# ACC2022F 2019 Variable and absorption student module

```ACC2022F MANAGEMENT ACCOUNTING I
2019
ABSORPTION AND VARIABLE COSTING
Correia, Langfield-Smith, Thorne, & Hilton – Chapter 2 and 3
Contents of this pack:
Pages numbered
Student Lecture Outlines and Examples
2 – 12
Homework Tutorials and student solutions
Textbook Problems, AV01, AV02
13 - 22
Homework submission tutorial – AV03
– Due 16:00pm 16 March
23
Tutorial practical – AV04
To be done in your tutorial
24
1
MANAGEMENT ACCOUNTING 1:
ABSORPTION AND VARIABLE COSTING
Module objectives
 Explain the differences between absorption costing and a variable costing system.
 Explain the difference in objectives between the two costing systems.
 Prepare profit statements based on a variable costing and absorption costing system.
 Understand the importance of the contribution margin and how to calculate it.
 Reconcile profit from an absorption costing system to a variable costing system and the other way
around.
 Explain the benefits of variable costing and absorption costing.
Introduction
This module considers the two costing systems, absorption costing and variable costing. The two have
different objectives and are used for different purposes. There is therefore an appropriate time to use
absorption costing and there is an appropriate time to use variable costing.
Absorption costing- IAS2, Inventories, requires inventory to be valued in terms of absorption costing
Variable costing- useful for internal management reports
2
Lecture examples:
Note:It is important to understand the key principle from each lecture example and be able to
apply the principle to various situations. Please do not try and memorise these examples
and apply them blindly.
Lecture example 1:
Company A manufactures rugby balls. The following costs are incurred in the manufacturing process:
Variable costs:
Direct materials
Direct labour
Variable MOH
R8/u
R3/u
R4/u
Fixed costs
Fixed MOH
R100 000
R50 000
Overheads are allocated based on number of units produced. Co A estimated that 50 000 units will
be produced in 2011. Budgeted fixed manufacturing overheads were R100 000.
Calculate the product cost per unit under both the absorption costing system and the variable
costing system.
Product cost:
Variable
Absorption
Direct materials
Direct labour
Variable MOH
Applied Fixed MOH
Product Cost
Notice the following:
 The different treatment of fixed manufacturing overheads between the two costing methods.
 The product costs differ between the two costing methods.
3
Lecture example 2:
Production and Inventory data
Planned production
Beginning inventory
Actual production
Sales
Ending inventory
Cost data
Direct material per unit
Direct labour per unit
Fixed
Variable per unit
Selling price per unit
Product cost- variable costing
Product cost- absorption costing
March
2,000
0
2,000
1,900
?
April
2,000
?
2,000
1,800
?
May
2,000
?
2,000
2,300
?
800
500
200
250,000
125
800
500
200
250,000
125
800
500
200
250,000
125
100,000
100
100,000
100
100,000
100
3,000
3,000
3,000
?
?
?
?
?
?
* Variable selling and admin expenses vary in proportion to the number of units sold.
** Fixed manufacturing overheads are allocated based on the number of units produced, actual
manufacturing overheads are the same as budgeted.
QUESTION:
Prepare the income statement under variable and absorption costing.
4
Solution:
Product cost:
Variable
Absorption
Direct materials
Direct labour
Variable MOH
Applied Fixed MOH
Manufacturing Product cost
Total product cost
•
•
Income statement formats for variable and absorption costing are important!
What are you used to seeing?
Income statement
Sales revenue
Less: Cost of goods sold
Gross profit
Other income
Other expenses
Net Profit
xxx
(xxx)
xxx
xxx
(xxx)
xxx
5
•
As we go through the example make a list of differences between a variable and absorption
costing system below:
Production and Inventory data
Beginning inventory
Actual production
Sales
Ending inventory
•
March
2 000
1 900
April
2 000
1 800
May
2 000
2 300
Use this table along with the product cost calculated above to get inventory values for the
Income Statements.
6
VARIABLE COSTING
March
5,700,000
April
5,400,000
May
6,900,000
Contribution Margin
2,660,000
2,520,000
3,220,000
Less: Fixed expenses
(250,000)
(100,000)
(250,000)
(100,000)
(250,000)
(100,000)
Operating profit
2,310,000
2,170,000
2,870,000
March
5,700,000
April
5,400,000
May
6,900,000
Gross profit
2,612,500
2,475,000
3,162,500
Fixed
Variable
(100,000)
(190,000)
(100,000)
(180,000)
(100,000)
(230,000)
Operating profit
2,322,500
2,195,000
2,832,500
Sales revenue
Less: Variable cost of goods sold
Beginning inventory
Less: ending inventory
ABSORPTION COSTING
Sales revenue
Less: Cost of goods sold
Beginning inventory
Less: ending inventory
Notice the following:
 The different lay out of the income statement for the different costing methods.
 Profit differs between the two costing methods in the different periods
 The total profit over the three year period is the same for both costing methods. Why is this??
7
Lecture example 3:
Company B manufactures slip slops. The company estimated that it would produce 20 000 units per month.
Currently there is no inventory on hand.
FMOH is allocated based on number of units produced.
The company budget sales for the next 3 months to be:
March 19 000 units
April 20 500 units
May 20 000 units
Cost and revenue information is as follows:
Selling price:
R180/unit
Direct material:
R 50/unit
Direct labour:
R 20/unit
VMOH
R 10/unit
FMOH
R 15/unit (Pre-determined overhead rate = R300 000/ 20 000 units)
Other fixed costs
R35 000
Selling expense 10% of Selling Price
Question 1:
Prepare the income statement under variable and absorption costing.
Question 2:
Perform a reconciliation of the profit attained under variable costing to the profit attained under absorption
costing for each of the three months.
Starting point: In order to draw up the Income Statements, you will need the product costs:
Product cost per unit
Variable
Absorption
DM
DL
VMOH
FMOH
Product costs
8
Then get an understanding of the inventory movements:
Units:
March
April
May
Opening balance
Less: Sales
Closing balance
Solution:
VARIABLE COSTING
March
April
May
300000
35 000
300000
35 000
300000
35 000
March
3 420 000
April
3 690 000
May
3 600 000
35 000
342 000
35 000
369 000
35 000
360 000
Sales revenue
Less: Variable cost of goods sold
Beginning inventory
Less: ending inventory
Variable manufacturing cost of goods sold
Contribution Margin
Less: Fixed expenses
Operating profit
ABSORPTION COSTING
Sales revenue
Less: Cost of goods sold
Beginning inventory
Less: ending inventory
Gross profit
Fixed
Variable
Operating profit
9
Notice the following from the Income Statements:
 Profit differs between the two costing methods in the different periods
 The only period where profit does not differ is where the beginning and ending inventory are the
same. Why is this?
Reconciling profit under the two systems:
Have you managed to spot the difference between the two costing methods that result in profit being
different?
 The only difference is the timing with which fixed manufacturing overhead becomes an expense.
Under variable costing the fixed overheads are treated as a period cost and expensed as incurred. Under
absorption costing the fixed overheads is capitalised to inventory and expensed as part of the cost of goods
are sold.
What happens when there is no change in inventory? [May]
What happens when inventory increases? [March]
What happens when inventory decreases? [April]
10
Reconciliation:
March
April
May
Net profit under VARIABLE costing
Less: Fixed MOH in opening inventory
Add: Fixed MOH in closing inventory
Net profit under ABSORPTION costing
Reconciliation (abbreviated):
March
April
May
March
April
May
Net profit under VARIABLE costing
Net fixed MOH deferred in inventory
(change in inventory x fixed MOH rate)
Net profit under ABSORPTION costing
It can also be done in the reverse direction:
Reconciliation:
Net profit under ABSORPTION costing
ADD: Fixed MOH in opening inventory
LESS: Fixed MOH in closing inventory
Net profit under VARIABLE costing
11
Delta (Pty) Ltd has three manufacturing factories situated in different cities (Pretoria, Cape Town and
Durban) in the country. Each factory is run by a manager. Each factory has its own selling department. The
following cost and revenue information apply to the different factories:
Selling price:
Direct material:
Direct labour:
VMOH
FMOH
R220/unit
R 50/unit
R 20/unit
R 10/unit
R 240 000
Other fixed costs
R35 000
Fixed manufacturing overhead is allocated based on number of units produced. The factories produced the
following amount of units:
Pretoria: 20 000
CT:
22 000
Durban: 23 000
Each factory managed to sell 20 000 units.
Question 1: Prepare the profit statement for each manager using absorption costing.
Question 2: Explain how this illustrates how managers can manipulate profits
Pretoria
Cape Town
Durban
Revenue
Cost of goods sold
Opening balance
Production costs
Closing balance
Gross profit
Other expenses
Operating profit
FMOH rate
Product cost/unit
** Solution will be put under resources on vula at the end of the week
12
AV01
(15 marks: 18 minutes)
The Hadfield Company was organized on January 1, 2008, to manufacture and sell a unique electronic part.
The company's plant is highly automated with low variable and high fixed manufacturing costs. Operating
results for the first three years of activity were as follows (absorption costing basis):
Sales
................................................................................
Cost of goods sold:
Beginning
inventory
.............................................................................
manufactured
.............................................................................
Goods available for
sale
.............................................................................
Less ending
inventory
.............................................................................
Cost of goods
sold
................................................................................
Gross
profit
................................................................................
expenses
................................................................................
Net operating income
(loss)
................................................................................
2008
R500,000
2009
R400,000
2010
R500,000
-0-
-0-
140,000
400,000
420,000
380,000
400,000
420,000
520,000
-0-
140,000
95,000
400,000
280,000
425,000
100,000
120,000
75,000
85,000
75,000
85,000
R 15,000
R 45,000
R(10,000)
The following additional information is provided:






Variable manufacturing costs (direct labour, direct materials, and variable manufacturing overhead) total
R2 per unit, and fixed manufacturing costs total R300 000 per year;
Fixed manufacturing costs are applied to units of product on the basis of each year's production (i.e., a
new fixed manufacturing overhead rate is computed each year);
The company uses a FIFO inventory flow;
Variable selling and administrative expenses are R1 per unit sold;
Fixed selling and administrative expenses total R70 000 per year;
Production and sales information for the three years is as follows:
Production in
units
....................................
2008
50,000
2009
60,000
2010
40,000
13
Sales in
units
....................................
50,000
40,000
50,000
14
Required:
a. Explain the difference(s) between variable costing and absorption costing. List two advantages of each.
(4 marks)
b. Compute net operating income for each year under the variable costing approach by preparing a
reconciliation between the absorption profit and variable profit. Do not prepare an income statement.
(9 marks)
c. Referring to the absorption costing income statements, explain why the company suffered a loss in 2010
but reported a profit in 2008, although the same number of units was sold in each year.
(2 marks)
15
AV01 Solution
(a)
The main difference between variable and absorption costing is the treatment of fixed manufacturing
overheads. Absorption costing treats fixed manufacturing overheads as a product cost, whereas
variable costing treat them as period costs.
Better decision making
Consistent with CVP
Management easily understand
Impact of fixed costs on profits emphasized
Net income closer to cash flow
Consistent with std costing
Profit not affected by changes in inventories
Easier to estimate profitability of products and segments
Required by GAAP
Highlights importance of fixed costs in making products
External and internal accounting and performance measures consistent
(b)
Total fixed manufacturing
.................................................
Total
units
.................................................
per
unit
.................................................
2008
2009
R300,000
R300,000
R300,000
50,000
60,000
40,000
R6
R5
R7.50
Net operating income under variable costing approach:
2001
Net operating income (loss) under
absorption
costing
.............................................................
inventory under absorption
costing
.............................................................
inventory under absorption
costing
.............................................................
2010
2009
2010
R15,000
R45,000
(R10,000)
-0-
(R100,000)
(R75,000)
-0-
-0-
R100,000
16
Net operating income (loss) under
variable
costing
.............................................................
(c)
R15,000
(R55,000)
R15,000
The fixed overhead cost deferred in inventory from 2009 was charged against 2010 operations. This
added charge against 2010 operations was offset somewhat by the fact that part of 2010's fixed
overhead costs were deferred in inventory to future years. Overall, the added costs charged against
2010 were greater than the costs deferred to future years, so the company reported less income for
the year even though the same number of units was sold as in 2008.
17
AV02
Past Test 2: 2010 (Question 1)
Simoniz (Pty) Ltd (hereafter Simoniz) is a new division of Alco Motor Group Limited (herafter Alco)
that started on 1 October 2008. Simoniz manufactures a high quality polishing product used by the
motor spray-painting industry to achieve a high gloss shine on new or re-sprayed motor cars. In the
first year of operations, Simoniz reported the following net income to its Alco Head Office.
Simoniz (Pty) Ltd
Income Statement
For the Year ended 30 September 2009
a
Sales
Less: Cost of goods sold b
Gross margin
Less: Selling and administrative expenses c
Net income
a
b
c
R
42,500,000
32,500,000
10,000,000
5,125,000
4,875,000
The selling price is R85 per unit
Variable manufacturing costs are R51 per unit
Fixed selling expenses are R2,000,000
In 2009, Simoniz produced 100,000 units more than it sold because sales were less than expected.
The marketing manager believed the sales slump was due to a soft economy and was confident that
sales for the next year (2010) could be at least 10 percent higher. Overhead is applied on the basis
of units produced using expected actual activity. Any under- or overapplied overhead is closed to
Cost of Goods Sold. For 2009, there was no under- or overapplied overhead.
In 2010, total fixed costs, planned production units, variable costs per unit, and selling price per unit
remained unchanged from 2009. Also budgeted fixed costs equalled actual fixed costs. The
production for 2010 was 95,000 units less than expected because of unexpected equipment
problems. The production manager was however pleased that production costs were completely in
line with plans.
Simoniz sold 575,000 units in 2010 and the marketing manager was pleased that actual sales had
exceeded his prediction of a 10 percent sales increase. You are the recently appointed financial
manager.
18
Required:
1.
Prepare the Income Statement for Simoniz (Pty) Ltd for the year ended
30 September 2010 for presentation to its Head Office at the Alco Motor Group
Limited. The Income Statement should show the full inventory movement.
Show workings for all numbers you have derived and reflect full workings for
each number in your income statement.
(18 marks)
2.
Despite the optimism of the marketing director and the production director
your experience tells you that the directors at Head Office are not going to be
happy with the 2010 results of Simoniz (Pty) Ltd. The marketing director and
the production director are very disappointed to hear your opinion. Refer to
your Income Statement prepared in part 1. above and explain why you think
the Head Office is not going to be pleased with the results.
(2 Marks)
Without producing an Income Statement determine what the net income
would be if the results of Simoniz (Pty) Ltd were presented in the Variable
Costing format.
(2 Marks)
3.
19
AV02 Solution
Simoniz (Pty) Ltd
Absorption-Costing Income Statement for the Year Ended 30 September 2010
R
R
Sales
575,000 units x R85
48,875,000
Less: Cost of goods sold
Opening inventory
100,000 units x R65
6,500,000
505,000 units x R65
32,825,000
39,325,000
Less: Ending inventory
30,000 unitsx R65
(1,950000)
37,375,000
95,000 units x R14
1,330,000
(38,705,000)
Gross margin
10,170,000
Variable
575,000 units x R6.25
3,953,750
Fixed
2,000,000
(5,593,750)
Net income
* Applied fixed overhead (R14 × 505,000)
Actual fixed overhead (R14 × 600,000)
4,576,250
R7,070,000
8,400,000
R1,330,000
Test 2: 2010
QUESTION 1 SUGGESTED SOLUTION
1.
Calculations
• Sales units = R42,500,000 ÷ R85 = 500,000 units
• Absorption cost per unit = R32,500,000 ÷ 500,000 units = R65 per unit
• Fixed cost per unit = R65 – variable cost R51 = R14 per unit
• Production was 100,000 unitsmore than sales 500,000 units = 600,000 units
• 2009 budgeted and actual fixed manf. overheads = 600,000units x R14 = R8,400,000
• 2009 closing inventory = 0 + 600,000 produced – 500,000 sold = 100,000 units
• 2010 production = 600000 as for 2009 - 95,000 =505,000 units
• Variable selling = R5,125,000 -2,000,000 = 3,125,000 ÷ 500000 = R6.25
20
2.
Although sales units increased by 75,000 units (a 15% increase) which was good and costs
remained the same which was also good the company under-produced by 95,000 units and
this cost of (95,000 units x R14) under-allocated fixed costs R1,330,000 has reduced net income.
3.
Net income per Absorption Costing
100,000 – 30,000 = 70,000 x R14
Net income per Variable Costing
4,576,250
980,000
R5,556,250
21
Part 1
Variable R20; Absorption R24
Part 2a
Gross Margin R750,000 ; Net Profit R400,000
Part 2b
Contribution Margin R1,000,000 ; Net profit R300,000
Part 3
Difference R100,000
Part 4.
No check numbers
PROBLEM 7.50 Normal costing; profit under absorption and variable costing (appendix): manufacturer
1 (a)
Furry Pillows Pty Ltd
Profit report under absorption costing
for the year ended 31 December 20X7
Sales revenue
9,000 x
R 400.00
Less: Cost of goods sold
9,000 x
R 194.00 1
Gross margin
Variable
Fixed
Net profit
(b)
Furry Pillows Pty Ltd
Profit report under variable costing
For the year ended 31 December 20X7
Sales revenue
Less: Variable expenses
Variable manufacturing costs
Contribution margin
Less: Fixed expenses
Net profit
R 3,600,000
1,746,000
R 1,854,000
90,000
600,000
R 3,600,000
9,000 x R 400.00
9,000 x R 144.00
690,000
R 1,164,000
1,296,000
90,000
500,000
600,000
1,386,000
R 2,214,000
1,100,000
R 1,114,000
1
As there are no work in process inventories or beginning finished goods inventory, all manufacturing costs are related to
finished goods.
Direct material
R 800,000
Direct labour
R 400,000
240,000
Variable cost of manufacture
R 1,440,000 or R 144.00 per unit
500,000
Absorption cost of manufacture
R 1,940,000 or R 194.00 per unit
2 The absorption costing profit is higher because 1 000 units produced are carried forward as finished goods inventory. Each
unit carries forward a cost for the manufacturing overhead, that is expensed under variable costing.
Cost for manufacturing overhead per unit = R 50.00
3 Inventory calculations (units):
0
10,000
9,000
1,000
Finished-goods inventory, January 1
Less: Units sold
Finished-goods inventory, December 31
Finished goods
Absorption costing
Variable costing
No. of Units
1,000 x
1,000 x
Cost per unit
R 194.00
R 144.00
units
units
units
units
Absorption
costing
R 194,000
Variable
costing
R 144,000
22
PROBLEM 7.50 (continued)
4.
The major arguments for variable costing are:
(a).
Variable costing provides useful information for short-term decisions, such as whether to make or buy a
component, and pricing.
(b)
Under variable costing, profit is a function of sales and the classification of costs as fixed or variable makes
it simple to plan costs and profits.
(c)
Cost volume profit analysis requires a variable costing format.
(d)
Variable costing provides a useful perspective of the impact that fixed costs have on profits by bringing
them together and highlighting them, instead of having them scattered throughout the statement.
The major arguments for absorption costing are:
(a)
In the modern business environment, there is likely to be a high level of fixed overhead and, therefore, a
relatively small percentage of manufacturing costs may be assigned to products under variable costing. At
Furry Pillows more than one quarter of the manufacturing cost is fixed manufacturing overhead.
(b)
In the longer term a business must cover its fixed costs too, and many managers prefer to use absorption
cost in cost-based pricing decisions. They argue that fixed manufacturing overhead is a necessary cost
incurred in the production process.
Generally the arguments in favour of variable costing are considered to outweigh those in favour of absorption
costing. If fixed overhead costs are high, a significant proportion of manufacturing costs may not be assigned to
products under variable costing. However, absorption costing does not solve this problem effectively, because of
the distortions caused by using volume-based cost drivers to assign fixed manufacturing overhead costs to products.
Perhaps it would be better to recommend a new approach to costing, such as activity-based costing, rather than
either of these two conventional costing systems.
23
ACC2022F Management Accounting 1 - AV03
Submission deadline 16h00 Friday 8 March 2019
Please complete this submission tutorial as neatly as possible. No late submissions will be accepted. Show all workings clearly. No
submission will be given unless all questions are attempted and workings are shown clearly.
Question 1
Smith Company had net operating income of R105,000 using variable costing and R125,000 using
absorption costing. Variable production costs were R20 per unit. Total fixed manufacturing
overhead was R176,000 and 11,000 units were produced. During the year, the inventory level
A)
B)
C)
D)
increased by 1,000 units.
increased by 1,250 units.
decreased by 1,000 units.
decreased by 1,250 units.
Question 2
If a company has a variable costing profit of R100 000, and an absorption costing profit of R104 000.
FMOH per unit in both opening and closing inventory were R8 per unit. There were 10 000 units in
opening inventory. By how many units did closing inventory increase/decrease?
Question 3
If a company has a variable costing profit of R100 000, and an absorption costing profit of R68 000.
FMOH per unit in opening were R12 per unit, and R8 per unit in closing inventory. There were 10 000
units in opening inventory. How many units were in closing inventory?
Question 4
If a company has a variable costing profit of R100 000, and an absorption costing profit of R81 100.
FMOH per unit in opening were R11 per unit, and R9 per unit in closing inventory. Total fixed
manufacturing costs incurred for the year were R1 125 000. There were 10 000 units in closing
inventory.
a) What percentage of the fixed costs incurred during the year were deferred in closing inventory
under absorption costing?
b) Explain what your answer in a) means with regards to when you recognise the full R1 125 000 as
an expense in your Income Statement.
c) How many units were sold during the year?
d) How many units would have to be produced in order for the absorption costing profit to be
R253,600, and what would the FMOH cost per unit be at this level of production?
Question 5
Complete the additional lecture example on page 12 of this module.
24
ACC2022F Management Accounting 1 – AV04
Practical for the week beginning 11 March 2019
Absorption & Variable Costing
This is not a test. No printed solution will be provided. You are expected to work through the problem in the tutorial session until
it has been completed. Your tutor will be available to assist you.
Source: Past final examination
(31 MARKS: 37 MINUTES)
Michael Gomes, brother of your old friend John Gomes, is on the board of directors of Russell Sheraton Limited. The
results for the year ended 31 March 2005 reflected the worst loss in the history of the company, as shown below:
Sales (50,000 units)
Cost of goods sold:
Beginning inventory (10,000 units)
Cost of goods manufactured (50,000 units)*
Goods available for sale
Less: Ending inventory (10,000 units)
Cost of goods sold
Gross margin
Less selling expenses
Loss
R’000
50,000
7,500
37,500
45,000
(7,500)
(37,500)
12,500
(14,000)
(1,500)
*The variable cost of manufacture per unit is R500. The variable selling expenses are R100 per unit.
On 15 April 2005 the board of directors replaced the Chief Executive Officer (CEO) with David Jones who agreed to
assume the position without a salary if he would receive a bonus of 40 percent of profits before interest and tax. The
board agreed and within a short period, the new president had the production facilities operating at full capacity of
75,000 units.
Despite no growth in sales, the next period's income statement showed a profit with no change in the cost behaviour
patterns. Immediately after the income statement was prepared, the new CEO accepted his bonus and resigned with no
explanation. The board of directors cannot understand the new CEO’s actions.
Required:
a.
Explain (with reasons) whether the company's income statement for last year
(31 March 2005) was prepared on a variable costing or an absorption costing basis.
(2 marks)
b.
Using the information provided in the question prepare an income statement for the year ended 31 March 2006
using the method reflected in the question and your answer to part a.
(13 marks)
c.
Using an alternative reporting procedure, prepare an income statement for the year ended 31 March 2006
which would not reflect a bonus due to the new CEO. It is not necessary to reflect the movement of inventory.
(7 marks)
d.
Prepare a reconciliation of the net income obtained in parts b. and c. The inventory movement and relevant
cost component must be reflected.
(4 marks)
e.
How much would the new CEO have received as a bonus using the approach in part b. Do you think the new
president deserved the bonus? Why or why not? Can you relate this to a real-life situation?
(5 marks)
ALL WORKINGS MUST BE CLEARLY SHOWN
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