Operating Statement - Marginal and Absorption Costing

OPERATING STATEMENTS UNDER MARGINAL AND ABSORPTION COSTING TECHNIQUES The income statement of an organization shows the operating results at a particular period. The results can be presented using either the marginal or the absorption costing techniques. In marginal costing, only variable costs are charged as a cost of sales and a contribution is calculated. Period fixed costs are constant amounts and no matter what the volume of sales and production is (provided that operation is within a relevant range), are charged in full to the income statement of the period in which they occur. It follows that by making and selling one extra unit of a product, total cost will rise only by the variable cost i.e., the marginal Cost of production for that unit. Similarly, total cost will fall by the variable cost per unit for each reduction by one unit in the level of activity. The additional profit earned by making and selling one extra unit of output is the extra revenue from sales minus the variable cost of the unit. Under absorption costing, both variable and fixed costs are charged to cost units. This implies that the closing inventory includes a fair share of fixed production overhead. This will make the value higher than marginal costing. Example 1: OLUWASEKEMI LTD produces a single product which is bottled and sold in cases. The normal annual level of operations on which the production overhead absorption is based is 36,000 cases. Data for the last financial year were as follows: Production 40,000 cases Sales 32,000 cases N Selling price 60 Cost: Production: Direct Labour 12 Direct Materials 14 Variable overhead 8 Fixed overhead (budgeted & incurred) 216,000 Selling & Administrative cost: Fixed 50,000 Variable 15% of sales revenue There were no opening stock of finished goods and the work-in-progress inventory may be assumed to be the same at the end of the year as it was at the beginning of the year. You are required to prepare profit statements for the year based on: (I) Marginal costing method (II) Absorption costing method SOLUTION: MARGINAL COSTING METHOD N N Sales (32,000 cases x N60) Less variable cost of sales: Opening inventory Add: variable production cost Direct labour (40,000 cases x N12) Direct material (40,000 cases x N14) Variable overhead (40,000 cases x N8) 1,920,000 - Less closing inventory:(8000/40,000 x N1360,000) 480,000 560,000 320,000 1,360,000 272,000 VARIABLE COST OF PRODUCTION Add variable selling and Admin 1,088,000 288,000 VARIABLE COST OF SALES CONTRIBUTION Less Fixed costs: Production Selling & Administrative 1,376,000 544,000 216,000 50,000 266,000 278,000 PROFIT ABSORPTION COSTING Fixed overhead Absorption Rate (FOAR) = N Sales (32,000 cases x N60) Less cost of production: Opening stock Direct labour (40,000 cases x N12) Direct material (40,000 cases x N14) 480,000 560,000 Variable overhead (40,000 cases x N8) Fixed overhead (40,000 cases x N6) 320,000 240,000 N 1,920,000 1,600,000 Less closing inventory:(8000/40,000 x N1600,000) COST OF PRODUCTION GROSS PROFIT Add over absorbed fixed ptn OH (40,000 – 35,000) x N6 CONTRIBUTION 320,000 1,280,000 640,000 24,000 544,000 Less selling and Administrative costs: Fixed variable NET PROFIT 50,000 288,000 338,000 326,000 Example II: Using the information below, prepare profit statements for the months of November and December 2020 using i. Marginal costing ii. Absorption costing Per Unit: N Sales price 50 Direct material 18 Variable production overhead 3 Direct wages 4 Per Month: Fixed production overhead 99,000 Fixed selling overhead 14,000 Fixed administrative expenses 26,000 Variable selling expense, 10% of sales value Normal capacity was 11,000 units per month: Sales Production November (units) 10,000 12,000 December (units) 12,000 10,000 SOLUTION: MARGINAL COSTING NOVEMBER N’000 Sales (N50 x 10,000) Less: variable cost of production: Opening Inventory Add: Direct material (N18 x 12,000) Variable ptn OH (N3 x 12,000) Direct wages (N4 x 12,000) Less closing inventory (2,000/12,000 x 300,000) VARIABLE COST OF PRODUCTION Add variable selling expenses VARIABLE COST OF SALES CONTRIBUTION Less: Fixed costs Production Selling Administrative DECEMBER N’000 500 216 36 48 300 50 N’000 N’000 600 50 180 30 40 300 - 250 300 50 60 300 200 99 14 26 Net Profit 360 240 99 14 26 139 61 139 101 Absorption costing Fixed overhead Absorption Rate (FOAR) = NOVEMBER N’000 N’000 Sales (N50 x 10,000) Less: cost of production: Opening inventory Add: Direct material (N18 x 12,000) Variable ptn OH (N3 x 12,000) Direct wages (N4 x 12,000) Fixed production OH Less closing inventory (2,000/12,000 x 408,000) TOTAL PRODUCTION COST OF SALES 500 600 216 68 180 36 48 108 408 68 30 40 90 408 340 GROSS PROFIT Add/less over/under absorbed fixed OH (12,000 – 11,000) x N9 DECEMBER N’000 N’000 408 160 9 192 9 169 Less selling expenses: Variable Fixed Admin Net Profit 50 14 26 183 60 14 26 90 79 100 83 ASSIGNMENT IT IS WELL Ltd is considering its plan for the year ending 31 December 2021. It makes and sells a single product, which has budgeted costs and selling price as follows: N per unit Selling price 45 Direct materials 11 Direct labour 8 Production overhead: variable 4 Fixed 3 Selling overhead: Variable 5 2 Fixed Administration overhead: fixed 3 Fixed overhead costs per unit are based on a normal annual activity level of 96,000 units. These costs are expected to be incurred at a constant rate throughout the year. Activity levels during January and February 2021 are expected to be: January (units) February (units) Sales 7,000 8,750 Production 8,500 7,750 Assume that there will be no stocks held on 1 January 2021. Required: a. Prepare in columnar format, profit statements for each of the two months of January and February 2021 using: Absorption costing (ii) Marginal costing (i) b. Reconcile and explain the reasons for any differences between the marginal and absorption profits for each month which you have calculated in your answer to (a) above c. Based upon marginal costing, calculate i. The annual breakeven sales value; and ii. The activity level, in units, which will yield an annual profit of N122,800 d. Explain 3 fundamental assumptions underpinning single product breakeven analysis.