Question

In: Accounting

Please assist with the question below. Teddy Ltd manufactures and sells a single product. The organisation...

Please assist with the question below.

Teddy Ltd manufactures and sells a single product. The organisation uses a fully integrated absorption costing system for both internal and external reporting purposes. The comparative monthly results for the most recent two months (February and March 2019) have just been tabled at a meeting. The sales director says, our break-even point is 15 128 units. In February, we sold above our break-even point and made loss, and in March we sold below break-even point and made profit. This is clearly not correct!

The meeting confirms the following supporting data:

1. The actual selling price and prime cost elements for each month were as budgeted, namely:

Selling price R400 / unit.

Direct materials R120 / unit.

Direct labour R45 /unit.

2. Monthly manufacturing overheads were budgeted according to the following cost volume relationship:

Overhead R900 000 R1 200 000
Production unit 10 000 25 000

The organisation's normal operating capacity for the purpose of deriving a predetermined overhead absorption rate is 20 000 units per month. All manufacturing overhead costs where exactly as budgeted.

3. Actual variable selling and fixed administration costs were as budgeted, namely:

Variable selling costs R20 per unit sold.

Fixed administration cost R2 250 000

4. Actual sales and production units for each month were as follows:

February March
Sales units 15 500 14 000
Production units 12 000 21 000

5. The organisation had 4000 units of finished goods in opening inventory on 1 February 2019. There were no opening or closing inventory of raw material or work-in-progress in either of the two months.

The sales director says, we have verified all the supporting financial data and it is correct. Perhaps the accountant could explain how this strange situation has arisen?

Required:

1. Prepare income statement for each month according to the organisation's existing method of reporting.

2. Prepare income statement for each month according to the variable costing system.

3. Reconcile and explain to the sales director the differences between the two statements given for 1 an 2 above in such a way to eliminate his confusion. State why both statements may be acceptable.

4. Discuss the arguments put forward for the use of variable costing system.

Solutions

Expert Solution

1 ).

Income Statement of Teddy Ltd manufactures for the period February and March 2019 (Absorption costing )

Particulars

February

( R)

March

( R)

Total

( R )

Sales

6200000

( 15500 * $ 400 )

5600000

( 14000 * 400 )

11800000

Less: Expenses

Direct Materials

1860000

( 15500 * $ 120 )

1680000

( 14000 * $ 120 )

3540000

Direct Labor

697500

( 15500 * 45 )

630000

( 14000 * 45 )

1327500

Variable manufacturing overhead

310000

( 15500 * $ 20 )

280000

( 14000 * 20

590000

Fixed Manufacturing overhead

810833

(140000 + ( 700000 /12000 * 11500) )

479167

(29167+(700000/ 21000 * 13500 )

1290000

Variable selling cost

310000

( 15500 * $ 20 )

280000

( 14000 * 20 )

590000

Fixed administration expenses

2250000

2250000

4500000

Total Expenses

(6238333)

(5599167)

(11837500)

Net profit / loss

( 38333 )

loss

833

( 38000 )

loss

· Manufacturing overhead is a mixed cost in this question because it is increasing slightly with increase in production. It can be separated into fixed and variable component using high – low point method’

Variable cost per unit = Highest value – Lowest value / Highest units – lowest units

                               = 300000 / 15000 = $ 20

Therefore fixed cost = 1200000 – ($ 20 * 25000 ) = $ 700000   

Because of no other information given in the question fixed manufacturing portion in the opening units of 4000 in February = 700000 / 20000 * 4000 = $ 140000

fixed manufacturing portion in the opening units of 500 in March = 700000 /12000 * 500 )

= 29167

For the month of February in absorption costing fixed manufacturing cost related to opening inventory will also take and current year cost will allocated based on production to sold units and for march ending inventory of february will be considered.

2 )

Income Statement of Teddy Ltd manufactures for the period February and March 2019 ( Variable costing )

Particulars

February

( R)

March

( R)

Total

( R )

Sales

6200000

( 15500 * $ 400 )

5600000

( 14000 * 400 )

11800000

Less : Variable costs

Direct Materials

1860000

( 15500 * $ 120 )

1680000

( 14000 * $ 120 )

3540000

Direct Labor

697500

( 15500 * 45 )

630000

( 14000 * 45 )

1327500

Variable manufacturing overhead

310000

( 15500 * $ 20 )

280000

( 14000 * 20

590000

Variable selling cost

310000

( 15500 * $ 20 )

280000

( 14000 * 20 )

590000

Contribution

3022500

2730000

5752500

Less : Fixed costs

Fixed Manufacturing overhead

700000

700000

1400000

Fixed administration expenses

2250000

2250000

4500000

Net income or loss

72500

( 220000 )

loss

( 147500 )

loss

3)

Reconciliation of variable costing and absorption costing income statements for the month of February

Variable costing operating income                                       $ 72,500

Add: portion of fixed manufacturing overhead

    For the ending inventory (500*700000/12000)                 $ 29,167

Less: Portion of fixed manufacturing overhead

     For the beginning inventory sold in the month              $ 140,000

Absorption costing operating income                                 ($ 38,333)

Reconciliation of variable costing and absorption costing income statements for the month of March

Variable costing operating income                                       ( 220000 )

Add: portion of fixed manufacturing overhead

    For the ending inventory (7500*700000/21000)            $ 250000

Less: Portion of fixed manufacturing overhead

For the beginning inventory sold in the month

                                         (500*700000/12000)                ( $ 29167 )

Absorption costing operating income                                 ($ 833)

Absorption costing income statement is used for external financial reporting and it is accepted for tax reporting by US Internal Revenue service. Variable costing income statement is used for internal decision making.

4 )

In variable costing fixed manufacturing overhead is not part of the production costs , so companies are able to make more better decisions about profitability and product mix.

All fixed expenses are treated as period cost and expensed in the year in which it is incurred, so inventory will not carry any allocate d fixed cost so income will be directly related to sales not influenced by production – sales differences.

Operating income in variable costing is directly influenced by the sales, not depending on amount of fixed expenses.

Fixed overhead cost is more complicated in absorption costing compared to variable costing.

Fixed costs expenses incurred during the year are directly visible on variable costing.

Variable costing is simpler compared to absorption, it presents expense as they are incurred.

Fixed costs mean that they will not vary with production in short run. Variable costing does not vary with production and it is more consistent with this economic reality.

In absorption costing fixed manufacturing overhead is also treated as production cost , it will allocated with respect to sales basing on the production during the year. So inventory also carry a portion of this fixed expense and difference in production and sales will affect the total expenses. So income also will vary. That’s why breakeven is not satisfying according to the sales. It is concept based on variable costing. So break even analysis can be done in its pure form only in variable costing.

Variable costing is more appropriate for internal decision making, break even analysis is an internal analysis so variable costing is more preferable.


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