Income effects of alternative cost accumulation systems

Transcription

1 Income effects of alternative cost accumulation systems Solutions to Chapter 7 questions Question 7.22 (a) Manufacturing cost per unit of output = variable cost ( 6.40) + fixed cost ( / = 4.60) = 11 Absorption costing profit statement Sales ( units at 14 per unit) Manufacturing cost of sales ( units 11) Manufacturing profit before adjustment 66.0 Overhead over-absorbed a 4.6 Manufacturing profit 70.6 Note: a The normal activity that was used to establish the fixed overhead absorption rate was units but actual production in period 2 was units. Therefore a period cost adjustment is required because there is an over-absorption of fixed overheads of [( units units) 4.60]. (b) Sales Variable cost of sales ( units 6.40) Contribution to fixed costs Less fixed overheads 92.0 Profit 75.2 (c) (i) Compared with period 1 profits are higher in period 2 ( ). The reasons for the change are as follows: Additional sales (7000 units at a profit of 3 per unit) Difference in fixed overhead absorption (3000 units extra production at 4.60 per unit) a Additional profit Note: a Because fixed overheads are absorbed on the basis of normal activity ( units) there would have been an under-recovery of 9200 (2000 units 4.60) in period 1 when production was units. In period 2 production exceeds normal activity by 1000 units resulting in an over-recovery of The difference between the under- and over-recovery of ( ) represents a period cost adjustment that is reflected in an increase in profits of In other words, the under-recovery of 9200 was not required in period 2 and in addition there was an over-recovery of INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

2 (c) (ii) Additional profits reported by the marginal costing system are 4600 ( ). Because sales exceed production by 1000 units in period 2 there is a stock reduction of 1000 units. With an absorption costing system the stock reduction will result in a release of 4600 (1000 units at 4.60) fixed overheads as an expense during the current period. With a marginal costing system changes in stock levels do not have an impact on the fixed overhead that is treated as an expense for the period. Thus, absorption costing profits will be 4600 lower than marginal costing profits. (a) Marginal Absorption January costing costing ( ) ( ) ( ) ( ) Sales revenue (7000 units) Less: Cost of sales (7000 units) Direct materials Direct labour Variable production overhead Variable selling overhead Fixed overhead (7000 3) Contribution Gross profit Over absorption of fixed production overhead (1) Fixed production costs (2) Fixed selling costs (2) Variable selling costs Fixed admin costs (2) Net profit Marginal Absorption February costing costing ( ) ( ) ( ) ( ) Sales revenue (8750 units) Less: Cost of sales (8750 units) Direct materials Direct labour Variable production overhead Variable selling overhead Fixed overhead (8750 3) Contribution Gross profit Under absorption of fixed production overhead Fixed production costs (2) Fixed selling costs (2) Variable selling costs Fixed admin costs (2) Net profit Question 7.23 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 47

3 Workings: (1) Fixed production overhead has been unitized on the basis of a normal monthly activity of 8000 units ( units per annum). Therefore monthly production fixed overhead incurred is (8000 3). In January actual production exceeds normal activity by 500 units so there is an over-absorption of 1500 resulting in a period cost adjustment that has a positive impact on profits. In February production is 250 units below normal activity giving an under-absorption of production overheads of 750. (2) With marginal costing fixed production overheads are treated as period costs and not assigned to products. Therefore the charge for fixed production overheads is per month (see note 1). Both marginal and absorption costing systems treat non-manufacturing overheads as period costs. All of the nonmanufacturing overheads have been unitized using a monthly activity level of 8000 units. Therefore the non-manufacturing fixed overheads incurred are as follows: Selling = (8000 2) Administration = (8000 3) (b) In January additional profits of 4500 are reported by the absorption costing system. Because production exceeds sales by 1500 units in January there is a stock increase of 1500 units. With an absorption costing system the stock increase will result in 4500 (1500 units 3) being incorporated in closing stocks and deferred as an expense to future periods. With a marginal costing system changes in stock levels do not have an impact on the fixed overhead that is treated as an expense for the period. Thus, absorption costing profits will be 4500 higher than marginal costing profits. In February sales exceed production by 1000 units resulting in a stock reduction of 1000 units. With an absorption costing system the stock reduction will result in a release of 3000 (1000 units at 3) fixed overheads as an expense during the current period. Thus, absorption costing profits are 3000 lower than marginal costing profits. (c) (i) Contribution per unit = Selling price ( 45) unit variable cost ( 28) = 17 Break-even point (units) = Annual fixed costs ( )/unit contribution ( 17) = 3765 units Break-even point ( sales) = 3765 units 45 selling price = The above calculations are on a monthly basis. The sales value of the annual break-even point is ( ). (ii) Required contribution for an annual profit of = Fixed costs ( ) = Required activity level = Required contribution ( ) Unit contribution ( 17) = units (d) See Cost volume profit analysis assumptions in Chapter 8 for the answer to this question. Question 7.24 (a) Preliminary calculations January June July December ( ) ( ) Production overheads (Over)/underabsorbed (12 000) Change in overheads Change in production volume (units) INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

4 Production variable overhead rate per unit 3 Fixed production overheads ( ( )) Distribution costs Decrease in costs Decrease in sales volume (units) Distribution cost per unit sold 1 Fixed distribution cost ( ( )) Unit costs are as follows: ( ) ( ) Selling price 36 Direct materials 6 Direct labour 9 Variable production overhead 3 Variable distribution cost 1 19 Contribution 17 Note that the unit direct costs are derived by dividing the total cost by units produced Marginal costing profit statement January June July December Sales Variable costs at 19 per unit sold Contribution Fixed costs: Production overhead Selling costs Distribution cost Administration Profit 71 (14) (b) Marginal costing stock valuation per unit = 18 per unit production variable cost Absorption costing stock valuation per unit = 20 per unit total production cost January June July December Absorption costing profit 77 (22) Fixed overheads in stock increase of 3000 units 6 Fixed overheads in stock decrease of 4000 units (8) Marginal costing profit (c) Absorption gross profit per unit sold = Annual gross profit ( )/Annual production ( units) = 16 Profit from January June 77 Reduction in sales volume ( ) (80) Difference in overhead recovery ( over recovery and under recovery) (24) Reduction in distribution cost 5 (22) INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 49

5 Question 7.25 (d) Fixed cost = Contribution per unit 17 Break-even point units (Fixed costs/contribution per unit) (e) See Some arguments in support of variable costing in Chapter 7 for the answer to this question. (a) Budgeted fixed overheads ( ) Fixed overhead rate per unit = = 7.50 Budgeted production ( units) Absorption Costing (FIFO) Profit Statement: Sales ( ) 3024 Less cost of sales: Opening stock ( ) 60 Add production ( a ) Less closing stock ( ) Add over-absorption of overheads b 27 Profit 891 Notes: a Variable cost per unit = 2070/ = 45 Total cost per unit = Fixed overhead = b Overhead absorbed ( ) = Actual overhead incurred = Over-recovery Marginal Costing (FIFO) Profit Statement: Sales 3024 Less cost of sales: Opening stock ( ) 50 Add production ( ) Less closing stock ( ) Contribution 1174 Less fixed overheads incurred 318 Profit 856 Reconciliation: Absorption profit exceeds marginal costing profit by ( ). The difference is due to the fixed overheads carried forward in the stock valuations: ( ) Fixed overheads in closing stocks ( ) Less fixed overheads in opening stocks (2000 5) Fixed overheads included in stock movement Absorption costing gives a higher profit because more of the fixed overheads are carried forward into the next accounting period than were brought forward from the last accounting period. 50 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

6 (b) Absorption Costing (AVECO) Profit Statement: Sales 3024 Opening stock plus production ( a ) 2475 Less closing stock ( ) Add over-absorption of overheads 27 Profit 885 Marginal Costing (AVECO) Profit Statement: Sales 3024 Less cost of sales Opening stock plus production ( b ) 2120 Less closing stock ( ) Contribution 1169 Less fixed overheads 318 Profit 851 Notes: a With the AVECO method the opening stock is merged with the production of the current period to ascertain the average unit cost: Opening stock ( ) + Production cost ( ) = Average cost per unit = / units b Average cost = (Production cost ( ) + Opening stock (50 000))/ units. Reconciliation: Difference in profits ( ) 34 Fixed overheads in closing stocks ( ) 44 Less fixed overheads in opening stock (2000 5) 10 Fixed overheads included in stock movement 34 The variations in profits between (a) and (b) are 6000 for absorption costing and 5000 for marginal costing. With the FIFO method all of the lower cost brought forward from the previous period is charged as an expense against the current period. The closing stock is derived only from current period costs. With the AVECO method the opening stock is merged with the units produced in the current period and is thus allocated between cost of sales and closing stocks. Therefore some of the lower cost brought forward from the previous period is incorporated in the closing stock at the end of the period. (a) It is assumed that opening stock valuation in 2001 was determined on the basis of the old overhead rate of 2.10 per hour. The closing stock valuation for 2001 and the opening and closing valuations for 2002 are calculated on the basis of the new overhead rate of 3.60 per hour. In order to compare the 2001 and 2002 profits, it is necessary to restate the 2001 opening stock on the same basis as that which was used for 2002 stock valuations. We are informed that the 2002 closing stock will be at the same physical level as the 2000 opening stock valuation. It should also be noted that the 2001 opening stock was twice as much as the 2000 equivalent. The 2000 valuation on the revised Question 7.26 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 51

7 basis would have been , resulting in a 2001 revised valuation of Consequently, the 2001 profits will be ( ) lower when calculated on the revised basis. From the 2001 estimate you can see that stocks increase and then decline in It appears that the company has over-produced in 2001 thus resulting in large opening stocks at the start of The effect of this is that more of the sales demand is met from opening stocks in Therefore production declines in 2002, thus resulting in an under recovery of fixed overheads, which is charged as a period cost. On the other hand, the under recovery for 2001 is expected to be The reconciliation of 2001 and 2002 profits is as follows: ( ) 2001 profits Difference in opening stock valuation for 2001 (60 000) Additional under recovery in 2002 ( ) Budgeted loss for 2002 (81 250) (b) To prepare the profit and loss accounts on a marginal cost basis, it is necessary to analyse the production costs into the fixed and variable elements. The calculations are: ( ) ( ) ( ) Total fixed overheads incurred Less under recovery Fixed overheads charged to production Total production cost Proportion fixed 3/10 6/13 (450/975) 6/13 Proportion variable (balance) 7/10 7/13 7/13 Profit and loss accounts (marginal cost basis) Actual 2000 Estimated 2001 Budget 2002 ( ) ( ) ( ) ( ) ( ) ( ) Sales Opening finished goods stock at marginal cost a a b Variable factory cost a b b a a b Closing finished goods stock at marginal cost a b b Fixed factory cost a a b Administrative and financial costs a a b Profit/(loss) ( ) (c) Notes a 7/10 absorption cost figures given in the question. b 7/13 absorption cost figures given in the question. The under absorption of overhead may be due to the fact that the firm is operating at a low level of activity. This may be due to a low demand for the firm s products. The increase in the overhead rate will cause the product costs to increase. When cost-plus pricing is used the selling price will also be increased. An increase in 52 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

8 selling price may result in a further decline in demand. Cost-plus pricing ignores price/demand relationships. For a more detailed discussion of the answer required to this question see section on Limitations of cost-plus pricing in Chapter 11. (d) For an answer to this question see section on Reasons for using cost-based pricing formulae in Chapter 11 and Some arguments in favour of absorption costing in Chapter 7. Note that SSAP 9 requires that absorption costing (full costing) be used for external reporting. (a) Sales for the second six-monthly period have increased for department A, but profit has declined, whereas sales for department B have declined and profit has increased. This situation arises because stocks are valued on an absorption cost basis. With an absorption costing system, fixed overheads are included in the stock valuations, and this can result in the amount of fixed overhead charged as an expense being different from the amount of fixed overhead incurred during a period. The effect of including fixed overheads in the stock valuation is shown below: Question July 31 December 1 January 30 June Department Department Department Department A B A B Fixed overheads brought forward in opening stock of finished goods a Fixed overheads carried forward in closing stock of goods b Profit increased by Profit reduced by Net profit as per absorption costing profit and loss account Profit prior to stock adjustment Notes a Stocks are valued at factory cost with an absorption costing system. The opening stock valuation for department A for the first six months is based on a product cost of 20 per unit. Therefore opening stock comprises 3000 units. Fixed manufacturing overheads are charged to the product made in department A at 12 per unit. Consequently, the stock valuation includes for fixed overheads. The same approach is used to calculate the fixed overheads included in the opening stock valuation for the second period and department B. b Closing stock for department B (first period) 6000 units ( / 20). Fixed overheads included in closing stock valuation (6000 units 12). The same approach is used to calculate fixed overheads included in the remaining stock valuations. Comments During the first six months for department A, stocks are increasing so that the stock adjustment results in a reduction of the fixed overhead charge for the period of Fixed manufacturing overheads of have been incurred during the period. Therefore the total fixed manufacturing overhead charge for the period is In the first period for department B stocks are declining and the stock adjustment will result in an additional fixed manufacturing overheads being included in the stock valuation. Consequently, the fixed manufacturing INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 53

9 overhead charge for the period is ( ). When stocks are increasing, the stock adjustment will have a favourable impact on profits (department A, period 1), and when stocks are declining, the stock adjustment will have an adverse impact on profits (department B, period 1). In the second period stocks decline in department A and the stock adjustment will have an adverse impact on profits, whereas in department B stocks increase and this has a favourable impact on profit. When the two periods are compared, the stock adjustment has an adverse impact on the profits of department A and a favourable impact on the profits of department B. With an absorption costing system, profit is a function of sales and stock movements, and these stock movements can have an adverse impact on profits even when sales are increasing. (b) Departmental profit and loss accounts (marginal costing basis) 1 July 31 December 1 January 30 June Department Department Department Department A B A B Sales revenue Variable manufacturing costs: Direct material Direct labour Variable overheads Variable factory cost of production Add opening stock of finished goods Less closing stock of finished goods Variable factory cost of goods sold Total contribution Less: Fixed factory overheads Fixed administrative and selling costs Net profit INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS