Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 1

How Do We Account for Inventory Changes?

The authors of this paper provide a method to incorporate both planned and unplanned changes in inventory levels (essentially, capacity usage) into the profit-variance model discussed in Chapters 14 and 15 of the text. As such, their reporting framework overcomes an inherent limitation of the basic model, which assumes that inventory changes are zero (or, insignificant in amount so that, for analytical purposes, they can be ignored).

How does the revised model presented by Balakrishnan and Sprinkle work? Essentially, we need to make two changes to the model presented in the text: one, prepare a flexible budget based on output (actual sales volume and mix) and the budgeted change in inventory; and two, include in all columns of the profitvariance report the cost of planned unused capacity. The difference between the master (static) budget column and the new flexible-budget column is the sales-volume variance, the difference between the two flexible-budget columns is equal to the inventory change variance, and the difference between the actual column and the variance. In each of the four columns of the variance-analysis report, the cost of unused capacity is divided between planned and unplanned idle capacity. (For additional details, refer to the original article.)

What additional insight does the revised model provide to managers? The authors argue that the revised profit-variance analysis is superior for three reasons: (1) the framework highlights the profit effects of producing for inventory; (2) the framework helps management disentangle the effects on profit of planned versus unplanned (i.e., a priori unanticipated circumstances) changes in inventory; and (3) flexible budget cost variances are computed using production volume, not sales volume. As such, the revised format can better assist managers in managing capacity-related costs. Finally, the revised reporting format facilitates performance evaluation by separating the profit impact attributable to planned and unplanned changes in inventory, sales volume, and capacity utilization.

Source: R. Balakrishnan and G. B. Sprinkle, “Integrating Profit Variances and Capacity Costing to Provide Better Managerial Information,” Issues in Accounting Education, no. 2 (May 2002), pp. 149–161.

Step 1 of 3

Profit variance analysis is the statement which shows the difference between the actual profit earned by company and the planned profit desired by the management or the decision makers.