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If the standards are not correct and up-to-date, they can
cause more harm than good. Nevertheless, actual costs
should be compared against benchmarks of performance. If
nothing else, current costs should be compared against past
performance. Many trade associations collect and publish
industry cost averages, which are helpful benchmarks for


Please refer again to Figure 18.1. Notice that the
$685 unit product cost includes $175 of fixed manufacturing
overhead costs. If the units are sold, the fixed overhead cost
ends up in the cost-of-goods-sold expense; if the units were
not sold then $175 fixed overhead cost per unit is included
in ending inventory. Inventory increased 1,000 units in this
example, so ending inventory carries $175,000 of fixed over-
head costs that will not be charged off to expense until the
products are sold in a future period. The inclusion of fixed
manufacturing overhead costs in inventory is called full-cost
absorption. This sounds very reasonable, doesn™t it?
Growing businesses need enough production capacity for
the sales made during the year and to increase inventory in
anticipation of higher sales next year. However, sometimes a
manufacturer makes too many products and production out-
put rises far above sales volume for the period, causing a
large increase in inventory”much more than what would be
needed for next year.
Suppose, for example, that the company had sold only
6,000 units during the year even though it manufactured
12,000 units. Figure 18.3 presents the profit and manufactur-
ing cost report for this disaster scenario. Notice that the com-
pany™s inventory would have increased by 6,000 units”as
many units as it sold during the year!
The inventory buildup could be in anticipation of a long
strike looming in the near future, which will shut down pro-
duction for several months. Or perhaps the company predicts
serious shortages of raw materials during the next several
months. There could be any number of such legitimate rea-
sons for a large inventory buildup. But assume not.
Instead, assume the company fell way short of its sales
goals for the year and failed to adjust its production output.
And assume the sales forecast for next year is not all that
encouraging. The large inventory overhang at year-end pres-
ents all sorts of problems. Where do you store it? Will sales
price have to be reduced to move the inventory? And what
about the fixed manufacturing overhead cost included in
inventory? This last question presents a very troublesome
accounting problem.


Management Profit Report for Year
Sales Volume = 6,000 Units
Per Unit Total
Sales revenue $1,400 $8,400,000
Cost-of-goods-sold expense ($ 685) ($4,110,000)
Gross margin $ 715 $4,290,000
Variable operating expenses ($ 305) ($1,830,000)
Contribution margin $ 410 $2,460,000
Fixed operating expenses ($2,300,000)
Operating profit (earnings before
interest and income tax) $ 160,000

Manufacturing Costs for Year
Annual Production Capacity = 12,000 Units
Actual Output = 12,000 Units
Basic Cost Components Per Unit Total
Raw materials $ 215 $2,580,000
Direct labor $ 260 $3,120,000
Variable overhead $ 35 $ 420,000
Fixed overhead $ 175 $2,100,000
Total manufacturing costs $ 685 $8,220,000

Distribution of Manufacturing Costs
11,000 units sold (see above) $ 685 $4,110,000
1,000 units inventory increase $ 685 $4,110,000
Total manufacturing costs $8,220,000
FIGURE 18.3 Excessive accumulation of inventory.

If only 6,000 units had been produced instead of the 12,000
actual output, the company would have had 50 percent idle
capacity”an issue discussed earlier in the chapter. By produc-
ing 12,000 units the company seems to be making full use of
its production capacity. But is it, really? Producing excessive
inventory is a false and illusory use of production capacity.
A good case can be made that no fixed manufacturing over-
head costs should be included in excessive quantities of inven-
tory; the amount of fixed overhead cost that usually would be


allocated to the inventory should be charged off as expense to
the period. Unless the company is able to slash its fixed over-
head costs, which is very difficult to do in the short run, it will
have these fixed overhead costs again next year. It should bite
the bullet this year, it is argued.
Assume the company will have to downsize its inventory
next year, which means it will have to slash production output
next year. Unless it can make substantial cuts in its fixed man-
ufacturing overhead costs, it will have substantial idle capac-
ity next year.
The question is whether the excess quantity of ending
inventory should be valued at only variable manufacturing
costs and exclude fixed manufacturing overhead costs. As a
practical matter, it is very difficult to draw a line between
excessive and normal inventory levels. Unless ending inven-
tory was extremely large, the full-cost absorption method is
used for ending inventory. The fixed overhead burden rate is
included in the unit product cost for all units in ending inven-

Manufacturers must determine their unit product costs; they
have to develop relatively complex accounting systems to keep
track of all the different costs that go into manufacturing their
products. Direct costs of raw materials and labor and variable
overhead costs are relatively straightforward. Fixed manufac-
turing overhead costs are another story. The chapter exam-
ines the problems of excess (idle) production capacity, excess
manufacturing costs due to inefficiencies, and excess produc-
tion output. Managers have to stay on top of these situations if
they occur and know how their unit product costs are affected
by the accounting procedures for dealing with the problems.

*One theory is that no fixed manufacturing overhead costs should be
included in ending inventory”whether normal or abnormal quantities are
held in stock. Only variable manufacturing costs would be included in unit
product cost. This is called direct costing, though more properly it should be
called variable costing. It is not acceptable for external financial reporting
or for income tax purposes.


Glossary for

accelerated depreciation (1) The estimated useful life of the fixed asset
being depreciated is shorter than a realistic forecast of its probable
actual service life; (2) more of the total cost of the fixed asset is allocated
to the first half of its useful life than to the second half (i.e., there is a
front-end loading of depreciation expense).

accounting A broad, all-inclusive term that refers to the methods and pro-
cedures of financial record keeping by a business (or any entity); it also
refers to the main functions and purposes of record keeping, which are
to assist in the operations of the entity, to provide necessary information
to managers for making decisions and exercising control, to measure
profit, to comply with income and other tax laws, and to prepare finan-
cial reports.

accounting equation An equation that reflects the two-sided nature of a
business entity, assets on the one side and the sources of assets on the
other side (assets = liabilities + owners™ equity). The assets of a business
entity are subject to two types of claims that arise from its two basic
sources of capital”liabilities and owners™ equity. The accounting equa-
tion is the foundation for double-entry bookkeeping, which uses a
scheme for recording changes in these basic types of accounts as either
debits or credits such that the total of accounts with debit balances
equals the total of accounts with credit balances. The accounting equa-
tion also serves as the framework for the statement of financial condi-
tion, or balance sheet, which is one of the three fundamental financial
statements reported by a business.


accounts payable Short-term, non-interest-bearing liabilities of a business
that arise in the course of its activities and operations from purchases on
credit. A business buys many things on credit, whereby the purchase
cost of goods and services are not paid for immediately. This liability
account records the amounts owed for credit purchases that will be paid
in the short run, which generally means about one month.

accounts receivable Short-term, non-interest-bearing debts owed to a
business by its customers who bought goods and services from the busi-
ness on credit. Generally, these debts should be collected within a month
or so. In a balance sheet, this asset is listed immediately after cash.
(Actually the amount of short-term marketable investments, if the busi-
ness has any, is listed after cash and before accounts receivable.)
Accounts receivable are viewed as a near-cash type of asset that will be
turned into cash in the short run. A business may not collect all of its
accounts receivable. See also bad debts.

accounts receivable turnover ratio A ratio computed by dividing annual
sales revenue by the year-end balance of accounts receivable. Technically
speaking, to calculate this ratio the amount of annual credit sales should
be divided by the average accounts receivable balance, but this informa-
tion is not readily available from external financial statements. For
reporting internally to managers, this ratio should be refined and fine-
tuned to be as accurate as possible.

accrual-basis accounting Well, frankly, accrual is not a good descriptive
term. Perhaps the best way to begin is to mention that accrual-basis
accounting is much more than cash-basis accounting. Recording only the
cash receipts and cash disbursement of a business would be grossly
inadequate. A business has many assets other than cash, as well as
many liabilities, that must be recorded. Measuring profit for a period as
the difference between cash inflows from sales and cash outflows for
expenses would be wrong, and in fact is not allowed for most businesses
by the income tax law. For management, income tax, and financial
reporting purposes, a business needs a comprehensive record-keeping
system”one that recognizes, records, and reports all the assets and lia-
bilities of a business. This all-inclusive scope of financial record keeping
is referred to as accrual-basis accounting. Accrual-basis accounting
records sales revenue when sales are made (though cash is received
before or after the sales) and records expenses when costs are incurred
(though cash is paid before or after expenses are recorded). Estab-
lished financial reporting standards require that profit for a period
must be recorded using accrual-basis accounting methods. Also, these


authoritative standards require that in reporting its financial condition a
business must use accrual-basis accounting.

accrued expenses payable The account that records the short-term, non-
interest-bearing liabilities of a business that accumulate over time, such
as vacation pay owed to employees. This liability is different than
accounts payable, which is the liability account for bills that have been
received by a business from purchases on credit.

accumulated depreciation A contra, or offset, account that is coupled
with the property, plant, and equipment asset account in which the origi-
nal costs of the long-term operating assets of a business are recorded.
The accumulated depreciation contra account accumulates the amount of
depreciation expense that is recorded period by period. So the balance in
this account is the cumulative amount of depreciation that has been
recorded since the assets were acquired. The balance in the accumulated
depreciation account is deducted from the original cost of the assets
recorded in the property, plant, and equipment asset account. The
remainder, called the book value of the assets, is the amount included on
the asset side of a business.

acid test ratio (also called the quick ratio) The sum of cash, accounts
receivable, and short-term marketable investments (if any) is divided by
total current liabilities to compute this ratio. Suppose that the short-term
creditors were to pounce on a business and not agree to roll over the
debts owed to them by the business. In this rather extreme scenario, the
acid test ratio reveals whether its cash and near-cash assets are enough


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