Income effects of alternative cost

accumulation systems
Solutions to Chapter 7 questions

Question 7.22 (a) Manufacturing cost per unit of output = variable cost (£6.40) + fixed cost
(£92 000/20 000 = £4.60) = £11
Absorption costing profit statement
(£000)
Sales (22 000 units at £14 per unit) 308.0
Manufacturing cost of sales (22 000 units × £11) 242.0
–––––
Manufacturing profit before adjustment 66.0
Overhead over-absorbed a 4.6
–––––
Manufacturing profit 70.6
–––––
Note:
a The normal activity that was used to establish the fixed overhead absorption rate

was 20 000 units but actual production in period 2 was 21 000 units. Therefore a
period cost adjustment is required because there is an over-absorption of fixed over-
heads of £4 600 [(22 000 units – 21 000 units) × £4.60].
(b) (£000)
Sales 308.0
Variable cost of sales (22 000 units × £6.40) 140.8
–––––
Contribution to fixed costs 167.2
Less fixed overheads 92.0
–––––
Profit 75.2
–––––
(c) (i) Compared with period 1 profits are £34 800 higher in period 2 (£70 600 –
£35 800). The reasons for the change are as follows:
(£000)
Additional sales (7000 units at a profit of £3 per unit) 21 000
Difference in fixed overhead absorption (3000 units extra
production at £4.60 per unit) a 13 800
––––––
Additional profit 34 800
––––––
Note:
aBecause fixed overheads are absorbed on the basis of normal activity (20 000
units) there would have been an under-recovery of £9200 (2000 units ×
£4.60) in period 1 when production was 18 000 units. In period 2 production
exceeds normal activity by 1000 units resulting in an over-recovery of £4600.
The difference between the under- and over-recovery of £13 800 (£9200 +
£4600) represents a period cost adjustment that is reflected in an increase in
profits of £13 800. In other words, the under-recovery of £9200 was not
required in period 2 and in addition there was an over-recovery of £4600.

46 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

(c) (ii) Additional profits reported by the marginal costing system are £4600 (£75 200
– £70 600). Because sales exceed production by 1000 units in period 2 there is a
stock reduction of 1000 units. With an absorption costing system the stock
reduction will result in a release of £4600 (1000 units at £4.60) fixed overheads
as an expense during the current period. With a marginal costing system
changes in stock levels do not have an impact on the fixed overhead that is
treated as an expense for the period. Thus, absorption costing profits will be
£4600 lower than marginal costing profits.

(a) Question 7.23

Marginal Absorption
January costing costing
(£) (£) (£) (£)
Sales revenue (7000 units) 315 000 315 000
Less: Cost of sales (7000 units)
Direct materials 77 000 77 000
Direct labour 56 000 56 000
Variable production overhead 28 000 28 000
Variable selling overhead 35 000 196 000
–––––– ––––––
Fixed overhead (7000 × £3) 21 000 182 000
–––––– ––––––
Contribution 119 000
Gross profit 133 000
Over absorption of fixed
production overhead (1) 1 500
––––––
134 500
Fixed production costs (2) 24 000
Fixed selling costs (2) 16 000 16 000
Variable selling costs 35 000
Fixed admin costs (2) 24 000 64 000 24 000 75 000
–––––– –––––– –––––– ––––––
Net profit 55 000 59 500
–––––– ––––––
Marginal Absorption
February costing costing
(£) (£) (£) (£)
Sales revenue (8750 units) 393 750 393 750
Less: Cost of sales (8750 units)
Direct materials 96 250 96 250
Direct labour 70 000 70 000
Variable production overhead 35 000 35 000
Variable selling overhead 43 750 245 000
–––––– ––––––
Fixed overhead (8750 × £3) 26 250 227 500
–––––– ––––––
Contribution 148 750
Gross profit 166 250
Under absorption of fixed
production overhead 750
––––––
165 500
Fixed production costs (2) 24 000
Fixed selling costs (2) 16 000 16 000
Variable selling costs 43 750
Fixed admin costs (2) 24 000 64 000 24 000 83 750
–––––– –––––– –––––– ––––––
Net profit 84 750 81 750
–––––– ––––––

INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 47

 Workings:
(1) Fixed production overhead has been unitized on the basis of a normal
monthly activity of 8000 units (96 000 units per annum). Therefore monthly
production fixed overhead incurred is £24 000 (8000 × £3). In January actual
production exceeds normal activity by 500 units so there is an over-absorption
of £1500 resulting in a period cost adjustment that has a positive impact on
profits. In February production is 250 units below normal activity giving an
under-absorption of production overheads of £750.
(2) With marginal costing fixed production overheads are treated as period costs
and not assigned to products. Therefore the charge for fixed production over-
heads is £24 000 per month (see note 1). Both marginal and absorption costing
systems treat non-manufacturing overheads as period costs. All of the non-
manufacturing overheads have been unitized using a monthly activity level
of 8000 units. Therefore the non-manufacturing fixed overheads incurred are
as follows:
Selling = £16 000 (8000 × £2)
Administration = £24 000 (8000 × £3)
(b) In January additional profits of £4500 are reported by the absorption costing sys-
tem. Because production exceeds sales by 1500 units in January there is a stock
increase of 1500 units. With an absorption costing system the stock increase will
result in £4500 (1500 units × £3) being incorporated in closing stocks and deferred
as an expense to future periods. With a marginal costing system changes in stock
levels do not have an impact on the fixed overhead that is treated as an expense
for the period. Thus, absorption costing profits will be £4500 higher than marginal
costing profits. In February sales exceed production by 1000 units resulting in a
stock reduction of 1000 units. With an absorption costing system the stock reduc-
tion will result in a release of £3000 (1000 units at £3) fixed overheads as an
expense during the current period. Thus, absorption costing profits are £3000
lower than marginal costing profits.
(c) (i) Contribution per unit = Selling price (£45) – unit variable cost (£28) = £17
Break-even point (units) = Annual fixed costs (£64 000)/unit contribution (£17)
= 3765 units
Break-even point (£ sales) = 3765 units × £45 selling price = £169 424
The above calculations are on a monthly basis. The sales value of the annual
break-even point is £2 033 100 (£169 425 × 12).
(ii) Required contribution for an annual profit of £122 800
= Fixed costs (£64 000 × 12) + £122 800
= £899 800
Required activity level = Required contribution (£899 800)
––––––––––––––––––––––––––––
Unit contribution (£17)
= 52 400 units
(d) See ‘Cost–volume–profit analysis assumptions’ in Chapter 8 for the answer to this
question.

Question 7.24 (a) Preliminary calculations

January–June July–December
(£) (£)
Production overheads 90 000 30 000
(Over)/underabsorbed (12 000) 12 000
–––––– ––––––
78 000 42 000
–––––– ––––––
Change in overheads £36 000
Change in production volume (units) 12 000

48 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

 Production variable overhead rate per unit £3
Fixed production overheads (£78 000 – (18 000 × £3)) £24 000
Distribution costs £45 000 £40 000
Decrease in costs £5 000
Decrease in sales volume (units) 5 000
Distribution cost per unit sold £1
Fixed distribution cost (£45 000 – (15 000 × £1)) £30 000
Unit costs are as follows:
(£) (£)
Selling price 36
Direct materials 6
Direct labour 9
Variable production overhead 3
Variable distribution cost 1 19
–– ––
Contribution 17
––
Note that the unit direct costs are derived by dividing the total cost by units
produced
Marginal costing profit statement
January–June July–December
(£000) (£000) (£000) (£000)
Sales 540 360
Variable costs at £19 per unit sold 285 190
––– –––
Contribution 255 170
Fixed costs:
Production overhead 24 24
Selling costs 50 50
Distribution cost 30 30
Administration 80 184 80 184
–– ––– –– –––
Profit 71 (14)
––– –––
(b) Marginal costing stock valuation per unit = £18 per unit production variable cost
Absorption costing stock valuation per unit = £20 per unit total production
cost
January–June July–December
(£000) (£000)
Absorption costing profit 77 (22)
Fixed overheads in stock increase of 3000 units 6
Fixed overheads in stock decrease of 4000 units (8)
–– ––
Marginal costing profit 71 14
–– ––
(c) Absorption gross profit per unit sold = Annual gross profit (£400 000)/Annual
production (15 000 units)
= £16
(£000)
Profit from January–June 77
Reduction in sales volume (5000 × £16) (80)
Difference in overhead recovery (£12 000 over recovery and £12 000
under recovery) (24)
Reduction in distribution cost 5
––
(22)
––

INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 49

 (d) Fixed cost £184 000 × 2 = £368 000
Contribution per unit £17
Break-even point 21 647 units (Fixed costs/contribution per unit)
(e) See ‘Some arguments in support of variable costing’in Chapter 7 for the answer to
this question.

Question 7.25 (a) Budgeted fixed overheads (£300 000)

Fixed overhead rate per unit = –––––––––––––––––––––––––––––––– = £7.50
Budgeted production (40 000 units)

Absorption Costing (FIFO) Profit Statement:

(£000)
Sales (42 000
£72) 3024
Less cost of sales:
Opening stock (2000
£30) 60
Add production (46 000
£52.50a) 2415
–––––
2475
Less closing stock (6000
£52.50) 315 2160
––––– –––––
864
Add over-absorption of overheadsb 27
–––––
Profit 891
–––––

Notes:
a Variable cost per unit = £2070/46 000 = £45

Total cost per unit = £45 + £7.50 Fixed overhead = £52.50

b Overhead absorbed (46 000
£7.50) = £345 000

Actual overhead incurred = £318 000

––––––––
Over-recovery £27 000
––––––––

Marginal Costing (FIFO) Profit Statement:

(£000) (£000)
Sales 3024
Less cost of sales:
Opening stock (2000
£25) 50
Add production (46 000
£45) 2070
–––––
2120
Less closing stock (6000
£45) 270 1850
––––– –––––
Contribution 1174
Less fixed overheads incurred 318
–––––
Profit 856
–––––

Reconciliation:
Absorption profit exceeds marginal costing profit by £35 000 (£891 000  £856 000).
The difference is due to the fixed overheads carried forward in the stock
valuations:
(£)
Fixed overheads in closing stocks (6000
£7.50) 45 000
Less fixed overheads in opening stocks (2000
£5) 10 000
––––––
Fixed overheads included in stock movement 35 000
––––––
Absorption costing gives a higher profit because more of the fixed overheads are
carried forward into the next accounting period than were brought forward from
the last accounting period.

50 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

(b) Absorption Costing (AVECO) Profit Statement:
(£000) (£000)
Sales 3024
Opening stock plus production
(48 000
£51.56a) 2475
Less closing stock (6000
£51.56) 309 2166
––––– –––––
858
Add over-absorption of overheads 27
–––––
Profit 885
–––––

Marginal Costing (AVECO) Profit Statement:

(£000) (£000)
Sales 3024
Less cost of sales
Opening stock plus production
(48 000
£44.17b) 2120
Less closing stock (6000
£44.17) 265 1855
––––– –––––
Contribution 1169
Less fixed overheads 318
–––––
Profit 851
–––––
Notes:
a With the AVECO method the opening stock is merged with the production of

the current period to ascertain the average unit cost:

Opening stock (2000
£30) + Production cost (£2 415 000) = £2 475 000
Average cost per unit = £2 475 000/48 000 units
b Average cost = (Production cost (£2 070 000) + Opening stock (50 000))/48 000

units.
Reconciliation:
(£000)
Difference in profits (£885  £851) 34
–––
Fixed overheads in closing stocks (309  265) 44
Less fixed overheads in opening stock (2000
£5) 10
–––
Fixed overheads included in stock movement 34
–––

The variations in profits between (a) and (b) are £6000 for absorption costing and
£5000 for marginal costing. With the FIFO method all of the lower cost brought
forward from the previous period is charged as an expense against the current
period. The closing stock is derived only from current period costs. With the
AVECO method the opening stock is merged with the units produced in the
current period and is thus allocated between cost of sales and closing stocks.
Therefore some of the lower cost brought forward from the previous period is
incorporated in the closing stock at the end of the period.

(a) It is assumed that opening stock valuation in 2001 was determined on the basis of Question 7.26
the old overhead rate of £2.10 per hour. The closing stock valuation for 2001
and the opening and closing valuations for 2002 are calculated on the basis of
the new overhead rate of £3.60 per hour. In order to compare the 2001 and 2002
profits, it is necessary to restate the 2001 opening stock on the same basis as
that which was used for 2002 stock valuations.
We are informed that the 2002 closing stock will be at the same physical level as
the 2000 opening stock valuation. It should also be noted that the 2001 opening
stock was twice as much as the 2000 equivalent. The 2000 valuation on the revised

INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 51

 basis would have been £130 000, resulting in a 2001 revised valuation of £260 000.
Consequently, the 2001 profits will be £60 000 (£260 000  £200 000) lower when
calculated on the revised basis.
From the 2001 estimate you can see that stocks increase and then decline in
2002. It appears that the company has over-produced in 2001 thus resulting in
large opening stocks at the start of 2002. The effect of this is that more of the
sales demand is met from opening stocks in 2002. Therefore production declines
in 2002, thus resulting in an under recovery of £300 000 fixed overheads, which
is charged as a period cost. On the other hand, the under recovery for 2001 is
expected to be £150 000.
The reconciliation of 2001 and 2002 profits is as follows:

(£)
2001 profits 128 750
Difference in opening stock valuation for 2001 (60 000)
Additional under recovery in 2002 (150 000)
–––––––––
Budgeted loss for 2002 (81 250)
–––––––––

(b) To prepare the profit and loss accounts on a marginal cost basis, it is necessary
to analyse the production costs into the fixed and variable elements. The calcula-
tions are:

2000 2001 2002

(£) (£) (£)
Total fixed overheads incurred 600 000 600 000 600 000
Less under recovery 300 000 150 000 300 000
–––––––– –––––––– ––––––––
Fixed overheads charged to production 300 000 450 000 300 000
–––––––– –––––––– ––––––––
Total production cost 1 000 000 975 000 650 000
Proportion fixed 3/10 6/13 (450/975) 6/13
Proportion variable (balance) 7/10 7/13 7/13

Profit and loss accounts (marginal cost basis)

Actual 2000 Estimated 2001 Budget 2002
(£) (£) (£) (£) (£) (£)
Sales 1 350 000 1 316 250 1 316 250
Opening finished
goods stock at
marginal cost 70 000a 140 000a 192 500b
Variable factory cost 700 000a 525 000b 350 000b
––––––––a ––––––––a ––––––––b
770 000 665 000 542 500
Closing finished
goods stock at
marginal cost 140 000a 630 000 192 500b 472 500 70 000b 472 500
–––––––– –––––––– –––––––– –––––––– –––––––– ––––––––
720 000 843 750 843 750
Fixed factory cost 600 000a 600 000a 600 000b
Administrative and
financial costs 220 000a 220 000a 220 000b
–––––––– –––––––– ––––––––
820 000 820 000 820 000
–––––––– –––––––– ––––––––
Profit/(loss) (£100 000) £23 750 £23 750
––––––––
–––––––– ––––––––
–––––––– ––––––––
––––––––

Notes
a 7/10
absorption cost figures given in the question.
b 7/13
absorption cost figures given in the question.

(c) The under absorption of overhead may be due to the fact that the firm is operating
at a low level of activity. This may be due to a low demand for the firm’s products.
The increase in the overhead rate will cause the product costs to increase. When
cost-plus pricing is used the selling price will also be increased. An increase in

52 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS

 selling price may result in a further decline in demand. Cost-plus pricing ignores
price/demand relationships. For a more detailed discussion of the answer required
to this question see section on ‘Limitations of cost-plus pricing’ in Chapter 11.
(d) For an answer to this question see section on ‘Reasons for using cost-based
pricing formulae’ in Chapter 11 and ‘Some arguments in favour of absorption
costing’ in Chapter 7. Note that SSAP 9 requires that absorption costing (full
costing) be used for external reporting.

(a) Sales for the second six-monthly period have increased for department A, but Question 7.27
profit has declined, whereas sales for department B have declined and profit has
increased. This situation arises because stocks are valued on an absorption cost
basis. With an absorption costing system, fixed overheads are included in the
stock valuations, and this can result in the amount of fixed overhead charged as
an expense being different from the amount of fixed overhead incurred during a
period. The effect of including fixed overheads in the stock valuation is shown
below:

1 July–31 December 1 January–30 June

Department Department Department Department
A B A B
(£000) (£000) (£000) (£000)
Fixed overheads brought
forward in opening
stock of finished goodsa 36 112 72 96
Fixed overheads carried
forward in closing stock
of goodsb 72 96 12 160
Profit increased by 36 64
Profit reduced by 16 60
Net profit as per absorption
costing profit and loss
account 94 50 53 83
Profit prior to stock
adjustment 58 66 113 19

Notes
aStocks are valued at factory cost with an absorption costing system. The opening

stock valuation for department A for the first six months is £60 000 based on a
product cost of £20 per unit. Therefore opening stock comprises 3000 units. Fixed
manufacturing overheads are charged to the product made in department A at
£12 per unit. Consequently, the stock valuation includes £36 000 for fixed over-
heads. The same approach is used to calculate the fixed overheads included in the
opening stock valuation for the second period and department B.
bClosing stock for department B (first period)  6000 units (£120 000/£20). Fixed

overheads included in closing stock valuation  £72 000 (6000 units
£12).
The same approach is used to calculate fixed overheads included in the
remaining stock valuations.

Comments
During the first six months for department A, stocks are increasing so that the
stock adjustment results in a reduction of the fixed overhead charge for the period
of £36 000. Fixed manufacturing overheads of £132 000 have been incurred during
the period. Therefore the total fixed manufacturing overhead charge for the period
is £96 000. In the first period for department B stocks are declining and the stock
adjustment will result in an additional £16 000 fixed manufacturing overheads
being included in the stock valuation. Consequently, the fixed manufacturing

INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS 53

 overhead charge for the period is £320 000 (£304 000  £16 000). When stocks
are increasing, the stock adjustment will have a favourable impact on profits
(department A, period 1), and when stocks are declining, the stock adjustment
will have an adverse impact on profits (department B, period 1).
In the second period stocks decline in department A and the stock adjustment
will have an adverse impact on profits, whereas in department B stocks increase
and this has a favourable impact on profit. When the two periods are compared,
the stock adjustment has an adverse impact on the profits of department A and
a favourable impact on the profits of department B. With an absorption costing
system, profit is a function of sales and stock movements, and these stock
movements can have an adverse impact on profits even when sales are increasing.

(b) Departmental profit and loss accounts (marginal costing basis)

1 July–31 December 1 January–30 June

Department Department Department Department
A B A B
(£000) (£000) (£000) (£000)
Sales revenue 300 750 375 675
––––
–––– ––––
–––– ––––
–––– ––––
––––
Variable manufacturing costs:
Direct material 52 114 30 132
Direct labour 26 76 15 88
Variable overheads 26 76 15 88
–––– –––– –––– ––––
Variable factory cost of production 104 266 60 308
Add opening stock of finished goods 24 98 48 84
–––– –––– –––– ––––
128 364 108 392
Less closing stock of finished goods 48 84 8 140
–––– –––– –––– ––––
Variable factory cost of goods sold 80 280 100 252
––––
–––– ––––
–––– ––––
–––– ––––
––––
Total contribution £220 £470 £275 £423
Less:
Fixed factory overheads 132 304 132 304
Fixed administrative and
selling costs 30 100 30 100
–––– –––– –––– ––––
Net profit 58 66 113 19
––––
–––– ––––
–––– ––––
–––– ––––
––––

54 INCOME EFFECTS OF ALTERNATIVE COST ACCUMULATION SYSTEMS