Few numbers capture the attention of managers and shareholders more than operating profits reported in the firm’s income statement.

In industries that require significant upfront investments in capacity, two key decisions have a substantial impact on a company’s financial accounting profits: (1) the amount of money a firm spends on fixed investments and (2) the extent to which the firm eventually utilizes capacity to meet customer demand. Unfortunately, the compensation and reward systems of a firm, as well as the choice of inventory-costing methods used to prepare the financial statements, may induce managers to make decisions that benefit short-term reported earnings at the expense of a firm’s long-term financial health. It may take a significant threat to motivate managers to make the right capacity and inventory choices, as the following article illustrates.

Under Armour Races to Defeat Its Inventory Backlog^*

Can you have too much of a good thing? When the good thing in question is excess inventory, the answer is a resounding “Yes!”

Under Armour, the athletic-apparel retailer, discovered this in 2017 when a software glitch caused inventory levels to soar. The company could not get its products to wholesalers on time, which caused inventory to swell by 22% year over year. To clear out its inventory, Under Armour had to slash prices to clear its backlog before it could get newer products on the shelves of its retail partners. This caused company revenue and profitability to drop for more than a year.

To better manage its inventory going forward, Under Armour implemented a new internal company system that ensures the company is managing its inventory and supply chain with efficiency and precision. Under Armour reduced its vendors by 25% and its products by 40% to better manage its existing operations and product line. By 2018, it was then able to cut its promotional days when products were on sale by one third, which increased revenue and helped stabilize operations in the competitive athletic-apparel marketplace.

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Managers in industries with high fixed costs, like manufacturing, must manage capacity levels and make decisions about how to use available capacity. Managers must also decide on management approaches to production and inventory (as Under Armour did). These decisions and the accounting choices managers make affect the operating profits reported in the income statements of manufacturing companies. This chapter focuses on two types of choices:

The inventory-costing choice is an important application of how choices in the costing system impact the results reported in a firm’s financial statements. The inventory-costing choice determines which manufacturing costs are treated as inventoriable costs. Recall from Chapter 2 that inventoriable costs are all costs of a product that are regarded as assets on the company’s balance sheet when they are incurred and expensed as cost of goods sold in the income statement when the product is sold. There are three types of inventory costing methods: variable costing, absorption costing, and throughput costing.
The denominator-level capacity choice focuses on the capacity level used to calculate budgeted fixed manufacturing cost rates used in costing systems. There are four possible choices of capacity levels: theoretical capacity, practical capacity, normal capacity utilization, and master-budget capacity utilization.

The chapter also discusses the factors that managers should consider when choosing among these different capacity levels when costing is done for managerial accounting purposes such as product costing, product pricing, or performance evaluation, and for financial or tax accounting purposes.