Absorption and Marginal Costing - Seminar Answers

QUESTION 1
a)

i)

Variable-costing profit statements

Year 1
Sales
Production

Sales (3 per unit)

Year 2

1,000 units

Sales

1,400 units Production

3,000

1,200 units
1,000 units
3,600

Variable costs:
Opening stock

200

Variable cost of goods manufactured

700

500

Cost of goods available for sale

700

700

Closing stocka

200

100

500

600

1,000

1,200

Variable manufacturing cost of goods sold

Variable marketing and admin. costs
Variable costs:

1,500

1,800

Contribution margin

1,500

1,800

Fixed costs
Fixed manufacturing costs

700

700

Fixed marketing and admin. costs

400

400

Fixed costs
Operating profit
a Unit stockable costs:
Year 1: 700 1,400 = 0.50 per unit
Year 2: 500 1,000 = 0.50 per unit

1,100

1,100

400

700

ii)

Absorption-costing profit statements

Sales (3 per unit)

Year 1
Sales
1,000 units
Production 1,400 units
3,000

Year 2
Sales
1,200 units
Production 1,000 units
3,600

Cost of goods sold:

Opening stock

400

Variable manufacturing costs

700

500

Fixed manufacturing costsa

700

700

1,400

1,600

400

240

Cost of goods available for sale

Closing stockb
Cost of goods sold
Gross margin

1,000

1,360

2,000

2,240

Marketing and administrative costs:

Variable marketing and admin. costs
Fixed marketing and admin. costs
Marketing and admin. costs
Operating profit
a Fixed manufacturing costs:
Year 1: 700 1,400 = 0.50 per unit
Year 2: 700 1,000 = 0.70 per unit
b Unit stockable costs:
Year 1: 1,400 1,400 = 1.00 per unit
Year 2: 1,200 1,000 = 1.20 per unit

1,000

1,200

400

400
1,400

1,600

600

640

b)
Reconciliation
Year 1

Year 2

Variable costing:
Operating profit
Closing stock

400

700

200

100

600

640

400

240

200

200

140

Absorption costing:
Operating profit
Closing stock
Fixed manuf. overhead
in opening stock
in closing stock

Absorption Variable
costing
costing
=
operating operating
income
income
Year 1: 600 400

Year 2: 640 700

Fixed
manuf.costs
in closing
stock

200 0

200

140 200

60

Fixed
manuf.costs
in opening
stock

QUESTION 2
a) Differences in operating profit between variable and absorption costing
are due solely to accounting for fixed costs. Do you agree? Explain.
No. Differences between variable costing and absorption costing are due to
accounting for fixed manufacturing costs. Fixed marketing and distribution costs are
not accounted for differently under variable costing and absorption costing.
b) Explain the main conceptual issue under variable costing and absorption
costing regarding the timing for the release of fixed manufacturing
overhead as expense.
The main issue between variable costing and absorption costing is the proper timing
of the release of fixed manufacturing costs as costs of the period:
i.
at the time of incurrence, or
ii.
at the time the finished units to which the fixed overhead relates are
sold.
Variable costing uses (i) and absorption costing uses (ii).
c) Give an example of how, under absorption costing, operating profit could
fall even though the unit sales level rises.
Under absorption costing, heavy reductions of stock during the accounting period
might combine with low production and a large production volume variance. This
combination could result in lower operating profit even if the unit sales level rises.
d) Critics of absorption costing have increasingly emphasised its potential
for promoting undesirable incentives for managers. Give an example.
Examples of dysfunctional decisions managers may make to increase reported
operating profit are:
i.
Plant managers may switch production to those orders that absorb the
highest amount of manufacturing overhead, irrespective of the demand by
customers.
ii.
Plant managers may accept a particular order to increase production even
though another plant in the same company is better suited to handle that
order.
iii.
Plant managers may defer maintenance beyond the current period to free
more time for production.
e) What are two ways of reducing the negative aspects associated with
using absorption costing to evaluate the performance of a plant
manager?
Approaches used to reduce the negative aspects associated with using absorption
costing include:

 Changing the accounting system.

Adopting either variable or throughput costing, both of which reduce

the incentives of managers to build up stock.

Adopting a stock-holding charge for managers who tie up funds in

stock.
Extending the time period used to evaluate performance. By evaluating
performance over a longer time period (say, three to five years), the incentive
to take short-run actions that reduce long-term profit is lessened.
Including non-financial as well as financial variables in the measures used to
evaluate performance.