Cost Management Accounting
Solutions (Additional questions)
CHAPTER 2
SOLUTIONS (ADDITIONAL QUESTIONS)
2.1.
a) too great and too small
b) activities.
c) activities
d) True
e) True
2.2
(a)
Contribution per unit = R20 – (R6 + R3.50)
= R10.50
Number of units sold = 400 units + 5 000 units – 900 units
= 4 500 units
Marginal costing statement:
Sales revenue (4 500 units x R20)
R90 000
Variable costs (4 500 units x R9.50)
(R42 750)
Total contribution (4 500 units x R 10.50)
Fixed production overheads
(R29 500)
Marginal costing profit
(b)
R47 250
R17 750
Profit under absorption costing
R20 700
Profit under marginal costing
R17 750
Difference
R 2 950
Fixed overhead absorption rate
= R29 500 / 5 000 units
= R5.90
Increase in inventory = 900 units – 400 units
= 500 units
Fixed overhead not charged to profit under absorption costing = 500 units x R5.90
= R2 950
Cost Management Accounting
Solutions (Additional questions)
2.3
The correct answer is C.
Inventory levels have fallen so marginal costing reports the higher profits
Absorption costing profit
R1 219 712
Add: Fixed overhead included in inventory level change (1 680 – 1 120) x R128
Marginal costing profit
R71 680
R1 291 392
If you choose option A, you deducted the fixed overhead included in the inventory level
change. If inventory levels decrease, absorption costing will report the lower profit, as well
as the fixed overhead absorbed during the period. Fixed overhead which had been carried
forward in opening inventory is released and included in cost of sales.
Option B is the absorption costing profit. The marginal costing profit must be different,
however, because there has been a change in inventory levels.
2.4
(a)(i) Marite’s costing method – absorption costing:
R’000
Sales (16 000 units x R60)
Less: Cost of sales (refer W1 for unit costs)
960
672
Opening inventory
Production (20 000 units x R42)
Closing inventory (4 000 units x R42)
0
840
(168)
Normal gross profit
Adjust for over-/(under-)absorbed fixed
production overhead W2
288
Adjusted gross profit
Less: Administration and selling costs
323
136
Administration (all fixed)
Selling (Sales x 10% + R15K fixed)
25
111
Profit
35
187
Cost Management Accounting
Solutions (Additional questions)
W1: Product cost per unit
DM + DL + VPO + FPO*
= R20 + R10 + R5 + R7
= R42
*Fixed production overhead rate (sometimes referred to as FOAR or POAR)
= R105 000 / 15 000 units
= R7
C2
Over-/(under-)recovery of fixed production overheads
Fixed production overhead control account:
Actual expenditure
Over-recovery of fixed
overheads
105 000 Absorbed overhead
(20 000 units x R7)
35 000
140 000
140 000
(a)(ii) Teboho’s costing method – variable costing:
Sales (16 000 units x R60)
960
Less: Variable costs (refer C1 for unit costs)
656
Opening inventory
Production (20 000 x R35)
Closing inventory (4 000 x R35)
Variable cost of sales
Variable admin and selling (10% x Sales)
0
700
(140)
560
96
Contribution
304
Less: Fixed costs
145
Production
Administration and selling (R25 + R15)
Profit
140 000
105
40
159
Cost Management Accounting
Solutions (Additional questions)
R’000
Per absorption costing (1)
187
Less: Fixed production overhead included in inventory increase (4 000 x R7)
(28)
Per variable costing (2)
159
C
1
Product cost per unit
DM + DL + VPO
= R20 + R10 + R5
= R35 (Note: Fixed production costs are not included in the product cost.)
(b)
Profit reconciliation:
The fundamental reason for the differences is that absorption costing (AC) treats
fixed production overheads (FPO) as product costs, whereas variable costing (VC)
treats these costs as period items.
Therefore, using VC (Teboho), all of the company’s FPO of R105 000 was charged
against income in the relevant period, whereas absorption costing expensed only
R77 0001. The difference of R28 000 is included in the company’s closing inventory
value (4 000 units x R7 per unit) and the expensing of it is deferred until the product
is actually sold.
1
2.5
(a)
R77 000 = 16 000 units actual production x R7 per unit – Over-recovery of R35 000
Income statements:
(i) Absorption costing
Period 1
Period 2
R’000
R’000
Sales (C1: 8 000 x R100, 10 000 x R100)
800
1 000
Less: Cost of sales
600
750
–
150
750
600
(150)
–
Normal gross profit
200
250
Over-/(under-)absorbed fixed production overhead
(C3)
(20)
(60)
Opening inventory
Production (C2: 10 000 x R75, 8 000 x R75)
Closing inventory (2 000 x R75)
Cost Management Accounting
Solutions (Additional questions)
Actual gross profit
180
190
Less: Selling overheads (C4)
(47)
(50)
(100)
(100)
33
40
Less: Administration overheads
Profit
(ii) Variable costing
Period 1
Period 2
R’000
R’000
Sales
800
1 000
Less: Total variable costs
452
565
–
110
550
440
(110)
–
440
550
12
15
Contribution
348
435
Less: Fixed costs
355
355
Production
220
220
35
35
100
100
(7)
80
Opening inventory [units x R55: C1 & C2)]
Production (units x R55: C1 & C2)
Closing inventory (units x R55: C1 & C2)
Variable cost of sales
Add: Variable selling costs (C4)
Selling
Administration
Profit/(loss)
Calculations:
C1
Units of production and sales:
Normal activity = R1m / R100 = 10 000 units
Sales (80%, 100%)
Production (100%, 80%)
C2
Period
1
Period
2
8 000
10 000
10 000
8 000
Product costs:
R’000
Variable costs:
Direct material
300
Direct wages
200
Production overhead
50
Cost Management Accounting
Solutions (Additional questions)
550 / 10 000
Variable costing =
Add: Fixed production overhead
rate
(R200 000 / 10 000)
Absorption costing =
C3
R55
R20
R75
Over-/(under-)absorbed:
Period 1
Period 2
Absorbed (10 000 x R20, 8 000 x
R20)
200
160
Actual 200 x R1.10
220
220
(Under)
(20)
(60)
C4
Selling overhead:
Selling variable cost = R1 500 / (10% x 10 000 = 1 000) = R1.50 per unit sold
 Budgeted fixed cost = R50 000 – (10 000 x R1.50) = R35 000
Variable selling (8 000, 10 000 x 1.50)
Add Fixed
(b)
Period 1
Period 2
R12 000
R15 000
35 000
35 000
R47 000
R50 000
Profit (loss) reconciliation:
Period
1
Period
2
R’000
R’000
33
40
73
Less: FPO included in inventory increase (2 000 x R20)
(40)
–
(40)
Add: FPO included in inventory decrease (2 000 x R20)
–
40
40
(7)
80
73
Absorption costing basis
Variable costing basis
Total
R’000
Cost Management Accounting
Solutions (Additional questions)
Whenever there is a change in inventory levels of manufactured goods, the
absorption and variable-based profits will differ. This occurs because of the different
way in which each method treats fixed production overheads (FPO): variable costing
as a period cost (i.e. when incurred), absorption costing as a product cost. The net
effect of this is that variable costing expenses the FPO when it is incurred,
absorption costing expenses the FPO when the product is sold.
When production exceeds sales, inventory increases and a portion of FPO is deferred
using absorption costing. In period 1, inventory increased by 2 000 units and
R40 000 FPO was deferred. Absorption costing was therefore higher by this amount.
When sales exceed production, inventory decreases and more FPO is expensed using
absorption costing resulting in a lower profit. Refer to period 2.
When sales and production are equal, the FPO expensed is the same using both
methods and profits are therefore identical. This occurred for periods 1 and 2 taken
together, and total profit for both methods was therefore the same at R73 000.
2.6
(a)
Product cost:
R
(b)
Direct material
9
Direct labour
5
Variable production
overheads
2
Variable cost product cost
16
Fixed production overhead
7
Absorption cost product cost
23
(R35 000 / 5 000 units = R7 FOAR VPO = R9 less
R7)
(As above)
Absorption costing:
R’000
Sales (2 900 units x R40)
Less: Cost of sales
Opening inventory
Production (4 800 units x R23)
116.0
66.7
0
110.4
Cost Management Accounting
Solutions (Additional questions)
Closing inventory (1 900 units x R23)
(43.7)
Normal gross profit
49.3
Adjust for over-/(under-) absorbed fixed production overhead
C1
(2.4)
Adjusted gross profit
46.9
Less: Administration and selling costs (2900 x R3 + R24K)
32.7
Profit
14.2
C1
Over-/(under-)recovery of fixed production overheads
Fixed production overhead control account:
Actual expenditure
36 000 Absorbed overhead (4 800 units x
R7)
Under-recovery of fixed overheads
36 000
55.1
Opening inventory
0
Closing inventory (1 900 x R16)
Variable cost of sales
(c)
116.0
Less: Variable costs
Production (4 800 x R16)
Variable admin and selling (2 900 units x R3)
76.8
(30.4)
46.4
8.7
Contribution
60.9
Less: Fixed costs
60.0
Production
36.0
Administration and selling
24.0
Profit
2 400
36 000
Variable costing:
Sales (2 900 units x R40)
33 600
0.9
Cost Management Accounting
Solutions (Additional questions)
Profit reconciliation:
Per absorption costing
14 200
Less fixed production overhead included in inventory increase (1 900
x R7)
(13 300)
Per variable costing
900
2.7
(a)
Absorption costing profit statement:
Opening inventory
0
Production cost
R1 528 800
(98 000 x R15.60)
Less: Closing inventory
(R124 800)
(8 000 x R15.60)
R1 404 000
Under-/(over-) recovery of fixed
overheads
R7 200
R360 000 – (98 000 x R3.60)
R1 411 200
Variable non-manufacturing costs
R144 000
Fixed non-manufacturing costs
R250 000
(90 000 x R1.60)
(R1 805 200)
Sales
Profit/(Loss)
(b)
R1 818 000
(90 000 x R20.20)
R12 800
Variable costing statement:
Opening inventory
0
Variable production cost
R1 176 000
(98 000 x R12)
Less: Closing inventory
(R96 000)
(8 000 x R12)
R1 080 000
Variable non-manufacturing costs
R144 000
(90 000 x R1.60)
(R1 224 000)
Sales
Contribution
R1 818 000
R594 000
Fixed costs
Production overheads
R360 000
Selling and administration
R250 000
Profit/(Loss)
(R16 000)
(90 000 x R20.20)
Cost Management Accounting
Solutions (Additional questions)
(c)
Explanation to operations director
Reconciliation
Absorption costing profit
R12 800
Fixed overhead included in closing inventory
R28 800 (8 000 x R3.60)
Variable costing profit
R16 000
Explanation
The absorption costing statement shows a profit of R12 800 whereas the variable
costing statement shows a loss of R16 000. The difference of R28 800 is due to the
absorption costing closing inventory computation including the equivalent value of
fixed production overhead. This is not the case in the variable costing closing
inventory computation where all fixed overheads are treated as a period cost.
With absorption costing, the fixed overheads of R28 800 will only be recorded as an
expense when the inventory of Product 007 is sold. Consequently, the absorption
costing computation shows a higher profit than the variable costing computation. For
internal profit measurements both methods are acceptable as long as there is
consistency in reporting. However, for external reporting it is generally accepted
(AC 108) that inventory values include all costs of production. Consequently it
might be surmised that the management accountant was preparing the profit
statement for internal use, and the group accountant for external use.
2.8
(a)
Traditional absorption costing approach:
Direct labour
hours
Product A (5 000 units x 1 hour)
5 000
Product b( 7 000 units x 2 hours)
14 000
19 000
Therefore: Overhead absorption rate = R285 000 / 19 000
= R15 per hour
Overhead absorbed would be as follows:
ProductA
1 hour x R15 = R15 per unit
Product B
2 hours x R15 = R30 per unit
Cost Management Accounting
Solutions (Additional questions)
(b)
ABC approach:
Machine hours
Product A
= 5 000 units x 3 hours
15 000
Product B
= 7 000 units x 1 hour
7 000
22 000
Using ABC the overhead costs are absorbed according to the cost drivers.
Machine-hour driven costs ( R220 000 / 22 000 m/c hours)
R10 per m/c hour
Set-up driven costs (R20 000 / 50 set-ups)
R400 per set-up
Order driven costs ( 45 000 / 75 orders)
R600 per order
Product A
Product B
Machine-driven costs (15 000 hrs x R10) R150 000
(7 000 x R10)
R70 000
Set-up costs (10 x R400)
R4 000
(40 x R400)
R16 000
Order handling costs (15 x R600)
R9 000
(60 x R600)
R36 000
R163 000
R122 000
Units produced
5 000
7 000
Overhead cost per unit
R32.60
R17.43
These figures suggest that Product M absorbs an unrealistic amount of overhead
using a direct labour hour basis. Overhead absorption should be based on the
activities which drive the costs, in this case machine hours, the number of production
run set-up and the number of orders handled for each product.
2.9.1
(a)
Budgeted fixed production costs / Budgeted output (normal level of activity)
= R1 600 / 800 units
Absorption rate = R2 per unit produced
During the quarter, the fixed production overhead absorbed = 220 units x R2 = R440
Cost Management Accounting
Solutions (Additional questions)
(b)
(c)
Actual fixed production overhead
R400 (0.25 of R1 600)
Absorbed fixed production overhead
(R440)
Over-absorption of overhead
R40
Profit for the quarter using absorption costing:
Sales (160 x R20)
R3 200
Production costs:
Variable (220 x R8)
Fixed (absorbed overhead 220 x R2)
Total (220 x R10)
Less: Closing inventories (220 x R10)
Production cost of sales
Adjustment for over-absorbed overhead
R1 760
R400
R2 200
R600
R1 600
R40
Total production costs
R1 560
Gross profit
R1 640
Less: Sales and distribution costs
Variable (160 x R4)
R640
Fixed (0.25 of R2 400)
R600
Net profit
(d)
R1 240
R400
Profit for the quarter using marginal costing:
Sales
Variable production costs
Less: Closing inventories (60 x R80)
Variable production cost of sales
Variable sales and distribution costs
Total variable cost of sales
R3 200
R1 760
R480
R1 280
R640
R1 920
Cost Management Accounting
Solutions (Additional questions)
Total contribution
Less: Fixed production costs incurred
Fixed sales and distribution costs
R1 280
R400
R600
Net profit
(e)
R1000
R280
The difference in profit is due to the different valuations of closing inventory. In
absorption costing, the 60 units of closing inventory include absorbed fixed
overheads of R120 (60 x R2), which are therefore costs carried over to the next
quarter and not charged against the profit of the current quarter. In marginal costing,
all fixed costs incurred in the period are charged against profit.
Absorption costing profit
R400
Fixed production costs carried forward in inventory value
R120
Marginal costing profit
R280
(f)
1. Fixed production costs are incurred in order to make output. It therefore seems
fair to charge all output with a share of these costs.
2. The requirements of the international accounting standard on inventory valuation
(IAS 2) states that closing inventory values should include a share of fixed
production overhead. Absorption costing fulfils that requirement.
3. Absorption costing is consistent with the accruals concept as a proportion of the
costs of production is carried forward to be matched against future sales.
4. Absorption costing involves charging fixed overheads to a product. This means it
is possible to ascertain whether it is profitable or not. The problem with
calculating the contribution of various products made by an enterprise is that it
may not be clear whether the contribution earned by each product is enough to
cover fixed costs.
5. Absorption costing is particularly useful in pricing decision in a job or batch
costing environment. It ensures that the profit mark-up is sufficient to cover fixed
costs.
Cost Management Accounting
Solutions (Additional questions)
(g)
TO:
The Managing Director
FROM:
The Management Accountant
DATE:
17 July 20x1
SUBJECT:
Inadequacy of traditional management accounting
Inadequacy 1:
Traditional management accounting grew out of cost accounting and hence its roots
are in manufacturing. For much of the twentieth century, manufacturing operated in
a business environment in which the supplier was of utmost importance, competition
was largely local and the speed of technical and social development, although rapid
compared with earlier eras, was far slower than at present. This simple operating
environment meant that an organisations’ managers were able to anticipate events
easily and plan with more certainty, using minimal external information, than is
possible today.
Now however, it is the customer who is king and the competitive environment
constantly threatens a product’s life cycle. To compete effectively, organisations
must therefore be flexible enough to cope with changes in customer requirements.
Such a focus on customers and competition requires a more forward-looking
approach, which must be substantially outward-looking and focus on external
information, as opposed to be backward-looking and inward-looking approach of
traditional management accounting.
Inadequacy 2:
The ‘management” that traditional management accounting was primarily intended
to serve was production management, hence the traditional emphasis on accounting
for labour costs, material costs and production overheads. Changes in organisations’
cost structures and in the nature of the costs have affected the relevance of such an
emphasis, however, and have led to the use of possibly misleading information,
especially with regard to overhead absorption.
Inadequacy 3:
The internal information used by management accounting tended to be sourced from
accounting systems which were directed towards financial reporting, but the
classifications of transactions for reporting purposes are not necessarily relevant for
decision making.
Cost Management Accounting
Solutions (Additional questions)
2.10
(a)
Absorption costing:
Duplo (Pty) Ltd – Actual results for latest year-end
R‘000
calculations
Sales (R1000 x 102 000 units) [120 000 less 15%]
102 000
Cost of sales
58 650
Opening Inventory
0
Production (138 000 [120 000 plus 15%] x R575)
79 350
Closing inventory (36 000 x R575) [R1 000 x 57.5%]
(20 700)
Normal Gross Profit
43 350
Over-/(under-)absorption
W1
Actual gross profit
2 250
45 600
Less: Administration and selling overheads
W2
Profit
20 100
25 500
Calculations:
C1 – Over-absorption
Production overheads
=
R30 000 000 x 50%
POAR
=
R15 000 000 / 120 0001 units
=
R125 per unit
Value of overhead absorbed (138 000 units x R125)
= R17 250 000
Value of overhead incurred2 (120 000 units x R125)
= R15 000 000
Over recovery due to volume variance
= R2 250 000
Notes:
1
Normal operating capacity = Budgeted sales level
2
Expenditure variance
= Nil as budgeted cost = Actual cost
C2 – Administration and selling overheads
Total admin and selling
= 120 000 units x R175 (R1 000 x 17.5%)
= R21 000 000
Less: Fixed costs
= R15 000 000
Total variable costs
= R6 000 000
Divide by 120 000 units
= R50 variable cost/unit
Total cost
= R15 000 000 + (102 000 units x R50/unit)
= R20 100 000
Cost Management Accounting
Solutions (Additional questions)
(b)
Variable costing:
Duplo (Pty) Ltd – Actual results for latest year-end
R’000
calculations
Sales (R1000 x 102 000) [102 000 less 15%]
102 000
Variable costs
51 000
Opening inventory
0
Production (138 000 [120 000 plus 15%] x R450)
62 100
Closing inventory (36 000 x R450) [R575 less R125]
Variable cost of sales
(16 200)
45 900
Variable selling (102 000 x R50)
5 100
Contribution
51 000
Less: Fixed Costs
(c)
Production
15 000
Administration and selling
15 000
Profit
21 000
Reconcile respective profits:
R
Profit per absorption costing
Less: Inventory increase x FOAR
25 500 000
36 000 x R125
Profit per variable costing
(d)
21 000 000
Target units:
Contribution per unit (R1 000 x 50%)
=
R500
Target profit
=
R250 (Treat as a VC)
Target units
(e)
4 500 000
(R1 000 x 25%)
=
Fixed Costs / (Contribution – Target profit per unit)
=
R30 000 000 / (R500 – R250)
=
120 000 units’ sales and production
Inconsistency in profit reporting:
As the budgeted profit was a variable profit, it is quite possible that the variable
target of 25% of sales could be maintained. However, the production director’s
concern is due to the scale of the variance between budgeted and actual sales (less
15%) and production (up 15%). The profit target has been maintained because the
Cost Management Accounting
Solutions (Additional questions)
company uses AC. As production exceeded sales, the expensing of R4.5 million of
fixed manufacturing costs will be deferred until the finished inventory is actually
sold. Using VC, however, results in a more realistic profit % of 20.6% (21/102)
owing to the FC being expensed in the period incurred.
2.11
(a)
VC Statement
R millions
Sales
(100 000 x R200)
Less: Total variable costs
20.0
10.0
Opening inventory
0.0
Direct material
(120 000 x R50)
6.0
Direct labour
(120 000 x R30)
3.6
Production overheads (W2)
(120 000 x R10)
1.2
Closing inventory (W1)
(20 000 x R90)
Variable cost of sales
(1.8)
9.0
Add: Variable administration and selling (W4)
(100 000 x R10)
Contribution
1.0
10.0
Less: Fixed Costs
6.0
Production (W3)
3.0
Administration and selling (W4)
3.0
Profit
4.0
Calculations:
C1 – Product cost
Absorption costing
= R2 400 000 Closing inventory / 20 000 units
= R120 per unit
Planned production volume variable =120 000 units – 100 000 units
=20 000 units
Planned over-recovery
=R600 000
 Predetermined FOAR
=R600 000 / 20 000 units
= R30 per unit
Variable costing product cost =R120 less R30
= R90 per unit
Cost Management Accounting
Solutions (Additional questions)
C2 – Variable production overheads
Production OAR
R40 per unit
Less: Fixed production OAR
R30 per unit
Variable production OAR
R10 per unit
C3 – Fixed production overheads
Absorbed
R4 800 000
Less: Under-recovery
R600 000
Less: Variable production overheads R1 200 000 (120 000 units x R10 per unit)
Fixed production overheads
R3 000 000
C4 – Administration and Selling (use high-low method)
 Cost /  Activity
= (R4 200 000 – R3 800 000) / (120 000 units – 80 000 units)
= R10 VC per unit
Fixed cost
= R4 200 000 – 120 000 units x R10
= R3 000 000
Reconcile profits:
Absorption costing profit
R4 600 000
Less: Inventory Δ x FOAR
2.12
(a)
20 000 units x R30
R600 000
Variable costing profit
R4 000 000
Variable costing income statements:
Revised
budget
R
Sales
W1
Variable costs:
1 368 000
1 051 200
Prime costs
W2
907 200
Manufacturing overhead
W3
57 600
Cost of sales
Non-manufacturing overhead
964 800
W4
86.400
Contribution
316 800
Fixed costs:
288 000
Cost Management Accounting
Solutions (Additional questions)
Manufacturing
W5
144 000
Non-manufacturing
W4
144 000
Profit
C1 –
28 800
Sales:
Unit selling price
100
Less: Reduction of
5%
Revised unit price
95
Revised sales volume
14.400
Original budget
12 000
Add: Growth
Revised budget
C2 –
1 368 000
Prime cost:
Per unit
Less: Reduction of
Revised cost per unit
Revised production vol.
Revised budget
C3 –
20%
70
10%
63
14.400
907 200
Variable man overhead:
Per unit
Revised production
4
14.400
57 600
C4 –
Non-man. overhead:
Variable
Fixed
Total
33.33%
66.67% 100 00%
Original budget
72 000
144 000 216 000
Budgeted sales
12 000
Per unit
6
Revised sales
14.400
Revised budget
86.400
144 000
Cost Management Accounting
Solutions (Additional questions)
C5 –
Original budget
90 000
Additional per annum
54 000
Per month
4.500
x number of months
12
Revised
(b)
144 000
Breakeven point and MOS% – Revised budget:
BEP
=
Fixed costs
Contribution per unit
= 288 000
22
= 13 091
C1 – Contribution per unit:
W1
units
22
Total contribution
316 800
/ Unit sales
14.400
MOS% = Budgeted sales – BEP
Budgeted sales
= 14.400
–
13 091
x 100
14.400
= 9.1%
Sales can decline by just over 9% and the product will break even. Any further decline
in sales will result in losses being incurred for the year.
Cost Management Accounting
Solutions (Additional questions)
(c)
Actual income statement for the year ended 31 March 20x2:
Absorption costing:
R
Sales
W1
1 349 000
Cost of sales
1 093.400
Production costs
W2
1 155 000
Less: Closing inventory
W3
61 600
Normal gross profit
255 600
Over-/under-absorbed fixed manufacturing overhead
4 000
W4
Actual gross profit
Non-manufactruing overhead
259 600
W5
229 200
Profit
W1
W2
30.400
Units
14 200
Price
95
Sales
1 349 000
Product cost:
Prime
Variable manufacturing overhead
4
Variable product cost
67
Fixed manufacturing overhead
10 W2.1
Total for absorption costing
77
Units produced
Total production cost
C2.1 – Budgeted overhead
Budgeted production
Predetermined rate
C3 –
63
15 000
1 155 000
144 000
14.400
10
Closing inventory:
Production
15 000
Sales
14 200
Units of inventory
Unit cost
Inventory value
800
77
61 600
Cost Management Accounting
Solutions (Additional questions)
C4 –
Over-/under-absorbed:
Actual
146 000
Absorbed
150 000
Units produced
15 000
Fixed cost per unit
10
Over-absorbed
C5 –
4 000
Non-manufacturing overhead:
Variable rate
(d)
6
Units sold
14 200
Variable cost
85 200
Fixed per budget
144 000
Total
229 200
Actual profit – variable costing:
Contribution per unit
[see part (b)]
Units sold
14 200
Total contribution
312.400
Less: Fixed costs
290 000
Manufacturing
146 000
Non-manufacturing
144 000
Profit
(e)
22
22.400
Absorption versus variable costing:
Absorption profit
30.400
Variable profit
22.400
Difference
Increase in inventory (closing inventory)
Fixed manufacturing cost per unit
8 000
800
10
8 000
Cost Management Accounting
Solutions (Additional questions)
Because absorption costing treats fixed manufacturing overhead as a product
cost, the fixed costs capitalised in closing inventory are deferred and recognised
as an expense only the following year, when the inventory is sold.
Under variable costing these costs are a period cost and are written off when
incurred. The amount of fixed manufacturing costs expensed during the current
year therefore exceeded what was expensed using absorption costing. The
variable costing profit was therefore lower by this amount.
Fixed manufacturing costs expensed:
2.13
(a)
Variable costing
146 000
Absorption costing
138 000
Actual incurred
146000
Less: deferred in closing inventory
8 000
Excess absorption profit
8 000
Target units
= (Fixed Costs + Target profit) / Contribution per unit
= (R8ma + R5mb + R2.4mc) / R440d
= 35 000 units
Calculations:
1.
Production fixed costs from high-low method (see below)
2.
Administration fixed costs (given)
3.
Target profit before tax (treat as a FC)
4.
Contribution per unit = Selling price – Variable costs
= R1 2001 – R3602 – R2403 – 1004 – R605
= R440
1
Selling price = R1 200 per unit (Prime cost x 2 = R600 x 2)
2
Raw Materials = R600 x 60% = R360 per unit
3
Direct Labour = R600 x 40% = R240 per unit
4
Variable production overheads (use high-low method):
 Cost /  Activity = R1m / 10 000 units
= R100/unit
FPOH = R11m – (30 000 units x R100)
= R8m
Cost Management Accounting
Solutions (Additional questions)
OR
R12m – (40 000 units x R100)
= R8m
5
(b)
Variable selling cost = R1 200 x 5% = R60 per unit
Actual results – fully-integrated absorption costing system:
R
Sales
(35 000 units x R1 200)
Less: Cost of sales
42 000 000
32 499 950
Opening inventory
(0 units)
Production
(39 0001 units x 928.572)
36 214 230
Closing inventory
(4 000 units x 928.57)
(3 714 280)
Normal gross profit
0
9 500 050
(4 0003 units x R228.57)
Over-/(under-)absorbed FPO
Actual gross profit
914 280
10 414 330
Less: Administration overheads
Selling overheads
5 000 000
(35 000 units x R60)
Profit
2 100 000
3 314 330
Calculations:
1.
2.
Production
=
Sales + Closing inventory – Opening inventory
=
35 000 + 4 000 – 0
=
39 000
Product cost:
Raw material
R360.00
Direct labour
R240.00
Variable POH
R100.00
Fixed POH
R228.57 (R8m / 35 000 units)
R928.57
3.
As there is no fixed overhead expenditure variance, the over-absorption of
fixed overheads is solely due to a fixed overhead volume variance
(production units exceeded sales units by 4 000 units).
Cost Management Accounting
Solutions (Additional questions)
(c)
Actual results – variable costing system:
R
Sales
(35 000 units x R1 200)
Less: Variable costs
42 000 000
26 600 000
Opening inventory
(0 units)
0
Production
(39 000 units x 7001)
27 300 000
Closing inventory
(4 000 units x 700)
(2 800 000)
Variable cost of sales
24 500 000
Add: Variable selling (35 000 units x R60)
2 100 000
Contribution
15 400 000
Less: Fixed osts
13 000 000
Production
8 000 000
Administration
5 000 000
Profit
2 400 000
Calculations:
1.
Product cost:
Raw material
Direct labour
Variable POH
(d)
R360.00
R240.00
R100.00
R700.00
Reconcile AC and VC profit:
R
AC profit
3 314 330
VC profit
2 400 000
Difference
914 330
Inventory change units X FOAR (4 000 x R228.57)
914 280
914 280*
* Rounding difference
(e)
The MD has an expectation that the AC profit should equal the targeted profit as
there was no sales price or cost variances and actual sales units were as per budgeted
sales units.
Cost Management Accounting
Solutions (Additional questions)
A fully-integrated absorption costing system pre-determines the fixed production
overhead absorption rate according to a budgeted fixed cost and a budgeted activity
level. In the event that the actual activity and cost are as budgeted, no distortion will
occur. In this case, actual production exceeded budgeted production by 4 000 units
leading to an over-recovery of fixed overheads.
As VC treats all fixed costs as a period cost, no distortion can arise and therefore, as
was shown earlier, the actual VC profit was as expected.
The difference between the respective VC and AC profits is explained by the
inclusion of FC in the product cost. VC expenses all FC when incurred, AC will
expense the FC included in the closing inventory when the units are actually sold.
It is generally recognised that VC is more effective for decision-making purposes as
profit is a function of sales only (unlike AC profit, which is a function of both sales
and production), and performance is therefore more realistically reported. It is
recommended that the firm should use VC for internal reporting purposes.
2.14
(a)
Fully-integrated absorption costing system:
February
March
R’000
R’000
Sales (15 500, 14 000 x R400)
6 200
5 600
Less: Cost of sales
3 410
3 080
880
110
Production (12 000, 21 000 x 220)
2 640
4 620
Closing inventory (W1,W3: 500, 7500 x R220)
(110)
(1650)
Normal gross profit
2 790
2 520
Over-/(under-)absorbed fixed production overhead (W4)
(280)
35
Actual gross profit
2 510
2 555
310
280
2 250
2 250
(50)
25
Opening inventory (W1,W3: 4 000, 500 x R220)
Less: Selling overheads (15 500, 14 000 x R20)
Administration overheads
Profit
Cost Management Accounting
Solutions (Additional questions)
(b)
Variable costing:
February
March
R’000
R’000
Sales (15 500, 14 000 x R400)
6 200.0
5 600.0
Less: Total variable costs
3 177.5
2 870.0
740.0
92.5
2 220.0
3 885.0
(92.5)
(1 387.5)
2 867.5
2 590.0
310.0
280.0
Contribution
3 022.5
2 730.0
Less: Fixed costs
2 950.0
2 950.0
Production
700
700
2 250
2 250
72.5
(220)
Opening inventory (W1, W3: 4 000, 500 x R185)
Production (12 000, 21 000 x R185)
Closing inventory (W1, W3: 500, 7500 x R185)
Variable cost of sales
Add: Variable selling costs (15 500, 14 000 x R20)
Administration
Profit/(loss)
Calculations:
C1 – Opening and closing inventory of units:
February
Opening inventory
Add: Production
Less: Sales
March
4 000
500
12 000
21 000
(15 500)
14 000
500
7 500
= Closing Inventory
C2 – Manufacturing overheads
Use high-low method to derive variable cost per unit
 Cost /  Activity
= (R1 200 000 – R900 000) (25 000 units – 10 000 units)
= R20 variable production cost per unit
Fixed production overhead
= R1 200 000 – (25 000 units x R20)
= R700 000
Predetermined fixed overhead absorption rate (POAR)
= R700 000 / 20 000 units
= R35 per unit
Cost Management Accounting
Solutions (Additional questions)
C3 – Product cost (Same for each month, i.e. February and March):
R
Direct material
120
Direct labour
45
Variable production overhead
20
Variable production cost (for VC)
185
POAR
35
Full absorption cost (for AC)
220
C4 – Over-/(under-)absorbed fixed production overhead:
Fixed production overhead control account (February):
Actual expenditure
700 000 Absorbed overhead (12 000 units x R35)
Under-recovery of fixed overheads
700 000
420 000
280 000
700 000
Fixed production overhead control account (March):
Actual expenditure
700 000 Absorbed overhead (21 000 units x R35)
Over-recovery
35 000
735 000
(c)
735 000
735 000
Reconciliation:
Profit per absorption costing
Finished inventory movement (units)
x POAR
= Fixed production overhead included in
(R50 000)
R25 000
–3 500
+7 000
R35
R35
R122 500 (R245 000)
inventory decrease/(increase)
Profit per variable costing
R72 500 (R220 000)
Explanation:
The difference in profits arises as a result of the treatment of the fixed production
overheads by the respective methods. AC expenses the fixed costs when the units are
sold, VC when the FC is incurred. As sales exceeded production in February, the
company drew from existing inventory in order to meet the sales and consequently
there was an inventory reduction. In the case of AC, this meant that the FC incurred
in a prior periods was expensed in February. This explains why AC shows a loss in
Cost Management Accounting
Solutions (Additional questions)
February and VC a profit. In March the reverse occurred. As production exceeded
sales, there was an increase in finished inventory. Consequently, AC will defer the
expensing of the fixed costs until a later period when the units are actually sold. VC
expenses the fixed costs when incurred. The net effect is that AC shows a profit and
VC a loss.
For internal profit measurements both methods are acceptable as long as there is
consistency in reporting. However, for external reporting it is generally accepted
(AC108) that inventory values include all costs of production.
However, one should question the use of absorption costing for internal reporting.
Management accountant theorists advocate it is superior to absorption costing as it is
more effective in decision making. It is clear from the VC results shown above in (b)
that the profit is consistent with the breakeven benchmark as used by the sales
director.
(d)
Arguments put forward for variable costing:

Variable costing provides more useful information for decision making as it
does not include fixed costs which do not change with volume. The impact of
management decisions is therefore more correctly observed where volume is
changing.

Fixed factory cost is more closely related to the ability to produce than to the
production of specific units. Since fixed costs would be incurred regardless of
production, and since it relates to the capacity to produce for a period of time,
it should be charged to the income and expenditure account as a period cost.

Variable costing removes from profit the effect of inventory changes. Where
inventory levels are likely to fluctuate significantly, profits might be distorted
when they are calculated on an absorption costing basis, since the inventory
changes will significantly affect the amount of fixed overheads charged to an
accounting period.

Variable costing avoids fixed overheads being capitalised in un-saleable
inventory. If surplus inventory cannot be disposed of, the profit calculation
for the current period will be misleading, since the fixed overhead
expenditure will have been deferred until a later accounting period.
2.15
(a)
Budget – absorption costing profit statements:
Cost Management Accounting
Solutions (Additional questions)
May
June
R’000
R’000
Sales (16 000 units x R300, 16 000 units x R300)
4 800
4 800
Less: Cost of sales
3 280
3 280
0
615
3 895
2 665
(615)
0
1 520
1 520
(85)
(170)
Adjusted gross profit
1 435
1 350
Less: Administration
500
500
160
160
775
690
Opening inventory (0 units x R205, 3 000 units x R205)
– C1, C2, C3
Production (19 000 units x R205, 13 000 x R205)
– C1, C2, C3
Closing inventory (3 000 units x R205, 0 units x R205)
– C1, C2, C3
Normal gross profit
Adjust for over-/(under-)recovered FMOH – W4
Selling (16 000 units x R10, 16 000 units x R10)
Profit
Calculations:
C1 – Manufacturing overheads:
Use high-low method to determine VC & FC
 Cost /  Activity = VC/unit
 Cost
= R1.8 m – R1.3m
= R500 000
 Activity
= 22 000 units – 12 000 units
= 10 000 units
VC/Unit
= R500 000 / 10 000 units
= R50 per unit
FC
= R1.8 m – (22 000 units x R50)
= R700 000
 Predetermined FOAR = R700 000 / 20 000 units (normal operating capacity)
= R35/unit
C2 – Product cost:
Cost Management Accounting
Solutions (Additional questions)
Prime cost
R120 (40% x R300)
Variable manufacturing overheads
R50
Variable production cost
R170 Variable costing
Fixed manufacturing overheads
R35
Full production cost
R205 Absorption costing
C3 – Budgeted closing inventory in units:
May
Opening inventory
June
0
3 000
Add: Production
19 000
13 000
Less: Sales
16 000
16 000
3 000
0
= Closing inventory
C4 – Planned over-/(under-)recovery of fixed manufacturing overheads
Planned expenditure:
May R50 000 more than normal budget  R700 000 + R50 000 = R750 000
June R75 000 less than normal budget  R700 000 – R75 000 = R625 000
May fixed overhead control account:
Planned expenditure R750 000
Absorbed
R665 000 (19 000 units x R35 per unit)
Under-recovered
R750 000
85 000
R750 000
June Fixed Overhead Control Account
Planned expenditure R625 000
Absorbed
R455 000 (13 000 units x R35 per unit)
Under-recovered
R625 000
(b)
R170 000
R625 000
Reconcile planned under-recovery for May:
Volume
= (Normal activity – Planned activity) x POAR
= (20 000 units – 19 000 units) x R35
= (R35 000)
Cost Management Accounting
Solutions (Additional questions)
(Explanation: The planned volume is 1 000 units less than normal operating capacity
resulting in a planned under-recovery of 1 000 x R35 = R35 000 in the budget.)
Expenditure
= Normal Budgeted – Planned Budgeted
= R700 000 – R750 000
= (R50 000)
(Explanation: The normal budget expenditure is R700 000 compared to the planned
expenditure of R750 000. This has given rise to a planned under-recovery of R50
000 in the budget.)
Volume under-recovered
–R35 000
Expenditure under-recovered –R50 000
Total under-recovered
–R85 000
Reconciles to under-recovered
(c)
Variable costing profit statements:
May
June
R’000
R’000
Sales (16 000 units x R300, 16 000 units x R300)
4 800
4 800
Less: Variable costs
2 880
2 880
0
510
Production (19 000 units x R170, 13 000 x R170)
3 230
2 210
Closing inventory (3 000 units x R170, 0 units x R170)
(510)
0
Variable cost of sales
2 720
2 720
Add: Variable selling
160
160
1 920
1 920
500
500
750
625
670
795
Opening Inventory (0 units x R170, 3 000 units x R170)
– C1, C2, C3
Contribution
Less: Fixed administration expenses
Fixed manufacturing overheads
Profit
Note:
The reason why the profit is not equal from one period to the next is because of the
planned fixed manufacturing overhead expenditure variance. If there were no
planned expenditure variance, the budgeted profit for each month would have been:
May
R670 000 + R50 000 = R720 000
June
R795 000 – R75 000 = R720 000
Cost Management Accounting
Solutions (Additional questions)
(d)
Reconcile respective profits :
May
June
Absorption costing profit (R’000)
775
690
Variable costing profit (R’000)
670
795
Difference (R’000)
105
(105)
0
3 000
Opening inventory – units
(e)
Closing inventory – Units
3 000
0
Inventory movement – Units
3 000
(3 000)
x Fixed OAR per unit
x R35
x R35
Reconciles to difference (R’000)
105
(105)
Explanation:
Fully-integrated absorption costing system resulting in over-/under-recovery:
When using a fully-integrated absorption costing system, the fixed manufacturing
overhead absorption rate is predetermined on the basis of budgeted manufacturing
cost and activity. The latter is normally a volume-based method such as labour
hours, machine hours or units of production.
The fixed overhead is then absorbed into the production cost according to the actual
activity levels. However, in all likelihood actual expenditure and activity will not
equate to the budgeted levels. Consequently there will be an over- or under-recovery
which is the balancing or reconciling item to reflect the actual fixed costs incurred as
compared to the allowed cost.
(f)
Explanation:
Why absorption costing is inconsistent in reporting profits:
The absorption costing profit derived in the budget has behaved in an inconsistent
fashion. Despite sales units remaining unchanged and planned fixed manufacturing
expenditure being reduced, the profit is higher in May than it is in June. This has led
to the MD’s concern about the validity of the budget. Absorption costing
incorporates all cost of manufacture (both variable and fixed) when deriving the
product cost as required by AC108. This method consequently matches the
production costs to the revenue in the period of the sale.
Cost Management Accounting
Solutions (Additional questions)
The inconsistency in profit reporting can arise for two reasons:
1.
Actual production and sales not equal
The company is planning to over-produce by 3 000 units in May and to
under-produce by 3 000 units in June relative to the planned sales levels.
As a result, the fixed manufacturing overheads, included in the closing
inventory value at the end of May (i.e. incurred in May), will be expensed in
June when the plan is to sell 3 000 units. Consequently, R105 000 of fixed
overhead incurred in May is expensed in June, resulting in a lower than
expected budgeted profit. (The reconciliation of the AC profit to VC profit
was shown earlier.) Generally speaking, this inconsistency occurs whenever
there are prior periods of surplus production (build-up of finished inventory)
followed by periods of sales in excess of production (run-down of finished
inventory, as per this example).
2.
Predetermined rate and actual rate not equal
The inconsistency in absorption profit reporting can also be explained with
reference to the distorting effect of the under- or over-recovered fixed
manufacturing overheads. Whenever there is a fixed manufacturing
expenditure and/or volume variance encountered, there will be a resultant
inconsistency or distortion in the reporting of the AC profit.
As discussed earlier, over- and under-recoveries occur whenever budgeted
activity and/or fixed expenditure are at variance with actual activity and/or
fixed expenditure. The magnitude of the distortion can be demonstrated as
follows:
Planned change in sales units from May to June
Nil
x Standard profit (R300 – R205 = R95)
R95
Expected change in profit from May to June
Nil
Actual change in profit (R775K to R690K)
(R85 000)
Distortion
(R85 000)
Reconcile
–6 000 units x R35 (FOAR)
(R210 000)
Planned reduction in FC
R125 000
Reconciles to actual planned change in profit
(R85 000)
Cost Management Accounting
Solutions (Additional questions)
Under normal circumstances, the reduction in production from 19 000 units
to 13 000 units would have reduced profit by R210 000 (i.e. 6 000 units less
x R35 FOAR). However, the company plans to reduce FC temporarily from
R750 000 in May to R625 000 in June (i.e. a reduction of R125 000).
Alternative reconciliation
Under-absorption not repeated from May
R85 000
Under-absorption incurred in June
(R170 000)
Reconciles to actual planned change in profit
(R85 000)
(Note: The above reconciliation is not required and you will not be examined
on this. It is therefore for information purposes only.)
Conclusion:
The financial accountant has drawn up the budgeted statement correctly according to
absorption costing principles. However, one would have to question whether
absorption costing is effective in terms of decision making. Under absorption
costing, profit is a function of both production and sales, and therefore leads to
distortions as encountered in Swallow (Pty) Ltd (as demonstrated in the above
reconciliation). In fact, it is possible to manipulate profit (positively or negatively)
by changing production levels.
An alternative method, variable costing, matches variable production costs to sales
and consequently treats all fixed manufacturing costs as a period cost. Consequently
variable costing looks at the profit as a result of the increase or decrease in
contribution over a relevant range of activity. As a result, profit is a function of sales
only; assuming no change in cost structure, and therefore performance is more
realistically reported, as shown in the variable costing budget statement.
2.16
(a)
Absorption costing profit statement:
Opening inventory
–
Production cost
R1 528 800 (98 000 x R15.60)
Less: Closing inventory
(R124 800) (8 000 x R15.60)
R1 404 000
Under-/(over-)recovery of fixed overheads
R7 200 R360 000 – (98 000 x R3.60)
Cost Management Accounting
Solutions (Additional questions)
R1 411 200
Variable non-manufacturing costs
R144 000 (90 000 x R1.60)
Fixed non-manufacturing costs
R250 000
R1 805 200
Sales
Profit/(loss)
(b)
R1 818 000 (90 000 x R20.20)
R12 800
Variable costing statement:
–
Opening inventory
Variable production cost
R1 176 000 (98 000 x R12)
Less: Closing inventory
(R96 000) (8 000 x R12)
R1 080 000
Variable non-manufacturing costs
R144 000 (90 000 x R1.60)
R1 224 000
Sales
Contribution
R1 818 000 (90 000 x R20.20)
R594 000
Fixed costs
Production overheads
R360 000
Selling and administration
R250 000
Profit/(loss)
(c)
(R16 000)
Reconciliation:
Absorption costing profit
R12 800
Fixed overhead included in closing inventory
R28 800 (8 000 x R3.60)
Variable costing profit
R16 000
Explanation:
The absorption costing statement shows a profit of R12 800, whereas the variable costing
statement shows a loss of R16 000. The difference of R28 800 is due to the absorption
costing closing inventory computation including the equivalent value of fixed production
overhead. This is not the case in the variable costing closing inventory computation where
all fixed overheads are treated as a period cost.
With absorption costing, the fixed overheads of R28 800 will only be recorded as an
expense when the inventory of Product 007 is sold. Consequently, the absorption costing
Cost Management Accounting
Solutions (Additional questions)
computation shows a higher profit than the variable costing computation. For internal
profit measurements, both methods are acceptable as long as there is consistency in
reporting. However, for external reporting it is generally accepted (AC 108) that
inventory values include all costs of production. (See Vigario pages 1 and 69).
Consequently it might be surmised that the management accountant was preparing the
profit statement for internal use, and the group accountant for external use.
(d)
Arguments put forward for variable costing:
Variable costing provides more useful information for decision making as it does not
include fixed costs which do not change with volume. The impact of management
decisions is therefore more correctly observed where volume is changing.
Fixed factory cost is more closely related to the ability to produce than to the production
of specific units. Since fixed costs would be incurred regardless of production, and since it
relates to the capacity to produce for a period of time, it should be charged to the income
and expenditure account as a period cost.
Variable costing removes from profit the effect of inventory changes. Where inventory
levels are likely to fluctuate significantly, profits might be distorted when they are
calculated on an absorption costing basis, since the inventory changes will significantly
affect the amount of fixed overheads charged to an accounting period.
Variable costing avoids fixed overheads being capitalised in un-saleable inventory. If
surplus inventory cannot be disposed of, the profit calculation for the current period will
be misleading, since the fixed overhead expenditure will have been deferred until a later
accounting period.