Question

You are the Management Accountant of a chair manufacturing business. The business is running for 3 years. You have used marginal cost approach and FIFO (First in First Out) to value the stock in the financial statements. You are interested to know what the recorded profits would have been if absorption costing had been used instead. Using the following information, prepare a statement for each of the three years comparing both methods:

(a) Total fixed indirect production cost is £64,000 per year.

(b) Direct labour costs over each of the three years were £16 per unit.

(c) Direct material costs over each of the three years were £12 per unit.

(d) Variable expenses which vary in direct ratio to production were £20 per unit.

(e) Sales were: Year 1: 36,000 units; Year 2: 40,000 units; Year 3: 60,000 units. The selling price remained constant at £70 per unit.

(f) Production is at the rate of: Year 1: 40,000 units; Year 2: 48,000 units; Year 3: 51,000 units.

(g) Other overheads are as follows:

• Selling and Distribution overheads are: Year 1: £10,000 for each year; Year 2: £10,500, Year 3: £11,000
• Administrative overheads £15,000 for each year

(h) Interest expense: Year 1: £1,000; Year 2: £1,250; Year 3: £1,500

Required:

Prepare the income statements using marginal and absorption costs for the three years (6 income statements in total) with calculations / workings of closing stock and comment on the results.

Answer 1

income statement for 3 years

	Year 1		Year 2		Year 3
	Absorption costing	Marginal costing	Absorption costing	Marginal costing	Absorption costing	Marginal costing
Sales (Qty)	36000	36000	40000	40000	60000	60000
Selling price	70	70	70	70	70	70
Sales(Value) (A)	2520000	2520000	5760000	5760000	4200000	4200000
Production(Qty) (B)	40000	40000	48000	48000	51000	51000
Material@12 per unit	480000	480000	576000	576000	612000	612000
Labor @ 16 per unit	640000	640000	768000	768000	816000	816000
Variable expenses@20 per unit	800000	800000	960000	960000	102000	102000
Fixed production Overhead	64000		64000		64000
Product cost (C)	1984000	1920000	2368000	2304000	2512000	2448000
Unit cost (D)=(C/B)	49.6	48	49.33	48	49.255	48
Opening stock(Qty) (E)	0	0	4000	4000	12000	12000
Opening stock(value)(D*E of previous year)	0	0	198400	192000	592000	576000
Closing stock(Qty)(F)	4000	4000	12000	12000	3000	3000
Closing stock(Value)(D*F)	198400	192000	592000	576000	147765	144000
Cost of goods sold(G)	1785600	1728000	197400	1920000	2956235	2880000
Less: Period cost
Fixed production OH		64000		64000		64000
Selling & distribution	10000	10000	10500	10500	11000	11000
Administration	15000	15000	15000	15000	15000	15000
Total(H)	25000	89000	25500	89500	26000	90000
Cost of sale(I)=(G+H)	1810600	1817000	1999900	2009500	2982235	2970000
Earning before interest(A-I)	709400	703000	800100	790500	1217765	1230000
Interest	1000	1000	1250	1250	1500	1500
Net income	708400	702000	798850	789250	1216265	1228500

The difference in net income in two costing method is due to the difference in stock. in absorption costing we charged fixed production overhead to product cost. in marginal costing, the same is taken as Period cost.