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STUDENT NOTES
Accountants and managers require financial information for many different purposes. To help make such decisions, costs can be classified in different ways: direct or indirect (in relation to production product costs) fixed, variable or semi-variable (in relation to time period costs). The difference in the treatment of fixed and variable costs is often crucial in making these decisions. The way fixed and variable costs are treated can give substantially different valuations of stock and hence profits. Dividing costs into product costs or period costs is essential in considering cost elements in absorption and marginal costing. Product costs: can be identified with a product, e.g. direct wages and direct materials. can be charged against revenue in the period when the products to which they relate are sold. form part of the valuation of stock of finished goods and work-inprogress. Period costs are not included in the valuations of stock. vary with production. Period costs: are those associated with time as opposed to product, e.g. annual insurance. can be charged against revenue in the period in which they are incurred. are usually fixed over a period of time, e.g. annual rent.
Advantages of marginal costing Easy for non-accountants to understand and can be used with standard costing systems. Can be used in break-even analysis. Fixed costs are incurred over a period of time. Such costs are not therefore directly related to production and hence are not included in the valuation of stock. Profits calculations are more realistic because they are related to the time period during which they arise. Fixed costs are not carried forward from one accounting period to the next. Assists when choices have to be made between alternatives, and contribution (selling price variable costs) is a critical consideration. Pricing policy can be related to variable costs as fixed costs are deducted from total contribution. This can assist when making decisions regarding special orders. The unit cost is pre-determined. Problems arising from a variable fixed cost per unit are eliminated. Apportionment of overheads is required. Overhead apportionment is frequently calculated on a subjective basis of the relationship between fixed costs and departmental activity. Under or over-absorption of overheads is avoided. (See section on under and over-absorption of overheads). The procedures to deal with under or over-absorption of overheads takes place when the level of activity differs from the pre-planned level. Useful when a costing is required for a specific decision that management is considering. Advantages of absorption (total) costing Fixed costs are incurred as a natural part of production. As absorption costing includes all relevant production costs in valuing closing stock a more realistic profit figure can be calculated. In marginal costing losses can occur in periods when sales are low and total fixed costs are written off. If the goods are sold in a later period then a distortion in the profit figures may arise.
Absorption costing gives better information for pricing products as it includes both variable and fixed costs. Marginal costing may lead to lower prices being offered if the firm is operating below capacity. Customers may still expect these lower prices as demand/capacity increases. Which method should be used? As both methods have advantages and disadvantages, the precise method to use will depend on specific circumstances and the nature of the product/business. Where the viability of a product is desired, marginal costing would be used. However, a firm with a long-maturing product, such as whisky, may decide absorption costing is the more appropriate method. Only one method will be used by a firm. Over and under-absorption of overheads In the first set of examples provided in this resource the problem of over and under-absorption of overheads has been avoided by assuming that the actual and normal or planned output are the same. This is an unrealistic assumption. Consider the following example. Normal/planned production level Normal/planned fixed overheads Actual production 8,000 units 40,000 7,500 units
Fixed cost per unit = 40,000/8,000 = 5 Cost charged to production = 7,500 5 = 37,500 Under-absorbed fixed cost = 40,000 37,500 = 2,500 This means that 2,500 less than the actual fixed cost has been charged to the finished products, thus this under-absorbed overhead must be deducted from the profit calculated.
Exemplar 1
Normal production equals actual production Consider the following information illustrating the manufacture of a single product. Selling price per unit Variable cost per unit Annual fixed cost Normal production level Actual production level Sales 20 12 40,000 10,000 units 10,000 units 9,500 units
The profit statement using absorption costing would appear as shown below. Profit statement using absorption costing Sales (note 1) Less cost of sales Variable costs (Note 2) Fixed costs (Note 3) 190,000
Closing stock (Note 4) Profit Note 1 Note 2 Note 3 Note 4 Sales 9500 units 20 = 190,000 Variable costs 10,000 12 = 120,000 Fixed costs entered as actual figure
152,000 38,000
Closing stock (units) = 10,000 9,500 = 500 units Closing stock valued at total cost per unit number of units Total cost per unit (TCpu) = Variable cost per unit (VCpu) + Fixed cost per unit (FCpu) Fixed cost per unit calculated on normal production level = 40,000 / 10,000 units = 4 per unit TCpu = 12 + 4 = 16 Closing stock = 500 units 16 = 8,000
Profit statement using marginal costing Sales (Note 1) Less cost of sales Variable costs (Note 2) Closing stock (Note 5) Contribution Fixed cost Profit 190,000
120,000 6,000
Note 5 Closing stock valued at variable cost per unit number of units Closing stock = 500 12 = 6,000 As can be seen, the treatment of fixed costs has an influence on the valuation of closing stock and the eventual profit. The following table illustrates the differences. Absorption Closing stock Profit 8,000 38,000 Marginal 6,000 36,000
Exercise 1 From the following data relating to three firms, prepare two statements each to show how profit is calculated using (a) (b) Absorption costing Marginal costing.
Selling price per unit Variable cost per unit Annual fixed cost Normal production level (units) Actual production level (units) Sales (units)
Exercise 1 Solution Firm A (a) Profit statement using absorption costing Sales Less cost of sales Variable costs Fixed costs 462,500
333,000 129,500
(b)
Sales Less cost of sales Variable costs Closing stock (Note 2) Contribution Fixed costs Profit
300,000 22,500
Note 1 Fixed costs/Output = 60,000/20,000 units = 3 per unit TCpu = VCpu + FCpu = 15 + 3 = 18 Closing stock (units) = Production Sales = 20,000 18,500 = 1,500 1,500 18 = 27,000 Note 2 Closing stock (units) VCpu = 1,500 15 = 22,500
Firm B (a) Profit statement using absorption costing Sales Less cost of sales Variable costs Fixed costs 42,000
33,600 8,400
(b)
Sales Less cost of sales Variable costs Closing stock (Note 2) Contribution Fixed costs Profit
20,000 3,200
Note 1 Fixed costs/Output = 20,000/5,000 units = 4 per unit TCpu = VCpu + FCpu = 4 + 4 = 8 Closing stock (units) = Production Sales = 5,000 4,200 = 800 800 8 = 6,400 Note 2 Closing stock (units) VCpu = 800 4 = 3,200
Firm C (a) Profit statement using absorption costing Sales Less cost of sales Variable costs Fixed costs 690,000
575,000 115,000
(b)
Sales Less cost of sales Variable costs Closing stock (Note 2) Contribution Fixed costs Profit
480,000 20,000
460,000 230,000
110,000
Note 1 Fixed costs/Output = 120,000/60,000 units = 2 per unit TCpu = VCpu + FCpu = 8 + 2 = 10 Closing stock (units) = Production Sales = 60,000 57,500 = 2,500 2,500 10 = 25,000 Note 2 Closing stock (units) VCpu = 2,500 8 = 20,000
Exemplar 2
Under and over-absorption of overheads OTR plc sets up as a manufacturing business in Aberdeen. The selling price of its single product is 25 per unit. Direct material costs are 4 per unit and the direct labour costs are 11 per unit. Annual fixed costs are 50,000 for a normal production level of 10,000 units. The following information relates to production and sales for Year 1 and Year 2. Year 1 11,500 10,000 Year 2 9,500 10,500
You are required to prepare statements showing the valuation of stock and the profit figures for Years 1 and 2 using: (a) (b) Absorption costing Marginal costing.
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(a)
Sales (Note 1) Less cost of sales Opening stock Variable costs (Note 2) Fixed costs (Note 3)
Note 1 Sales Year 1 = 10,000 units 25 = 250,000 Year 2 = 10,500 units 25 = 262,500 Note 2 Variable costs Year 1 = 11,500 units (4 + 11) = 172,500 Year 2 = 9,500 units (4 + 11) = 142,500 Note 3 Fixed costs Fixed cost per unit = 50,000/10,000 = 5 Fixed cost charged to production in Year 1 = 11,500 5 = 57,500 Fixed cost charged to production in Year 2 = 9,500 5 = 47,500 Note 4 Closing stock Year 1 = (11,500 10,000) (4 + 11 + 5) = 30,000 Year 2 = (1,500 + 9,500 10,500) 20 = 10,000 Note 5 Over/under-absorption of overheads Year 1 = 57,500 50,000 = 7,500 over-absorbed Year 2 = 50,000 47,500 = 2,500 under-absorbed
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(b)
Sales (Note 1) Less cost of sales Opening stock Variable costs (Note 2)
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Exercise 2 PLK plc sets up as a manufacturing business in Dundee. The selling price of its single product is 30 per unit. Direct material costs are 6 per unit and the direct labour costs are 10 per unit. Annual fixed costs are 80,000 for a normal production level of 20,000 units. The following information relates to production and sales for Year 1 and Year 2. Year 1 19,000 18,000 Year 2 20,500 19,500
You are required to prepare statements showing the valuation of stock and the profit figures for Year 1 and Year 2 using: (a) (b) Absorption costing Marginal costing.
Exercise 3 Annie Hall plc sets up as a manufacturing business in Kirkcaldy. The selling price of her single product is 10 per unit. Direct material costs are 3 per unit and the direct labour costs are 2 per unit. Annual fixed costs are 100,000 for a normal production level of 50,000 units. The following information relates to production and sales for Year 1 and Year 2. Year 1 48,000 47,000 Year 2 52,000 52,500
You are required to prepare statements showing the valuation of stock and the profit figures for Year 1 and Year 2 using: (a) (b) Absorption costing Marginal costing.
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Exercise 2 Solution (a) Profit statement using absorption costing Year 1 540,000 Year 2 585,000
Sales Less cost of sales Opening stock Variable costs Fixed costs
Closing stock
(b)
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Exercise 3 - Solution (a) Profit statement using absorption costing Year 1 470,000 Year 2 525,000
Sales Less cost of sales Opening stock Variable costs Fixed costs
Closing stock
(b)
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Exemplar 3
Using overhead absorption rates Thompson and Burnett are a manufacturing partnership. During Year 1 the following information becomes available. Sales Costs Direct material Direct labour (12 per labour hour) Variable production overheads Fixed production overheads Fixed selling and distribution expenses 800,000
Information regarding opening and closing stock is as follows: Direct Material 1 Jan 31 Dec 60,000 75,000 Direct Labour 36,000 48,000 Variable Production Overhead 18,000 35,000 Fixed Production Overhead ? ?
Fixed overheads are recovered at 6 per direct labour hour. You are required to prepare two profit statements using: (a) (b) Absorption costing Marginal costing.
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(a)
Sales Less cost of sales Opening stock (Note 1) Direct material Direct labour Variable production overhead Fixed production overhead (Note 2)
Note 1 Number of labour hours charged to opening stock = 36,000/12 = 3,000 Fixed overhead charged to opening stock = 3,000 6 per hour = 18,000 Valuation of stock = 60,000 + 36,000 + 18,000 + 18,000 = 132,000 Note 2 Fixed overhead charged to production. Number of labour hours worked = 240,000/12 = 20,000 Fixed overhead charged to production = 20,000 6 = 120,000 Note 3 Number of labour hours charged to closing stock = 48,000/12 = 4,000 Fixed overhead charged to closing stock = 4,000 6 per hour = 24,000 Valuation of stock = 75,000 + 48,000 + 35,000 + 24,000 = 182,000 Note 4 Under-absorbed overhead = 124,000 120,000 = 4,000
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(b)
Sales Less cost of sales Opening stock (Note 5) Direct material Direct labour Variable production overhead
Closing stock (Note 6) Contribution Fixed production overheads Fixed selling and distribution expenses Profit
596,000 204,000
124,000 25,000
149,000 55,000
Note 5 Valuation of stock = 60,000 + 36,000 + 18,000 = 114,000 Note 6 Valuation of stock = 75,000 + 48,000 + 35,000 = 158,000
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Exercise 4 Telfer and Burrows are a manufacturing partnership. During Year 1 the following information becomes available. Sales Costs Direct material Direct labour (10 per labour hour) Variable production overheads Fixed production overheads Fixed selling and distribution expenses 600,000
Information regarding opening and closing stock is as follows. Direct Material 1 Jan 31 Dec 15,000 30,000 Direct Labour 18,000 24,000 Variable Production Overhead 12,000 20,000 Fixed Production Overhead ? ?
Fixed overheads are recovered at 4 per direct labour hour. You are required to prepare two profit statements using: (a) (b) Absorption costing Marginal costing.
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Exercise 4 Solution (a) Profit statement for Year 1 using absorption costing Sales Less cost of sales Opening stock (Note 1) Direct material Direct labour Variable production overhead Fixed production overhead (Note 2) 600,000
Note 1 Number of labour hours charged to opening stock = 18,000/10 = 1,800 Fixed overhead charged to opening stock = 1,800 4 = 7,200 Valuation of stock = 15,000 + 18,000 + 12,000 +7,200 = 52,200 Note 2 Fixed overhead charged to production Number of labour hours worked = 180,000/10 = 18,000 Fixed overhead charged to production = 18,000 4 = 72,000 Note 3 Number of labour hours charged to closing stock = 24,000/10 = 2,400 Fixed overhead charged to closing stock = 2,400 4 = 9,600 Valuation of stock = 30,000 + 24,000 + 20,000 + 9,600 = 83,600 Note 4 Under-absorbed overhead = 75,000 72,000 = 3,000
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(b)
Sales Less cost of sales Opening stock Direct material Direct labour Variable production overhead
Closing stock Contribution Fixed production overheads Fixed selling and distribution expenses Profit
416,000 184,000
75,000 45,000
120,000 64,000
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Exemplar 4
Calculating sales volume and value Compo PLC produces a new type of compost for use in domestic greenhouses. The following information relates to Year 1 and Year 2 during which time all unit costs and revenues remained constant. Annual fixed costs of production were 95,000. The compost was sold in 50 litre bags at 50 per bag. Variable costs of production which were constant over the 2 years are: Per litre 0.33 0.12 0.20
Stock data 1 January Year 1 1 January Year 2 31 December Year 2 50,000 75,000 25,000
The production budget shows a normal level of activity of 950,000 litres per annum. You are required to calculate for both years: (a) (b) (c) total sales value (assume no wastage) total variable costs charged to production (i) the fixed overhead absorption rate based on the normal level of activity
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(ii) total fixed costs charged to production (iii) the value of over- or under-absorption of fixed costs (d) opening and closing stock values for use in (i) absorption cost accounts (ii) marginal cost accounts the profit or loss earned (i) using absorption costing (ii) using marginal costing.
(e)
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(a)
Selling price per litre = 50/50 = 1 per litre Sales volume (litres) Year 1 50,000 900,000 950,000 75,000 875,000 Year 2 75,000 1,000,000 1,075,000 25,000 1,050,000
Opening stock Production Closing stock Sales Sales Year 1 = 875,000 1 = 875,000 Sales Year 2 = 1,050,000 1 = 1,050,000 (b)
Total variable costs charged to production Year 1 = 900,000 65p = 585,000 Total variable costs charged to production Year 2 = 1,000,000 65p = 650,000 (i) Fixed overhead absorption rate = 95,000/950,000 = 10p per litre Fixed costs charged to production Year 1 = 900,000 10p = 90,000 Fixed costs charged to production Year 2 = 1,000,000 10p = 100,000
(c)
(ii)
(iii) Under-absorbed overhead Year 1 = 95,000 90,000 = 5,000 (under) Over-absorbed overhead Year 2 = 95,000 100,000 = 5,000 (over) (d) Opening and closing stock values (i) Absorption costing Total cost per unit = Variable cost per unit + Fixed cost per unit = 65p + 10p = 75p 1 January Year 1 = 50,000 75p = 37,500 31 December Year 1 = 75,000 75p = 56,250 31 December Year 2 = 25,000 75p = 18,750
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(ii)
Marginal costing 1 January Year 1 = 50,000 65p = 32,500 31 December Year 1 = 75,000 65p = 48,750 31 December Year 2 = 25,000 65p = 16,250
(e)
(i)
Profit statement using absorption costing Year 1 875,000 Year 2 1,050,000 56,250 650,000 100,000 806,250 18,750
Sales Less cost of sales Opening stock Variable costs Fixed costs
Closing stock
213,750
267,500
(ii)
Profit statement using marginal costing Year 1 875,000 Year 2 1,050,000 48,750 650,000 698,750 16,250
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Exercise 5 Rosie Paterson set up a micro-brewery on 1 January Year 1 to produce beers to sell in Scotland. She has provided the following information relating to the year ended 31 December Year 1, when sales and production levels were 300,000 litres. Rosie Paterson has also estimated that there will no cost changes over the next 2 years. The normal level of activity in the brewery is 300,000 litres per annum. Sales Production costs Direct materials Direct labour Variable overheads Fixed production overhead 1,200,000
Net profit Projected figures for the next 2 years are: Year 2 290,000 330,000 Year 3 305,000 280,000
372,000
There was no opening stock at the beginning of Year 2. You are required to prepare statements showing the profits for Years 2 and 3 using: (a) (b) Absorption costing Marginal costing.
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Exercise 5 Solution (a) Profit statement using absorption costing Year 2 1,160,000 Year 3 1,220,000 110,400 224,000 280,000 44,800 224,000 883,200 41,400
Sales Less cost of sales Opening stock Direct materials (Note 2) 264,000 Direct labour (Note 3) 330,000 Variable overheads (Note 4) 52,800 264,000 Fixed costs (Note 5) 910,800 110,400
800,400 359,600
(b)
Profit statement using marginal costing Year 2 1,160,000 Year 3 1,220,000 78,400 224,000 280,000 44,800 627,200 29,400
Sales Less cost of sales Opening stock Direct materials Direct labour Variable overheads
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Note 1 calculation of unit costs Direct materials 240,000/300,000 litres = 80p per litre Direct labour 300,000/300,000 litres = 1 per litre Variable overheads 48,000/300,000 litres = 16p per litre Fixed production overheads 240,000/300,000 litres = 80p per litre Note 2 direct materials Year 2 330,000 80p 264,000 Year 3 280,000 80p 224,000
Note 4 variable overheads Year 2 330,000 16p 52,800 Year 3 280,000 16p 44,800
Note 5 fixed costs Year 2 330,000 80p 264,000 Year 3 280,000 80p 224,000
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* (80p + 1 + 16p + 80p) Note 7 closing stock (value) Units VCpu 40,000 1.96* 78,400 * (80p + 1 + 16p) 15,000 1.96 29,400
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Exercise 6 Carglass plc produces windscreens for cars at a standard selling price of 75 per unit. You are given the following anticipated figures for Years 2 and 3. Fixed costs of production for a normal year are 150,000 and normal production is 15,000 units. Variable costs per unit are: Direct materials Direct labour Variable overheads Production data: Units produced 16,000 15,500 20 15 10
Year 2 Year 3
Stock data: Date 31 December Year 1 1 January Year 3 31 December Year 3 Units 1,000 1,500 1,200
You are required to prepare statements showing the profits for Years 2 and 3 using: (a) (b) Absorption costing Marginal costing.
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Exercise 6 Solution (a) Profit statement using absorption costing Year 2 1,162,500 Year 3 1,185,000 82,500 310,000 232,500 155,000 155,000 935,000 66,000
Sales (Note 1) Less cost of sales Opening stock (Note 2) 55,000 Direct materials (Note 3) 320,000 Direct labour (Note 4) 240,000 Variable overheads (Note 5) 160,000 160,000 Fixed costs (Note 6) 935,000 82,500
852,500 310,000
10,000 320,000
(b)
Profit statement using marginal costing Year 2 1,162,500 45,000 320,000 240,000 160,000 765,000 67,500 Year 3 1,185,000 67,500 310,000 232,500 155,000 765,000 54,000
Sales Less cost of sales Opening stock (Note 8) Direct materials Direct labour Variable overheads
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Year 2 Note 1 sales (units) Opening stock + Production Closing stock 1,000 16,000 17,000 1,500 15,500 1,162,500
Year 3
1,000 1,000 (45 + 10) 55,000 16,000 20 320,000 16,000 15 240,000 16,000 10 160,000 16,000 10* 160,000 * (150,000/15,000) 1,500 55 (TCpu) 82,500 1,000 45 (VCpu) 45,000 1,500 45 (VCpu) 67,500
1,500 1,500 55 82,500 15,500 20 310,000 15,500 15 232,500 15,500 10 155,000 15,500 10 155,000
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