Income effects of alternative cost

accumulation systems

In product costing the costs attributed to each unit of production may be calculated Question IM 7.1
by using either Intermediate
(i) absorption costing, or
(ii) marginal (or direct or variable) costing.
Similarly, in departmental cost or profit reports the fixed costs of overhead or ser-
vice departments may be allocated to production departments as an integral part of
the production departments’ costs or else segregated in some form.
Required:
Describe absorption and marginal (or direct or variable) costing and outline the
strengths and weaknesses of each method. (c. 11 marks)
ACCA P2 Management Accounting

Discuss the arguments for and against the inclusion of fixed overheads in stock val- Question IM 7.2
uation for the purpose of internal profit measurement. Intermediate
Solo Limited makes and sells a single product. The following data relate to periods Question IM 7.3
1 to 4. Intermediate:
Preparation of
(£) variable and
absorption
Variable cost per unit 30 costing
Selling price per unit 55 statements
Fixed costs per period 6000

Normal activity is 500 units and production and sales for the four periods are as
follows:

Period 1 units Period 2 units Period 3 units Period 4 units

Sales 500 400 550 450

Production 500 500 450 500

There were no opening stocks at the start of period 1.

Required:
(a) Prepare operating statements for EACH of the periods 1 to 4, based on
marginal costing principles. (4 marks)
(b) Prepare operating statements for EACH of the periods 1 to 4, based on
absorption costing principles. (6 marks)
(c) Comment briefly on the results obtained in each period AND in total by the
two systems. (5 marks)
(Total 15 marks)
CIMA Stage 1 Cost Accounting

INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 37

Question IM 7.4 (a) PQ Limited makes and sells a single product, X, and has budgeted the
Intermediate: following figures for a one-year period:
Preparation of Sales, in units 160 000
variable and
absorption costing (£) (£)
systems and CVP
analysis Sales 6 400 000
Production costs:
Variable 2 560 000
Fixed 800 000

Selling, distribution and administration costs:

Variable 1 280 000
Fixed 1––––––––
200 000
Total costs 5 840 000
–––––––––
Net profit 560 000
–––––––––

Fixed costs are assumed to be incurred evenly throughout the year. At the begin-
ning of the year, there were no stocks of finished goods. In the first quarter of the
year, 55 000 units were produced and 40 000 units were sold.
You are required to prepare profit statements for the first quarter, using
(i) marginal costing, and
(ii) absorption costing. (6 marks)
(b) There is a difference in the profit reported when marginal costing is used
compared with when absorption costing is used.
You are required to discuss the above statement and to indicate how each of
the following conditions would affect the net profit reported
(i) when sales and production are in balance at standard (or expected) volume,
(ii) when sales exceed production,
(iii) when production exceeds sales.
Use the figures from your answer to (a) above to support your discussion; you
should also refer to SSAP 9. (9 marks)
(c) WF Limited makes and sells a range of plastic garden furniture. These items
are sold in sets of one table with four chairs for £80 per set.
The variable costs per set are £20 for manufacturing and £10 for variable
selling, distribution and administration.
Direct labour is treated as a fixed cost and the total fixed costs of
manufacturing, including depreciation of the plastic-moulding machinery, are
£800 000 per annum. Budgeted profit for the forthcoming year is £400 000.
Increased competition has resulted in the management of WF Limited
engaging market research consultants. The consultants have recommended
three possible strategies, as follows:

Reduce selling Expected increase

price per set by in sales (sets)
% %

Strategy 1 5 10
Strategy 2 7.5 20
Strategy 3 10 25
You are required to assess the effect on profits of each of the three strategies, and to
recommend which strategy, if any, ought to be adopted. (10 marks)
(Total 25 marks)
CIMA Stage 2 Cost Accounting

38 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

A manufacturer of glass bottles has been affected by competition from plastic bot- Question IM 7.5
tles and is currently operating at between 65 and 70 per cent of maximum capacity. Intermediate:
The company at present reports profits on an absorption costing basis but with Preparation of
the high fixed costs associated with the glass container industry and a substantial variable and
difference between sales volumes and production in some months, the accountant absorption
has been criticized for reporting widely different profits from month to month. To costing profit
counteract this criticism, he is proposing in future to report profits based on mar- statements and
ginal costing and in his proposal to management lists the following reasons for comments in
wishing to change: support of a
1. Marginal costing provides for the complete segregation of fixed costs, thus variable costing
facilitating closer control of production costs. system
2. It eliminates the distortion of interim profit statements which occur when there
are seasonal fluctuations in sales volume although production is at a fairly
constant level.
3. It results in cost information which is more helpful in determining the sales
policy necessary to maximise profits.
From the accounting records the following figures were extracted: Standard cost
per gross (a gross is 144 bottles and is the cost unit used within the business):

(£)

Direct materials 8.00

Direct labour 7.20
Variable production overhead 3.36
–––––
Total variable production cost 18.56
Fixed production overhead 7.52*
–––––
Total production standard cost 26.08
–––––
*The fixed production overhead rate was based on the following computations:
Total annual fixed production overhead was budgeted at £758 4000 or £632 000
per month.
Production volume was set at 1 008 000 gross bottles or 70 per cent of maximum
capacity.
There is a slight difference in budgeted fixed production overhead at different lev-
els of operating:

Activity level
(per cent of Amount per month
maximum capacity) (£000)

50–75 632
76–90 648
91–100 656

You may assume that actual fixed production overhead incurred was as budgeted.
Additional information:
September October

Gross sold 87 000 101 000

Gross produced 115 000 78 000
Sales price, per gross £32 £32
Fixed selling costs £120 000 £120 000
Fixed administrative costs £80 000 80 000

There were no finished goods in stock at 1 September.

INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 39

 You are required
(a) to prepare monthly profit statements for September and October using
(i) absorption costing; and
(ii) marginal costing; (16 marks)
(b) to comment briefly on the accountant’s three reasons which he listed to
support his proposal. (9 marks)
(Total 25 marks)
CIMA Stage 2 Cost Accounting

Question IM 7.6 A company manufactures a single product with the following variable costs per
Intermediate: unit
Calculation of Direct materials £7.00
overhead Direct labour £5.50
absorption rates Manufacturing overhead £2.00
and an
explanation of the The selling price of the product is £36.00 per unit. Fixed manufacturing costs are
differences in expected to be £1 340 000 for a period. Fixed non-manufacturing costs are expected
profits to be £875 000. Fixed manufacturing costs can be analysed as follows:

Production Department Service General

1 2 Department Factory

£380 000 £465 000 £265 000 £230 000

‘General Factory’ costs represent space costs, for example rates, lighting and heat-
ing. Space utilization is as follows:

Production department 1 40%

Production department 2 50%
Service department 10%

60% of service department costs are labour related and the remaining 40% machine
related.
Normal production department activity is:

Direct labour hours Machine hours Production units

Department 1 80 000 2400 120 000

Department 2 100 000 2400 120 000

Fixed manufacturing overheads are absorbed at a predetermined rate per unit of

production for each production department, based upon normal activity.
Required:
(a) Prepare a profit statement for a period using the full absorption costing system
described above and showing each element of cost separately. Costs for the
period were as per expectation, except for additional expenditure of £20 000 on
fixed manufacturing overhead in Production Department 1. Production and
sales were 116 000 and 114 000 units respectively for the period. (14 marks)
(b) Prepare a profit statement for the period using marginal costing principles
instead. (5 marks)
(c) Contrast the general effect on profit of using absorption and marginal costing
systems respectively. (Use the figures calculated in (a) and (b) above to
illustrate your answer.) (6 marks)
(Total 25 marks)
ACCA Cost and Management Accounting 1

40 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

Synchrodot Ltd manufactures two standard products, product 1 selling at £15 and Question IM 7.7
product 2 selling at £18. A standard absorption costing system is in operation and Advanced:
summarised details of the unit cost standards are as follows: Preparation and
comments on
Standard Cost variable and
Data – Summary absorption
Product 1 (£) Product 2 (£) costing profit
Direct Material Cost 2 3 statements
Direct Labour Cost 1 2
Overhead (Fixed and Variable) 7 9
––– –––
£10 £14
–––
––– –––
–––

The budgeted fixed factory overhead for Synchrodot Ltd is £180 000 (per quarter)
for product 1 and £480 000 (per quarter) for product 2. This apportionment to prod-
uct lines is achieved by using a variety of ‘appropriate’ bases for individual expense
categories, e.g. floor space for rates, number of workstaff for supervisory salaries
etc. The fixed overhead is absorbed into production using practical capacity as the
basis and any volume variance is written off (or credited) to the Profit and Loss
Account in the quarter in which it occurs. Any planned volume variance in the
quarterly budgets is dealt with similarly. The practical capacity per quarter is 30 000
units for product 1 and 60 000 units for product 2.
At the March board meeting the draft budgeted income statement for the
April/May/June quarter is presented for consideration. This shows the following:

Budgeted Income Statement for April, May and June

Product 1 Product 2

Budgeted Sales Quantity 30 000 units 57 000 units

Budgeted Production Quantity 24 000 units 60 000 units
Budgeted Sales Revenue £450 000 £1 026 000
Budgeted Production Costs
Direct Material £48 000 £180 000
Direct Labour 24 000 120 000
Factory Overhead 1204 000 540 000
£276 000 £840 000
Add:
Budgeted opening
Finished Goods
Stock at 1 April (8000 units) 180 000 (3000 units) 1142 000
356 000 £882 000
Less:
Budgeted closing
Finished Goods
Stock at 30 June (2000 units) 1120 000 (6000 units) 1184 000
Budgeted Manufacuring
Cost of Budgeted Sales £336 000 £798 000
Budgeted Manufacturing
Profit £114 000 £228 000
Budgeted
Administrative and
Selling Costs (fixed) 130 000 1148 000
Budgeted Profit £84 000 £180 000

The statement causes consternation at the board meeting because it seems to show
that product 2 contributes much more profit than product 1 and yet this has not
previously been apparent.

INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 41

 The Sales Director is perplexed and he points out that the budgeted sales pro-
gramme for the forthcoming quarter is identical with that accepted for the current
quarter (January/February/March) and yet the budget for the current quarter
shows a budgeted profit of £120 000 for each product line and the actual results
seem to be in line with the budget.
The Production Director emphasises that identical assumptions, as to unit variable
costs, selling prices and manufacturing efficiency, underlie both budgets but there has
been a change in the budgeted production pattern. He produces the following table:
Budgeted Production Product 1 Product 2
January/February/March 30 000 units 52 500 units
April/May/June 24 000 units 60 000 units
He urges that the company’s budgeting procedures be overhauled as he can see no
reason why the quarter’s profit should be £24 000 up on the previous quarter and
why the net profit for product 1 should fall from £4.00 to £2.80 per unit sold,
whereas, for product 2 it should rise from £2.11 to £3.16.
You are required:
(a) To reconstruct the company’s budget for the January/February/March quarter.
(6 marks)
(b) To restate the budgets (for both quarters) using standard marginal cost as the
stock valuation basis. (8 marks)
(c) To comment on the queries raised by the Sales Director and the Production
Director and on the varying profit figures disclosed by the alternative budgets.
(8 marks)
(Total 22 marks)
ACCA Level 2 Management Accounting

Question IM 7.8 The accountant of Minerva Ltd, a small company manufacturing only one product,
Advanced: wishes to decide how to present the company’s monthly management accounts. To
Explanation of date only actual information has been presented on an historic cost basis, with
difference stocks valued at average cost. Standard costs have now been derived for the costs
between of production. The practical capacity (also known as full capacity) for annual pro-
absorption and duction is 160 000 units, and this has been used as the basis for the allocation of
variable costing production overheads. Selling and administration fixed overheads have been allo-
profit statements cated assuming all 160 000 units are sold. The expected production capacity for
2001 is 140 000 units. It is anticipated now that, for the twelve months to
31 December 2001, production and sales volume will equal 120 000 units, compared
to the forecast sales and production volumes of 140 000 units. The standard cost
and standard profit per unit based on practical capacity is:
(£ per unit) (£ per unit)

Selling price 25.00

Production costs:
Variable 8.00
Fixed 06.00
14.00
Variable selling costs 01.00 15.00
10.00
Other fixed costs:
Administration 2.10
Selling 01.20 03.30
Standard profit per unit 06.70

The accountant has prepared the following three drafts (see below) of Minerva
Ltd’s profit and loss account for the month of November 2000 using three different
accounting methods. The drafts are based on data relating to production, sales and
stock for November 2000 which are given below.
42 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS
 Production and sales quantities November 2000
(units)

Opening stock 20 000

Production 08 000
28 000
Less Sales 10 000
Closing stock 18 000
––––––

The accountant is trying to choose the best method of presenting the financial
information to the directors. The present method is shown under the Actual costs
column; the two other methods are based on the standard costs derived above.
The following estimated figures for the month of December 2000 have just come
to hand:
Sales 12 000 units at £25 Production 14 000 units
Production costs: Administration costs £24 500
variable £116 000 Selling costs:
fixed £90 000 variable £12 000
fixed £15 000

Draft profit and loss accounts for the month ended 30 November 2000
Actual costs
Absorption Variable cost
cost method method
(£000) (£000) (£000) (£000) (£000) (£000)

Sales (10 000 units at £25) 250 250 250

Opening stock 280 280 160
Production costs:
variable 60 112a 64
fixed 066 000 –—
406 392 224
Closing stock 261 145 252 140 144 80
105 110 170
Variable selling costs –— –— –10
Gross profit/contribution 105 110 160
Other expenses:
Production – fixed —- —- 80
Administration – fixed 23 21 28
Selling:
variable 11 10 —-
fixed 014 048 012 043 016 124
57 67 36
Variances
Production
variable – expenditure (4) (4)
fixed – volume 32 —-
– expenditure (14) (14)
Administration – volume 7 —
Administration – expenditure (5) (5)
Selling:
variable – expenditure 1 1
fixed – volume 4 —
fixed – expenditure –— (2) 019 (2) (24)
Net profit 057 048 (60)
–––– –––– ––-––
Note
aSum of variable and fixed costs.

INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 43

 Requirements
(a) Prepare a schedule explaining the main difference(s) between the net profit
figures for November 2000 under the three different allocation methods.
(8 marks)
(b) Discuss the relative merits of the two suggested alternative methods as a
means of providing useful information to the company’s senior management.
(8 marks)
(c) Draw up a short report for senior management presenting your
recommendations for the choice of method of preparing the monthly accounts,
incorporating in your report the profit and loss account for November and the
projected profit and loss account for December 2000 as examples of your
recommendations. (9 marks)
(Total 25 marks)
ICAEW P2 Management Accounting

44 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS