SG&A $35,000
• The overhead rate is computed annually

ACCT 4200 | University of Iowa | Professor Quinto 13 / 20

 Absorption & Variable Costing: Practice
Income Statement: Absorption Costing Year 1 Year 2
Year 1 Year 2
Beginning inventory (units) 0
Sales
Units produced 2,000 1,700
Less: Cost of goods sold
Gross margin Units sold 1,800
Less: SG&A expenses Ending inventory (units) 0
Net income (loss)
Per unit
SG&A expenses
Selling price $120
Cost of goods sold Year 1 Year 2
Variable manufacturing costs $40
Year 1 Year 2 Variable SG&A
Variable SG&A $30
Variable
manufacturing Fixed SG&A FMOH $42,500
SG&A expenses Fixed SG&A $35,000
FMOH

Cost of goods sold

ACCT 4200 | University of Iowa | Professor Quinto 14 / 20

 Absorption & Variable Costing: Practice
Income Statement: Variable Costing Year 1 Year 2
Year 1 Year 2
Beginning inventory (units) 0
Sales
Units produced 2,000 1,700
Less: Variable costs
Contribution margin Units sold 1,800
Less: Fixed costs Ending inventory (units) 0
Net income (loss)
Per unit
Variable costs
Selling price $120
Year 1 Year 2
Fixed costs Variable manufacturing costs $40
Variable
manufacturing Year 1 Year 2 Variable SG&A $30
Fixed MOH FMOH $42,500
Variable SG&A
Fixed SG&A Fixed SG&A $35,000
Variable costs Fixed costs

ACCT 4200 | University of Iowa | Professor Quinto 15 / 20

Absorption & Variable Costing: Practice
Reconciliation Year 1 Year 2
Net income under Variable Costing
Add: FMOH costs in Ending Inventory*
Less: FMOH costs in Beginning Inventory
Net income under Absorption Costing

*FMOH costs in Ending Inventory Year 1 Year 2

Units in ending inventory
FMOH per unit
FMOH costs in ending inventory

ACCT 4200 | University of Iowa | Professor Quinto 16 / 20

The Effect of Absorption Costing on Incentives

➢ Both sales and production affect net income

➢ The manager can increase income in the current period by
increasing production
o More overhead is assigned to inventory instead of being reported as expenses
in the current period
o But the effect is temporary—overhead in inventory is expensed when the
inventory is sold

⇒ Absorption costing may contribute to managerial myopia,

where long-term value is sacrificed to meet short-term goals

ACCT 4200 | University of Iowa | Professor Quinto 17 / 20

The Effect of Absorption Costing on Incentives

➢ “Earnings slightly less than zero

occur much less frequently than
would be expected given the
smoothness of the remainder of
the distribution,” Burgstahler
and Dichev (1997)
o Suggests that managers engage in
earnings management to meet
earnings targets

ACCT 4200 | University of Iowa | Professor Quinto 18 / 20

 The Effect of Absorption Costing on
Incentives
➢ How can we control the incentive to over-produce?
o Complicated issue because it’s difficult to discern whether inventory is being
built up because:
1. The manager is acting opportunistically, i.e., over-producing to boost current-period profits
2. The manager is acting in the interests of the company, i.e., producing the correct amount
of inventory to meet future demand

o Some ideas:

ACCT 4200 | University of Iowa | Professor Quinto 19 / 20

 Before Our Next Class …

➢ Read Chapter 4

➢ Print notes on ICON

ACCT 4200 | University of Iowa | Professor Quinto 20 / 20