ACC2022F MANAGEMENT ACCOUNTING I 2019 ABSORPTION AND VARIABLE COSTING Textbook reading: 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 Admin 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 Variable manufacturing overhead per unit Actual manufacturing overhead Pre-determined overhead rate per unit Actual selling and admin expense 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 Variable selling &admin 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 Fixed manufacturing overheads Fixed selling and admin 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 Less: selling and admin expenses 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 Add: production Less: ending inventory Variable selling & admin expenses ABSORPTION COSTING Sales revenue Less: Cost of goods sold Beginning inventory Add: production 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 Add: Production 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 Add: production Less: ending inventory Variable manufacturing cost of goods sold Variable selling & admin expenses Contribution Margin Less: Fixed expenses Fixed manufacturing overheads Fixed selling and admin expenses Operating profit ABSORPTION COSTING Sales revenue Less: Cost of goods sold Beginning inventory Add: production Less: ending inventory Gross profit Less: selling and admin expenses 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 Additional lecture example 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. Assume all factories start with an inventory balance of zero. 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 ............................................................................. Add cost of goods manufactured ............................................................................. Goods available for sale ............................................................................. Less ending inventory ............................................................................. Cost of goods sold ................................................................................ Gross profit ................................................................................ Less selling and administrative 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. Advantages of variable: 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 Advantages of absorbtion: Required by GAAP Highlights importance of fixed costs in making products External and internal accounting and performance measures consistent (b) Total fixed manufacturing overhead ................................................. Total units ................................................. Fixed manufacturing overhead 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 ............................................................. Fixed overhead costs deferred in inventory under absorption costing ............................................................. Fixed overhead costs released from 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 Add: Production 505,000 units x R65 32,825,000 39,325,000 Less: Ending inventory 30,000 unitsx R65 (1,950000) 37,375,000 Underapplied fixed overhead* 95,000 units x R14 1,330,000 (38,705,000) Gross margin 10,170,000 Selling and admin. expenses: 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) Underapplied fixed overhead 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 Add movement in inventory 100,000 – 30,000 = 70,000 x R14 Net income per Variable Costing 4,576,250 980,000 R5,556,250 21 PROBLEM 7.49 CHECK ANSWERS 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 Less: Selling and administrative expenses 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 Variable selling & administrative costs Contribution margin Less: Fixed expenses Fixed manufacturing overhead Fixed selling and administrative 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 Variable manufacturing overhead 240,000 Variable cost of manufacture R 1,440,000 or R 144.00 per unit Fixed manufacturing overhead 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 Add: Units produced 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 (select the correct answer below) Show workings or explain your answer: 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 25