Opening inventory of raw materials + Raw materials purchased Closing inventory of raw materials. Cost of raw materials consumed

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1 Chapter 22 Absorption and marginal costing ( 吸收成本法與邊際成本法 ) 22.1 Introduction ( 引言 ) Costs can be classified into fixed and variable costs ( 固定和變動成本 ), manufacturing and non-manufacturing costs ( 製造和非製造成本 ). There are two general approaches ( 方法 ) to account ( 處理 ) for them. These two approaches are known as absorption costing ( 吸收成本法 ) and marginal costing ( 邊際成本法 ). You will learn the preparation of financial statements using these two approaches. The preparation is for internal control and performance evaluation. These statements are usually called operating statements ( 營業表 ) Manufacturing accounts ( 製造帳戶 ) One of the differences between absorption costing and marginal costing is the ways ( 方法 ) in which the manufacturing account ( 製造帳戶 ) is prepared ( 編製 ). The manufacturing account is a financial statement which shows the manufacturing cost ( 製造成本 ) of goods completed in a period. Example: Preparation of a manufacturing account ( 編製製造帳戶 ) The following figures were related to the manufacturing of products by XYZ Co for the year ended 31 December 2010: Inventory of raw materials: Raw materials purchased in 2010 $80,000 1 Jan 2010 $5,000 Royalties $8, Dec 2010 $7,000 Factory rent $4,400 Wages: Depreciation on factory machinery $4,000 Direct labour $210,000 General factory expenses $3,100 Indirect labour $90,000 Work-in-progress 1 Jan 2010 $3, Dec 2010 $4,200 XYZ Co Manufacturing Account for the year ended 31 December 2010 Opening inventory of raw materials 5,000 Add Purchases 80,000 85,000 Less Closing inventory of raw materials (7,000) Cost of raw materials consumed 78,000 Direct labour 210,000 Royalties 8,500 Prime cost 296,500 Factory overheads: Factory rent 4,400 Depreciation on factory machinery 4,000 General factory expenses 3,100 11, ,000 Add Opening work-in-progress 3, ,500 Less Closing work-in-progress (4,200) Manufacturing cost of goods completed 307,300 The manufacturing cost of goods completed is broken down into direct and indirect manufacturing costs. Direct manufacturing costs ( 直接製造成本 ) Direct manufacturing costs can be easily traced ( 追溯 ) to a particular product. These are collectively known ( 統稱 ) as prime cost ( 主要成本 ). Prime cost ( 主要成本 ) is usually made up of three components: direct materials ( 直接材料 ), direct labour ( 直接人工 ) and other direct manufacturing costs ( 其他直接製造成本 ). Royalties ( 版稅 ) refer to payments made to someone whose invention or property ( 發明或專利 ) has been used in the manufacturing of a product. Royalties are usually charged on the basis of units produced ( 生產數量 ). They are classified as a direct manufacturing cost ( 直接製造成本 ). The cost of raw materials consumed ( 耗用原料成本 ) in a period can be calculated as follows: Cost of raw materials consumed = Opening inventory of raw materials + Raw materials purchased Closing inventory of raw materials 1

2 Indirect manufacturing costs ( 間接製造成本 ) Indirect manufacturing costs ( 間接製造成本 ) cannot be easily traced ( 追溯 ) to a particular product. Work-in-progress ( 在製品 ) Work-in-progress ( 在製品 ) refers to goods which are partly completed ( 部分完成 ) by the end of an accounting period. With work-in-progress remaining at the end of the previous period and the current period, the following adjustments ( 調整 ) must be made in the manufacturing cost of goods completed ( 製成品的製造成本 ): Manufacturing cost of goods completed = Prime cost + Factory overheads + Opening work-in-progress Closing work-in-progress Disclosure of manufacturing and non-manufacturing costs ( 製造和非製造成本的披露 ) The manufacturing cost ( 製造成本 ) of goods completed ( 製成品 ) will be shown in the income statement for the same period in the calculation of the cost of goods sold. Non-manufacturing overheads ( 非製造費用 ) will be shown in the income statement and not in the manufacturing account ( 製造帳戶 ). This method of preparing a manufacturing account, particularly the classification of manufacturing costs into direct and indirect costs, is required for financial reporting ( 財務匯報 ) purposes and is only applicable ( 適用於 ) with the absorption costing approach ( 吸收成本法 ). The manufacturing account can be prepared in another way when using the marginal costing approach ( 邊際成本法 ). Classwork 1 1 The following information is available for Global Manufacturing Co for the year ended 31 March $ Inventory as at 1 April 2010: Raw materials 24,000 Work-in-progress 9,550 Purchases of raw materials 213,400 Carriage on purchases (raw materials) 3,210 Manufacturing wages (direct cost) 132,800 Factory water and electricity 23,000 Factory rent 62,200 Other manufacturing expenses 14,300 Inventory as at 31 March 2011: Raw materials 26,200 Work-in-progress 8,700 Prepare the manufacturing account of Global Manufacturing Co for the year ended 31 March 2011 Answer: Global Manufacturing Co Manufacturing Account for the year ended 31 March 2011 Opening inventory of raw materials 24,000 Add Purchases 213,400 Carriage inwards 3, , ,610 Less Closing inventory of raw materials (26,200) Cost of raw materials consumed 214,410 Manufacturing wages 132,800 Prime cost 347,210 Factory overheads: Factory water and electricity 23,000 Factory rent 62,200 Other manufacturing expenses 14,300 99, ,710 Add Opening work-in-progress 9, ,260 Less Closing work-in-progress (8,700) Manufacturing cost of goods completed 447,560 2

3 2 The following balances were extracted from the books of Peter Co Ltd as at 31 December 2012: $ Sales 329,680 Raw material purchases 112,400 Raw material carriage inwards 8,600 Selling and distribution expenses 6,128 Factory workers wages 63,700 Rent and rates (office 60% : factory 40%) 13,175 Factory expenses 2,976 Subcontracting charges 800 Administration expenses 32,895 Interest revenue 1,218 Inventory as at 1 January 2012: Raw materials 41,212 Work-in-progress 10,060 Finished goods 31,500 Production machinery at net book value, 1 January 2012 (cost $218,500) 180,500 Office fixtures and equipment at net book value, 1 January 2012 (cost $95,000) 48,750 Additional information: (i) Inventory as at 31 December 2012: $ Raw materials 38,430 Work-in-progress 9,828 Finished goods 27,300 (ii) Depreciation to be provided for: Office fixtures and equipment Production machinery 15% on cost 20% on net book value Required: Prepare the manufacturing account for the year ended 31 December 2012 Answer: Peter Co Ltd Manufacturing Account for the year ended 31 December 2012 Opening inventory of raw materials 41,212 Add Purchases 112,400 Carriage inwards 8, , ,212 Less Closing inventory of raw materials (38,430) Cost of raw materials consumed 123,782 Factory workers wages 63,700 Subcontracting charges 800 Prime cost 188,282 Factory overheads: Rent and rates ($13,175 40%) 5,270 Factory expenses 2,976 Depreciation: Production machinery ($180,500 20%) 36,100 44, ,628 Add Opening work-in-progress 10, ,688 Less Closing work-in-progress (9,828) Manufacturing cost of goods completed 232,860 3

4 22.3 Absorption costing ( 吸收成本法 ) What is absorption costing? All manufacturing costs ( 製造成本 ), either fixed or variable, are treated as product costs ( 產品成本 ). All non-manufacturing costs ( 非製造成本 ) are treated as period costs ( 期間成本 ) and written off ( 註銷 ) to the profit and loss account as they are incurred. Inventories ( 存貨 ) absorb all the costs of manufacturing ( 製造成本 ). Example: Preparation of financial statements under absorption costing The following figures were extracted from the books of Baby Toys for the year ended 31 March 2011: Variable manufacturing costs: Direct materials Direct labour Ind. manu. costs Fixed manufacturing costs (all indirect) $10,000 $18 per unit produced $8 per unit produced $4 per unit produced Marketing costs: Variable $5 per unit sold Fixed $15,000 Selling price Opening inventory Production Sales Closing inventory $100 per unit sold 0 units 1,000 units 800 units 200 units Required: Prepare an income statement for the year ended 31 March 2011, using absorption costing. Answer Step 1 : Calculate the unit production costs under absorption costing. Unit fixed manufacturing cost = $10,000 1,000 = $10 per unit Unit production costs under absorption costing = $18 + $8 + $4 + $10 = $40 Step 2 : Prepare an income statement for the year ended 31 March 2011, using absorption costing, Baby Toys Income Statement for the year ended 31 March 2011 Sales (800 $100) 80,000 Opening inventory Add Manufacturing cost of goods completed (1,000 x $40) 40,000 Cost of goods available for sale 40,000 Less Closing inventory (200 x $40) (8,000) (32,000) Gross profit 48,000 Less Marketing costs [(Variable (800 x $5) + Fixed ($15,000)] (19,000) Net profit 29,000 The valuation of inventory ( 存貨的價值 ) has to include all manufacturing costs ( 製造 ), irrespective of whether ( 不論是否 ) they are fixed or variable ( 固定和變動 ). In public exams, gross profit ( 毛利 ) is sometimes called gross margin while net profit ( 純利 ) is sometimes called operating income, net income or net operating income. 4

5 Classwork 2 1. Rainbow Ltd makes a single product. The following figures were budgeted for the year ended 31 December 2010: Selling price per unit $38 Variable manufacturing costs per unit $18 Fixed manufacturing costs $168,000 Fixed selling and distribution overheads $78,000 Completed units Opening inventory 1,000 Production 12,000 Sales 12,600 There were no inventories of direct materials and work-in-progress. Costs in 2009 were the same as those budgeted for (a) Calculate the unit fixed manufacturing costs and unit production costs under absorption costing. (b) Prepare a budgeted income statement for the year ended 31 December 2010, using absorption costing, (a) Unit fixed manufacturing cost = $168,000 12,000 = $14 Unit production costs under absorption costing = $18 + $14 = $32 (b) Budgeted Income Statement for the year ended 31 December 2010 Sales (12,600 $38) 478,800 Opening inventory (1,000 x $32) 32,000 Add Manufacturing cost of goods completed (12,000 x $32) 384,000 Cost of goods available for resale 416,000 Less Closing inventory [(1, ,000 $12,600) x $32] (12,800) (403,200) Gross profit 75,600 Less Fixed selling and distribution overheads (78,000) Net loss (2,400) 2 Master Ltd commenced operations on 1 January 2012 and manufactures a single product. The following information is available for its first year of operations Units sold 86,000 Units manufactured 94,000 Cost and price data for 2012: $ Selling price per unit 240 Variable production costs per unit produced 58 Variable administrative and marketing costs per unit sold 15 The company incurred fixed production overheads of $282,000 in Fixed administrative and marketing costs in 2012 totalled $110,000. Prepare an income statement for the year ended 31 December 2012 using absorption costing. Unit fixed manufacturing cost = $282,000 94,000 = $3 Unit production costs under absorption costing = $58 + $3 = $61 Income Statement for the year ended 31 December 2012 $000 $000 Sales (86,000 $240) 20,640 Manufacturing cost of goods completed (94,000 x $61) 5,734 Less Closing inventory [(94,000 86,000) x $61] (488) (5,246) Gross profit 15,394 Less Variable administrative and marketing costs (86,000 $15) 1,290 Fixed administrative and marketing costs 110 (1,400) Net profit 13,994 5

6 3 Victory Ltd makes a single product. Its budgeted information is as follows: $ per unit Year ended 31 December Selling price 45 Production (units) 40,000 40,000 Direct materials cost 8 Sales (units) 38,000 42,000 Direct labour cost 10 Variable manufacturing overheads 6 Fixed manufacturing overheads and non-manufacturing overheads for both 2011 and 2012 are $120,000 and $80,000 respectively. There was no opening inventory on 1 January Prepare budgeted income statements for the year ended 31 December 2011 and 2012 respectively, using absorption costing. Unit production costs under absorption costing = [($120,000 40,000) + $8 + $10 + $6] = $27 Budgeted Income Statement for the year ended 31 December 2011 Sales (38,000 $45) 1,710,000 Add Manufacturing cost of goods completed (40,000 $27) 1,080,000 Less Closing inventory [(40,000 38,000) $27] (54,000) (1,026,000) Gross profit 684,000 Less Non-manufacturing overheads (80,000) Net profit 604,000 Budgeted Income Statement for the year ended 31 December 2012 Sales (42,000 $45) 1,890,000 Opening inventory 54,000 Add Manufacturing cost of goods completed (40,000 $27) 1,080,000 (1,134,000) Gross profit 756,000 Less Non-manufacturing overheads (80,000) Net profit 676,000 4 Treasure Ltd manufactures a single product. The company s financial year ends on 31 December. Inventory as at 1 January 2014 amounted to 3,000 units, with a value of $216,000 (under absorption costing). The company incurred fixed production overheads of $798,000 in Information on unit costs in 2013 and 2014: $ Selling and administrative overheads are as follows: Direct materials 15 Variable selling and administrative expenses $19 per unit sold Direct labour 22 Fixed selling and administrative expenses $180,000 per annum Variable production overheads 21 The selling price of the product in 2013 and 2014 was $260 per unit. Production (units) 57,000 Sales (units) 59,000 Prepare an income statement for the year ended 31 December 2012 using absorption costing. Income Statement for the year ended 31 December 2014 $000 $000 Sales (59,000 $260) 15,340 Opening inventory 216 Manufacturing cost of goods completed (57,000 $72) 4,104 Cost of goods available for resale 4,320 Less Closing inventory [(3, ,000 59,000) $72] (72) (4,248) Gross profit 11,092 Less Non-manufacturing overheads [59,000 $ ,000] (1,301) Net profit 9,791 6

7 Over- or under-absorption of fixed manufacturing overheads Adjustments in accordance with HKAS 2 Under-absorbed ( 少吸收 ) fixed manufacturing overheads ( 固定製造費用 ) are to be recognised ( 確認 ) as an expense ( 費用 ) in the period in which they are incurred ( 招致 ). In the case of over-absorption ( 多吸收 ), the amount of fixed manufacturing overheads ( 固定製造費用 ) absorbed into each unit of production is to be reduced ( 下調 ) so that inventories ( 存貨價值 ) are not measured above actual cost. Treatments required in public exams Add ( 加到 ) the under-absorbed fixed manufacturing overheads to the cost of goods sold. Deduct ( 扣除 ) the over-absorbed fixed manufacturing overheads from the cost of goods sold. Example: Preparation of financial statements with under-absorption of fixed manufacturing overheads The following figures were extracted from the books of Baby Toys for the year ended 31 March 2011: Variable manufacturing costs: Direct materials Direct labour Ind. manu. costs Fixed manufacturing costs (all indirect) $10,000 $18 per unit produced $8 per unit produced $4 per unit produced Marketing costs: Variable $5 per unit sold Fixed $15,000 Selling price Opening inventory Production Sales Closing inventory $100 per unit sold 0 units 1,000 units 800 units 200 units If the actual fixed factory overheads incurred amounted to $11,000 rather than $10,000, prepare an income statement for the year ended 31 March 2011, using absorption costing. Required: (a) Determine the under- /over-absorbed of fixed factory overheads (b) Prepare an income statement for the year ended 31 March 2011, using absorption costing, Answer (a) Under-absorption of fixed factory overheads = $11,000 $10,000 = $1,000 (b) Baby Toys Income Statement for the year ended 31 March 2011 Sales (800 $100) 80,000 Opening inventory Add Manufacturing cost of goods completed (1,000 x $40) 40,000 Cost of goods available for sale 40,000 Less Closing inventory (200 x $40) (8,000) 32,000 Add Under-absorption of fixed factory overheads 1,000 (33,000) Gross profit 47,000 Less Marketing costs [(Variable (800 x $5) + Fixed ($15,000)] (19,000) Net profit 28,000 7

8 Classwork 3 1 Snowball Ltd produces a single product. The company uses absorption costing but is considering adopting marginal costing instead. It wants to compare the results under these two costing systems. Fixed production overheads were absorbed at the rate of $30 per unit, based on the normal production level of 400,000 units per annum. The company s year-end date is 31 December. The following information was extracted from the books: 2013 Production in units 380,000 Sales in units 370,000 Cost and price data for 2012 and 2013: $ Direct materials per unit produced 34 Direct labour per unit produced 12 Variable production overheads per unit produced 9 Selling price per unit 170 Non-manufacturing overheads for the past two years are as follows: Variable non-manufacturing overheads $27 per unit sold Fixed non-manufacturing overheads $8,000,000 per annum As at 31 December 2013, 90,000 units of the product remained unsold. Required: (a) Calculate the unit production costs for 2013 under absorption costing; (b) Calculate the opening inventory in units and in value; (c) Determine the under- /over-absorbed of fixed production overheads; (d) Prepare an income statement for the year ended 31 December 2013, using absorption costing. (a) Unit production costs under absorption costing = $34 + $12 + $9 + $30 = $85 (b) Opening inventory + Production Closing inventory = Sales Opening inventory + 380,000 90,000 = 370,000 Opening inventory in units = 370, , ,000 = 80,000 units Opening inventory in value = 80,000 $85 = $6,800,000 (c) Fixed production overheads absorbed = 380,000 x $30 = $11,400,000 Normal fixed production overheads incurred = 400,000 x $30 = $12,000,000 Under-absorption of fixed production overheads = (400, ,000) $30 = $600,000 (d) Snowball Ltd Income Statement for the year ended 31 December 2013 $000 $000 Sales (370,000 $170) 62,900 Opening inventory 6,800 Add Manufacturing cost of goods completed (380,000 $85) 32,300 Cost of goods available for sale 39,100 Less Closing inventory (90,000 $85) (7,650) 31,450 Add Under-absorption of fixed factory overheads 600 (32,050) Gross profit 30,850 Less Variable non-manufacturing overheads (370,000 $27) 9,990 Fixed non-manufacturing overheads 8,000 (17,990) Net profit 12,860 8

9 22.4 Marginal costing ( 邊際成本法 ) Only variable manufacturing costs ( 變動製造成本 ) are treated as product costs ( 產品成本 ). All fixed manufacturing costs ( 固定製造成本 ) and non-manufacturing costs ( 非製造成本 ) are treated as period costs ( 期間成本 ) and written off ( 註銷 ) to the profit and loss account. This costing method is also called variable costing ( 變動成本法 ). Baby Toys Manufacturing Account for the year ended 31 March 2011 $ Direct materials 18,000 Direct labour 8,000 Factory overheads 4,000 Variable manufacturing cost of goods completed 30,000 The manufacturing account does not differentiate ( 區分 ) between direct and indirect manufacturing costs. It shows only the variable manufacturing cost of goods completed in a period. Example: Preparation of financial statements under marginal costing The following figures were extracted from the books of Baby Toys for the year ended 31 March 2011: Variable manufacturing costs: Direct materials $18 per unit produced Direct labour $8 per unit produced Ind. manu. costs $4 per unit produced Fixed manufacturing costs (all indirect) $10,000 Marketing costs: Variable $5 per unit sold Fixed $15,000 Selling price $100 per unit sold Opening inventory 0 units Production 1,000 units Sales 800 units Closing inventory 200 units Answer Step 1 : Calculate the unit production costs under marginal costing. Unit production costs under marginal costing = $18 + $8 + $4 = $30 Step 2 : Prepare a income statement for the year ended 31 March 2011, using marginal costing, Baby Toys Income Statement for the year ended 31 March 2011 Sales (800 $100) 80,000 Less Variable cost of goods sold: Opening inventory Add Variable manufacturing cost of goods completed (1,000 x $30) 30,000 Variable cost of goods available for sale 30,000 Less Closing inventory (200 x $30) (6,000) (24,000) Product contribution margin 56,000 Less Variable marketing costs (800 x $5) (4,000) Total contribution margin 52,000 Less Fixed manufacturing costs 10,000 Fixed marketing costs 15,000 (25,000) Net profit 27,000 Inventory is valued at variable manufacturing costs ( 變動製造成本 ) only. Product contribution margin ( 產品邊際貢獻 ) refers to the excess of sales revenue over the variable cost of goods sold. Total contribution margin ( 總邊際貢獻 ) refers to the excess of sales revenue over all variable costs ( 變動 ) incurred. Under absorption costing, the costs are classified into manufacturing and non-manufacturing. Under marginal costing, the costs are classified into variable and fixed. 9

10 Classwork 4 1. Rainbow Ltd makes a single product. The following figures were budgeted for the year ended 31 December 2010: Selling price per unit $38 Variable manufacturing costs per unit $18 Fixed manufacturing costs $168,000 Fixed selling and distribution overheads $78,000 Completed units Opening inventory 1,000 Production 12,000 Sales 12,600 There were no inventories of direct materials and work-in-progress. Costs in 2009 were the same as those budgeted for Prepare a budgeted income statement for the year ended 31 December 2010, using marginal costing. Budgeted Income Statement for the year ended 31 December 2010 Sales (12,600 $38) 478,800 Less Variable cost of goods sold: Opening inventory (1,000 x $18) 18,000 Add Variable manufacturing cost of goods completed (12,000 x $18) 216, ,000 Less Closing inventory [(1, ,000 $12,600) x $18] (7,200) (226,800) Contribution margin 252,000 Less Fixed manufacturing costs 168,000 Fixed selling and distribution overheads 78,000 (246,000) Net profit 6,000 2 Victory Ltd makes a single product. Its budgeted information is as follows: $ per unit Year ended 31 December Selling price 45 Production (units) 40,000 40,000 Direct materials cost 8 Sales (units) 38,000 42,000 Direct labour cost 10 Variable manufacturing overheads 6 Fixed manufacturing overheads and non-manufacturing overheads for both 2011 and 2012 are $120,000 and $80,000 respectively. There was no opening inventory on 1 January Prepare budgeted income statements for the year ended 31 December 2011 and 2012 respectively, using marginal costing; Budgeted Income Statement for the year ended 31 December 2011 Sales (38,000 $45) 1,710,000 Less Variable cost of goods sold: Variable manufacturing cost of goods completed [40,000 x ($8 + $10 + $6)] 960,000 Less Closing inventory [(40,000 38,000) x ($8 + $10 + $6)] (48,000) (912,000) Contribution margin 798,000 Less Fixed manufacturing overheads 120,000 Non-manufacturing overheads 80,000 (200,000) Net profit 598,000 Budgeted Income Statement for the year ended 31 December 2012 Sales (42,000 $45) 1,890,000 Less Variable cost of goods sold: Opening inventory [(40,000 38,000) x ($8 + $10 + $6)] 48,000 Variable manufacturing cost of goods completed [40,000 x ($8 + $10 + $6)] 960,000 (1,008,000) Contribution margin 882,000 Less Fixed manufacturing overheads 120,000 Non-manufacturing overheads 80,000 (200,000) Net profit 682,000 10

11 3 Good News Ltd manufactures a single product. Its financial year ends on 31 December. No opening inventory was in The following information was extracted from its books: 2013 Units produced 32,000 Units sold 32,000 Cost and price data for 2012 and 2013: Selling price per unit $110 Direct materials cost per unit produced $9 Direct labour cost per unit produced $8 Variable manufacturing overheads per unit sold $13 The company also incurred fixed manufacturing overheads of $96,000 per annum in Non-manufacturing overheads for the past two years are as follows: Variable non-manufacturing overheads $12 per unit sold Fixed non-manufacturing overheads $70,000 per annum Required: (a) Calculate the unit production costs under: (i) absorption costing; (ii) marginal costing. (b) Prepare an income statement for the year ended 31 December 2013 using: (i) absorption costing; (ii) marginal costing. (c) Calculate the break-even sales ( 保本銷售 ) in units and in dollars for the year ended 31 December (a) (i) Unit production costs under absorption costing = $9 + $8 + $13 + ($96,000 32,000) = $33 (ii) Unit production costs under marginal costing = $9 + $8 + $13 = $30 (b) (i) Under absorption costing: Good News Ltd Income Statement for the year ended 31 December 2013 $000 $000 Sales (32,000 $110) 3,520 Less Cost of goods sold (32,000 $33) (1,056) Gross profit 2,464 Less Variable non-manufacturing overheads (32,000 $12) 384 Fixed non-manufacturing overheads 70 (454) Net profit 2,010 (ii) Under marginal costing: Good News Ltd Income Statement for the year ended 31 December 2013 $000 $000 Sales 3,520 Less Variable cost of goods sold (32,000 $30) (960) Product contribution margin 2,560 Less Variable non-manufacturing overheads (32,000 $12) (384) Total contribution margin 2,176 Less Fixed manufacturing overheads 96 Fixed non-manufacturing overheads 70 (166) Net profit 2,010 (c) Break-even sales in units = ($96,000 + $70,000) ($2,176,000 32,000) = $166,000 $68 = 2,442 units Break-even sales in dollars = 2,442 x $110 = $268,620 11

12 4 Given the following income statement of a manufacturing company prepared for a certain year under the absorption costing approach: Sales 600,000 Manufacturing cost of goods completed 280,000 Less Closing inventory (70,000) (210,000) Gross profit 390,000 Less Expenses: Administrative expenses 100,000 Selling and distribution expenses 100,000 (200,000) Net profit 190,000 Required: Additional information: (i) Selling price was fixed at $100 per unit. (ii) Manufacturing costs included a fixed portion of $120,000. (iii) All administrative expenses were fixed. (iv) Selling and distribution expenses for each unit sold totalled $12. (a) Redraft the income statement by using the marginal costing approach. (b) Reconcile the difference in net profit between absorption costing and marginal costing. (c) Suppose a customer asks for a special order of 500 units and offers a unit price of $40. Assuming the factory has enough idle capacity and its existing cost behaviour remains unchanged, should the special order be accepted or rejected? Explain your answer. (d) Suggest one non-financial factor that should also be considered when making the above decision. (a) Budgeted Income Statement for the year ended 31 December 2011 Sales 600,000 Less Variable Cost of goods sold: Variable manufacturing cost of goods completed ($280,000 $120,000) 160,000 Less Closing inventory [2,000 x ($160,000 8,000)] (40,000) 120,000 Product contribution margin 480,000 Less Variable selling and distribution expenses ($600, ) x $12 (72,000) Contribution margin 408,000 Less Fixed manufacturing costs 120,000 Fixed administrative expense 100,000 Fixed selling and distribution expenses ($100,000 $72,000) 28,000 (248,000) Net profit 160,000 (b) Reconcile the difference in net profit between absorption costing and marginal costing. The profits reported for 2011 are reconciled as follows: $ Absorption costing profit 190,000 Decrease in closing inventory valuation (30,000) Marginal costing profit 160,000 (c) Fixed costs will not be affected by the acceptance of the special order. Therefore, only variable costs should be considered when making the decision. Sales = 500 $40 = $20,000 Variable manufacturing cost of goods sold = 500 ($120,000 6,000) = $10,000. Variable selling and distribution expenses = 500 $12 = $6,000 Contribution margin = $20,000 $10,000 $6,000 = $4,000 As the special order has a positive contribution margin, this order should be accepted (d) Non-financial factors that should be considered include Relationship with the customer Pressure from other customers to cut prices 12

13 22.5 Comparison of the two costing methods ( 兩種成本計算法的比較 ) Differences in the treatment and classification of costs ( 處理成本及把成本分類 ) 1 Manufacturing account ( 製造帳戶 ) The manufacturing account prepared under absorption costing show all the manufacturing costs ( 所有製造成本 ) (variable and fixed) ( 變動及固定 ) of goods completed, while the manufacturing account prepared under marginal costing shows the variable manufacturing costs ( 變動製造成本 ) of goods completed only. 2 Classification of costs ( 成本分類 ) The income statement prepared under absorption costing classifies costs by function: manufacturing and non-manufacturing ( 製造或非製造 ). In contrast, the income statement prepared under marginal costing classifies costs into fixed and variable costs ( 固定或變動 ). 3 Inventory valuation ( 存貨計價 ) Under absorption costing, both the variable and fixed manufacturing costs ( 變動及固定製造成本 ) are included in the valuation of inventory ( 存貨計價 ). Under marginal costing, only the variable manufacturing costs ( 變動製造成本 ) are included in the valuation of inventory. 4 Cost of goods sold ( 銷貨成本的金額 ) Under absorption costing, the cost of goods sold ( 銷貨成本 ) includes both the variable and fixed manufacturing costs. Under marginal costing, only the variable manufacturing costs are included in the cost of goods sold. Differences in the format of the income statement ( 損益表的格式 ) The income statement prepared under absorption costing shows the gross profit ( 毛利 ), while the income statement prepared under marginal costing shows the total contribution margin ( 總邊際貢獻 ) regardless of whether they are manufacturing or non-manufacturing. Over- or under-absorption of manufacturing overheads ( 多吸收或少吸收固定製造費用 ) Under absorption costing, if the actual fixed manufacturing overheads ( 實際固定成製造費用 ) incurred are different from the overheads absorbed ( 吸收製造費用 ), there will be over- or under-absorption of fixed manufacturing overheads. Under marginal costing, there is no absorption of fixed manufacturing overheads. Differences in reported net profit ( 報告純利的差異 ) Net profit is both defined as the excess of revenues over all costs and expenses incurred in the same period under absorption costing and marginal costing. However, the resulting net profit figures are different. This is due to different cost being absorbed by inventory. ( 因為期末存貨會吸收一部分的固定製造成本, 並轉到下期 ) Reconciliation of the difference in net profit under absorption and marginal costing ( 調節吸收與邊際成本在純利上的差別 ) Reconciliation = Net profit under absorption costing Net profit under marginal costing Fixed manufacturing costs included in Fixed manufacturing costs included in = closing inventory under absorption costing opening inventory under absorption costing Relationship between inventory level and net profit figure ( 存貨水平和純利的關係 ) The net profit figure reported under absorption costing may be higher or lower, depending on the level of inventory ( 庫存水平 ). In general, if the inventory level increase ( 庫存水平增加 ) during a period, a higher net profit figure ( 較高的純利數字 ) will be reported under absorption costing than under marginal costing. Conversely, if the inventory level decreases ( 庫存水平下降 ) during a period, a higher net profit figure will be reported under marginal costing than under absorption costing. This is because some fixed manufacturing costs ( 固定製造成本 ) of previous year were released ( 釋放出 ) from opening inventory ( 期初存貨 ) while a portion of fixed manufacturing costs incurred in current year were absorbed ( 吸收去 ) by the closing inventory ( 期末存貨 ). If the opening inventory is greater than the closing inventory (inventory level falls), the amount of fixed manufacturing costs released from opening inventory exceeds the amount absorbed to closing inventory. As a result, the net profit figure would be reduced. Comparison of net profit Absorption costing Marginal costing Increase in inventory level Higher Lower Decrease in inventory level Lower Higher No change in inventory level Same Same 13

14 Example: Comparison of the two costing methods The following figures were extracted from the books of Baby Toys for the year ended 31 March 2012: Variable manufacturing costs: Direct materials Direct labour Ind. manu. costs Fixed manufacturing costs (all indirect) $10,000 $18 per unit produced $8 per unit produced $4 per unit produced Marketing costs: Variable $5 per unit sold Fixed $15,000 Selling price $100 per unit sold Opening inventory 200 units Opening inventory value under absorption costing $8,000 Opening inventory value under marginal costing $6,000 Production 1,000 units Sales 1,100 units Closing inventory 100 units Income statement prepared under absorption costing Baby Toys Income Statement for the year ended 31 March 2012 Sales (1,100 $100) 110,000 Opening inventory 8,000 Add Manufacturing cost of goods completed [(1,000 x ($18 + $8 + $4) + (1,000 x $10,000/1,000)] 40,000 Cost of goods available for sale 48,000 Less Closing inventory (100 x $40,000/1,000) (4,000) (44,000) Gross profit 66,000 Less Marketing costs [(Variable (1,100 x $5) + Fixed ($15,000)] (20,500) Net profit 45,500 Income statement prepared under marginal costing Baby Toys Income Statement for the year ended 31 March 2011 Sales (1,100 $100) 110,000 Less Variable cost of goods sold: Opening inventory 6,000 Add Variable manufacturing cost of goods completed [(1,000 x ($18 + $8 + $4)] 30,000 Variable cost of goods available for sale 36,000 Less Closing inventory (100 x $30,000/1,000) (3,000) (33,000) Product contribution margin 77,000 Less Variable marketing costs (1,100 x $5) (5,500) Total contribution margin 71,500 Less Fixed manufacturing costs 10,000 Fixed marketing costs 15,000 (25,000) Net profit 46,500 Reconciliation = Fixed manufacturing costs included in closing inventory under absorption costing = 100 x $10,000/1, x $10,000/1,000 = $1,000 $2,000 = ($1,000) Fixed manufacturing costs included in opening inventory under absorption costing 14

15 22.6 Advantages and disadvantages of the two costing approaches Advantages of absorption costing/ disadvantages of marginal costing Absorption costing Marginal costing 1. Financial statements prepared for external reporting 1. Financial statements prepared for external reporting purposes are required to use this approach. purposes are not allowed to use this approach. 2. Distinguishing ( 分辨 ) between manufacturing and non- 2. Extra time and efforts ( 額外的時間和人力 ) are required manufacturing costs ( 製造與非製造成本 ) is easier than to distinguish between fixed and variable costs. distinguishing between fixed and variable costs ( 固定與變動成本 ). 3. Including both fixed and variable manufacturing costs in inventory valuation ( 存貨價值 ) can better reflect ( 較能反映 ) the costs incurred to produce goods. Disadvantages of absorption costing/ advantages of marginal costing Absorption costing 1. Fixed manufacturing costs ( 固定製造成本 ) are sunk costs ( 沉沒成本 ) and are irrelevant ( 無關 ) to decision-making ( 決策 ). 2. The net profit figure can be manipulated ( 操控 ) by changing the inventory level ( 存貨水平 ). Managers may be tempted to produce more units of inventories than needed in order to increase the net profit but this will hurt a company s profitability and liquidity in the long run. Marginal costing 1. Excluding sunk costs ( 不考慮沉沒成本 ) can help make better decisions. 2. Income statements prepared are more useful. They can help managers predict the change in net profit ( 預測純利的轉變 ) because the change in net profit is driven by changes in sales volume only, given a constant contribution margin per unit and constant fixed costs. We can see more examples of using contribution margin to predict the change in net profit next chapter A more complicated example Sharon started a small manufacturing business on 1 January The following figures were extracted from the books for the year ended 31 December 2009: $ Direct materials purchased 25,000 Direct labour cost 12,000 Fixed manufacturing overheads 6,000 Non-manufacturing overheads: Variable 5,000 Fixed 14,000 Selling price 100 per unit sold Units Completed 700 Sold 650 Closing inventories: Direct materials $1,000 Work-in-progress (50% completed for all manufacturing costs) 200 units Fixed manufacturing overheads were absorbed at the rate of $6 per unit based on the normal level of production. (a) Prepare a manufacturing account and income statement for the year ended 31 December 2009 using absorption costing. (b) Prepare a manufacturing account and income statement for the year ended 31 December 2009 using marginal costing. (a) Under absorption costing Manufacturing Account for the year ended 31 December 2009 $ Direct materials purchased 25,000 Less Closing inventory of direct materials (1,000) Cost of raw materials consumed 24,000 Direct labour 12,000 Prime cost 36,000 Fixed manufacturing overheads [( x 50%) x $6] 4,800 40,800 Less Closing work-in-progress ($40,800 x 100/800) (5,100) Manufacturing cost of goods completed 35,700 15

16 Income Statement for the year ended 31 December 2009 Sales (650 $100) 650,000 Manufacturing cost of goods completed (700 units) 35,700 Less Closing inventory ($35,700 x 50/700) (2,550) 33,150 Add Under-absorption of fixed factory overheads (W1) 1,200 (34,350) Gross profit 30,650 Less Non-manufacturing overheads ($5,000 + $14,000) (19,000) Net profit 11,650 W1 Under-absorption of fixed factory overheads = $6,000 (Incurred) $4,800 (Absorbed) = $1,200 (b) Under marginal costing Manufacturing Account for the year ended 31 December 2009 $ Direct materials purchased 25,000 Less Closing inventory of direct materials (1,000) Cost of raw materials consumed 24,000 Direct labour 12,000 Prime cost 36,000 Less Closing work-in-progress ($36,000 x 100/800) (4,500) Variable manufacturing cost of goods completed 31,500 Income Statement for the year ended 31 December 2009 Sales (650 $100) 650,000 Less Variable cost of goods sold: Variable manufacturing cost of goods completed (700 units) 31,500 Less Closing inventory ($31,500 x 50/700) (2,250) (29,250) Product contribution margin 35,750 Less Variable non-manufacturing overheads (5,000) Total contribution margin 30,750 Less Fixed manufacturing overheads 6,000 Fixed non-manufacturing overheads 14,000 (20,000) Net profit 10,750 16

17 Classwork 5 1 Cassia Limited manufactures a single product. The company has operated a system of absorption costing for management accounting purposes and has decided to consider using the variable costing system instead. The financial year of the company ends on 31 December. The following data have been extracted for the past two years Production in units 42,000 38,000 Sales in units 35,000 45,000 Actual cost per unit for 2006 and 2007 $ Direct materials cost 30 Direct labour cost 40 Variable production overhead costs 10 There was no opening inventory at the beginning of Fixed production overhead costs were $20 per unit, absorbed based on a normal production level of 40,000 units per annum. The non-production costs for the past two years were as follows: Variable non-production overhead costs $8 per unit sold Fixed non-production overhead cost per annum $150,000 Selling price per unit was $180 for the past two years. Required: (a) Prepare the operating statements for each of the past two years, in a columnar format using (i) absorption costing and (ii) marginal costing system. (b) Reconcile the profits reported in your answer to (a) (i) and (ii) above for each of the past two years. (c) Discuss any two reasons for using marginal costing system in preparing management accounts. (a) (i) Operating Statement (Using Absorption Costing) for the year ended 31 December 2006 $000 $000 Sales (35,000 x $180) 6,300 Opening inventory Add Variable production costs and overhead costs (42,000 x $80) 3,360 Fixed production overhead costs (42,000 x $20) 840 Less Closing inventory [(42,000 35,000) x 4,200,000 42,000] (700) 3,500 Less Over-absorbed fixed production costs [(42,000 40,000) x $20] (40) 3,460 Gross profit 2,840 Less Variable non-production overheads cost (35,000 x $8) 280 Fixed non-production overhead costs 150 Net profit 2,410 Operating Statement (Using Absorption Costing) for the year ended 31 December 2007 $000 $000 Sales (45,000 x $180) 8,100 Opening inventory 7,00 Add Variable production costs and overhead costs (38,000 x $80) 3,040 Fixed production overhead costs (38,000 x $20) 760 Less Closing inventory 4,500 Add Under-absorbed fixed production costs (2,000 x $20) 40 4,540 Gross profit 3,560 Less Variable non-production overheads cost (45,000 x $8) 360 Fixed non-production overhead costs 150 Net profit 3,050 17

18 (ii) Operating Statement (Using Marginal Costing) for the year ended 31 December 2006 $000 $000 Sales (35,000 x $180) 6,300 Less Variable cost of goods sold: Opening inventory Add Variable production costs and overhead costs (42,000 x $80) 3,360 Less Closing inventory [(42,000 35,000) x 3,360,000 42,000] (560) 2,800 Product contribution margin 3,500 Less Variable non-production overheads cost (35,000 x $8) 280 Total contribution margin 3,220 Less Fixed production overhead costs (40,000 x $20) 800 Fixed non-production overhead costs 150 (950) Net profit 2,270 Operating Statement (Using Marginal Costing) for the year ended 31 December 2007 $000 $000 Sales (45,000 x $180) 8,100 Less Variable cost of goods sold: Opening inventory 560 Add Variable production costs and overhead costs (38,000 x $80) 3,040 Less Closing inventory 3,600 Product contribution margin 4,500 Less Variable non-production overheads cost (45,000 x $8) 360 Total contribution margin 4,140 Less Fixed production overhead costs (40,000 x $20) 800 Fixed non-production overhead costs 150 (950) Net profit 3,190 (b) The profits reported for 2006 are reconciled as follows: $000 $000 Absorption costing profit 2,410 3, Decrease in closing inventory valuation (7,000 units $20) (140) Decrease in opening inventory valuation (7,000 units $20) 140 Marginal costing profit 2,270 3,190 (c) Excluding sunk costs can help make better decisions. Fixed costs are incurred on a time basis and are thus charged wholly as expenses in the period they occur rather than as part of the product cost Changes in production volume do not affect the unit cost of inventory which comprises only variable production costs 18

19 2 Rainbow Ltd makes a single product. The following figures were budgeted for the year ended 31 December 2010: Selling price per unit $38 Variable manufacturing costs per unit $18 Fixed manufacturing costs $168,000 Fixed selling and distribution overheads $78,000 Completed units Opening inventory 1,000 Production 12,000 Sales 12,600 There were no inventories of direct materials and work-in-progress. Costs in 2009 were the same as those budgeted for (a) (b) Prepare a budgeted income statement for the year ended 31 December 2010, using (i) absorption costing and (ii)marginal costing. Reconcile the difference in net profit between the two costing approaches. (a) (i) Under absorption costing Unit fixed manufacturing cost = $168,000 12,000 = $14 Unit production costs under absorption costing = $18 + $14 = $32 Budgeted Income Statement for the year ended 31 December 2010 Sales (12,600 $38) 478,800 Opening inventory (1,000 x $32) 32,000 Add Manufacturing cost of goods completed (12,000 x $32) 384, ,000 Less Closing inventory [(1, ,000 $12,600) x $32] (12,800) (403,200) Gross profit 75,600 Less Fixed selling and distribution overheads (78,000) Net loss (2,400) (ii) Under marginal costing Budgeted Income Statement for the year ended 31 December 2010 Sales (12,600 $38) 478,800 Less Variable Cost of goods sold: Opening inventory (1,000 x $18) 18,000 Add Variable manufacturing cost of goods completed (12,000 x $18) 216, ,000 Less Closing inventory [(1, ,000 $12,600) x $18] (7,200) (226,800) Contribution margin 252,000 Less Fixed manufacturing costs 168,000 Fixed selling and distribution overheads 78,000 (246,000) Net profit 6,000 (b) The profits reported for 2006 are reconciled as follows: $ Absorption costing loss (2,400) Increase in opening inventory valuation (1000 units $14) 14,000 Decrease in closing inventory valuation (400 units $14) (5,600) Marginal costing profit 6,000 19

20 3 Victory Ltd makes a single product. Its budgeted information is as follows: $ per unit Year ended 31 December Selling price 45 Production (units) 40,000 40,000 Direct materials cost 8 Sales (units) 38,000 42,000 Direct labour cost 10 Variable manufacturing overheads 6 Fixed manufacturing overheads and non-manufacturing overheads for both 2011 and 2012 are $120,000 and $80,000 respectively. There was no opening inventory on 1 January Prepare budgeted income statements for the year ended 31 December 2011 and 2012 respectively, using: (a) marginal costing; (b) absorption costing. (a) Under marginal costing: Budgeted Income Statement for the year ended 31 December 2011 Sales (38,000 $45) 1,710,000 Less Variable cost of goods sold: Variable manufacturing cost of goods completed [40,000 x ($8 + $10 + $6)] 960,000 Less Closing inventory [(40,000 38,000) x ($8 + $10 + $6)] (48,000) (912,000) Contribution margin 798,000 Less Fixed manufacturing overheads 120,000 Non-manufacturing overheads 80,000 (200,000) Net profit 598,000 Budgeted Income Statement for the year ended 31 December 2012 Sales (42,000 $45) 1,890,000 Less Variable cost of goods sold: Opening inventory [(40,000 38,000) x ($8 + $10 + $6)] 48,000 Variable manufacturing cost of goods completed [40,000 x ($8 + $10 + $6)] 960,000 (1,008,000) Contribution margin 882,000 Less Fixed manufacturing overheads 120,000 Non-manufacturing overheads 80,000 (200,000) Net profit 682,000 (b) Under absorption costing: Budgeted Income Statement for the year ended 31 December 2011 Sales (38,000 $45) 1,710,000 Manufacturing cost of goods completed {40,000 [$24 + ($120,000 40,000)]} 1,080,000 Less Closing inventory [1,080,000 x (40,000 38,000) 40,000] (54,000) (1,026,000) Gross profit 684,000 Less Non-manufacturing overheads (80,000) Net profit 604,000 Budgeted Income Statement for the year ended 31 December 2012 Sales (42,000 $45) 1,890,000 Opening inventory 54,000 Manufacturing cost of goods completed (40,000 $27) 1,080,000 (1,134,000) Gross profit 756,000 Less Non-manufacturing overheads (80,000) Net profit 676,000 20

21 (HKALE 2005, Paper 2, 2) (Absorption and marginal Costing) Yellow Stone Manufacturing Ltd commenced business in 2004 producing cleaning liquid Product X. Each bottle of Product X contains 1 litre of raw materials. The production budget for the year ended 31 December 2004 on the basis of 100,000 bottles is shown below: $ Raw materials ($10 per litre) 1,000,000 Direct labour ($2 per labour hour) 800,000 Factory overheads: Fixed 200,000 Other budget information: Selling and distribution expenses: Fixed $150,000 Variable $1 per bottle Administrative expenses fixed $400,000 Selling price $30 per bottle Sales volume 90,000 bottles Required: (a) (i) Prepare the budgeted income statement for Product X based on absorption costing to show the budgeted net profit for the year ended 31 December (ii) How will the budgeted net profit differ if marginal costing is used instead? Answer: (a) (i) Product X Budgeted income statement for the year ended 31 December 2004 Sales (90,000 $30) 2,700,000 Raw materials 1,000,000 Direct labour 800,000 Factory overheads 200,000 2,000,000 Less Closing stock ($2,000,000 x 10,000/100,000) (200,000) (1,800,000) Gross profit 900,000 Expenses Selling and distribution expenses ($150, ,000 x $1) 240,000 Administrative expenses 400, ,000 Budgeted net profit 260,000 (ii) Under marginal costing, the fixed factory overheads will not be absorbed into the closing stock but are written off as expenses. The value of closing stock will therefore be lower to $180,000 ($1,800,000 x 10,000/100,000), resulting in a corresponding reduction of budgeted net profit by $20,