So, during 2007, there was a drop of 20,000 units in inventory levels (matching the 20,000 more
units sold than produced). The smaller the denominator level, the larger is the budgeted fixed
cost allocated to each unit of production, and, when those units are sold (all the current
production is sold, and then some), the larger is the cost of each unit sold, and the smaller is the
operating income. Normal utilization capacity is the smallest capacity of the three, hence in this
year, when production was less than sales, the absorption-costing based operating income is the
smallest when normal capacity utilization is used as the denominator level.
4.
Reconcilation
Theoretical Capacity Operating Income
–
Practical Capacity Operating Income
$40,000
Decrease in inventory level during 2007
20,000
Fixed mfg cost allocated per unit under
practical capacity
–
fixed mfg. cost allocated
per unit under theoretical capacity ($12
–
$10)
$2
Additional allocated fixed cost included in COGS
under practical capacity = 20,000 units
$2 per unit =
$40,000
More fixed manufacturing costs are included in inventory under practical capacity, so, when
inventory level decreases (as it did in 2007), more fixed manufacturing costs are included in
COGS under practical capacity than under theoretical capacity, resulting in a lower operating
income.

9-38
9-37
(20
–
35 min.)
Effects of denominator-level choice.
1.
Normal capacity utilization.
Givens denoted*
Actual Costs
Incurred
(1)
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(2)
Flexible Budget:
Same Budgeted
Lump Sum
(as in Static Budget)
Regardless of
Output Level
(3)
Allocated:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(4)
$130,000
$120,000*
$120,000*
70,000 hrs.* × $2.00
a
= $140,000
$10,000 U*
$20,000 F*
Spending variance
Never a variance
Prodn. volume variance
Production,volume,variance
=
Error!
–
$20,000
=
($120,000
–
X)
X
=
$140,000
Budgeted fixed manufacturing,overhead rate per unit
=
$140,000
70,000 machine-hours
=
$2 per machine-hour
Denominator level
=
$120,000
$2
=
60,000 machine-hours

9-39
2.
Practical capacity.
Givens denoted*
Actual Costs
Incurred
(1)
Same Lump Sum
(as in Static Budget)
Regardless of
Budgeted Output
Level
(2)
Flexible Budget:
Same Lump Sum
(as in Static Budget)
Regardless of
Budgeted Output
Level
(3)
Allocated:
Budgeted Input
Allowed for
Actual Output
× Budgeted Rate
(4)
$130,000
$120,000*
$120,000*
70,000* × $1.20
a
= $84,000
$10,000 U*
$36,000 U*
Spending variance
Never a variance
Prodn. volume variance
Production-volume,variance
=
Error!
$36,000
=
($120,000
–
X)
X
=
$84,000
Budgeted manufacturing,overhead rate per unit
=
$84,000
70,000 machine-hours
=
$1.20 per machine-hour
Denominator level
=
$120,000
$1.20
=
100,000 machine-hours