PRACTICE QUESTION.docx - PRACTICE QUESTION This practice question illustrates the misleading effect on profit which absorption costing can have A

# PRACTICE QUESTION.docx - PRACTICE QUESTION This practice...

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PRACTICE QUESTION This practice question illustrates the misleading effect on profit which absorption costing can have. A company sells a product for Rs10. and incurs Rs4 of variable costs in its manufacture. The fixed costs are Rs900 per year and are absorbed on the basis of the normal production volume of 250 units per year. The results for the last four years, when no expenditure variances arose- were as follows: 2 nd year 3 rd year 4th year Total Item 1st year units units units units Opening stock 200 300 300 Production 300 250 200 200 950 300 450 500 500 950 Closing stock 200 300 300 200 200 Sales 100 150 200 300 750 Rs Rs Rs Rs Rs Sales value 1,000 1,500 2,000 3,000 7,500 Prepare a profit statement under absorption and marginal costing. 174
Cost & Management Accounting (MGT-402) VU Solution The profit statement under absorption costing would be as follows: 1 st year 2 nd year 3 rd year 4 th year Items Total Rs. Rs. Rs. Rs. Rs. Opening stock @ Rs7.60 1,520 2,280 2,280 Variable costs of 1,200 1,000 800 800 3,800 production @ Rs4 Fixed costs ® 900/250 1,080 900 720 720 3,420 =Rs3.60 2,280 3,420 3,800 3,800 7,220 Closing stock @Rs7.60 1,520 2,280 2,280 1,520 1,520 Cost of sales (760) (1,140) (1,520) (2,280) (5,700) (Under)/over absorption 180 Nil (180) (180) (180) (w) Net Profit 420 360 300 540 1,620 Working: Calculation of over / under absorption Fixed cost control account Incurred Year 1 900
Absorbed 1,080 300 x Rs. 3.60 Over absorption 180 1,080 1,080 Year 2 900 250 x Rs. 3.60 Year 3 900 200 x Rs. 3.60 720 Under absorption 180 900 900 Year 4 900 200 x 3.60 720 Under absorption 180 900 900 175
Cost & Management Accounting (MGT-402) VU If marginal costing had been used instead of absorption, the results would have been shown as follows: Item 1st year 2nd year 3rd year 4th year Total Rs Rs Rs Rs Rs Sales 1,000 1,500 2,000 3,000 7,500 Variable cost of sales (@ Rs4) 400 600 800 1,200 3,000 Contribution margin 600 900 1,200 1,800 4,500 Fixed costs 900 900 900 900 3,600 Net profit/ (loss) (300) - 300 900 900 The marginal presentation indicates clearly that the business must sell at least 150 units per year to break even, i.e. Rs900 + (10 - 4), whereas it appeared, using absorption costing, that even at 100 units it was making a healthy profit. The total profit for the four years is less under the marginal principle because the closing stocks at the end of the fourth year are valued at Rs800 (Rs4 x 200) instead of Rs 1,520, i.e. Rs720 of the fixed costs are being carried forward under the absorption principle.

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