CHAPTER 2: Decision-making based on internal cost allocation

CHAPTER 2
LEARNING UNIT 10: Methods for the treatment of fixed production overheads
ASSESSMENT CRITERIA
After working through this learning unit, you should be able to record inventory according to the
• discuss the differences between the variable and absorption costing method
• draft the income statements according to both the variable and absorption costing method by
using different inventory valuation methods
• reconcile the difference between the variable and absorption costing methods’ net profits
• identify which method is most appropriate in different circumstances

You should spend approximately 7-8 hours on mastering the learning outcomes of this Learning Unit.

10.1 INTRODUCTION

In Learning Unit 3 we saw that, in building an accounting system, management must, among others,
make a selection from each of five groups of methods.
1) What the reporting capability of the inventory system must be, i.e., management must select either
the periodic or the perpetual method. We discussed these methods in greater detail in Learning
Unit 6.
2) How costs will flow from inventory, i.e., management must make a cost flow assumption and select
the associated cost formula, either specific identification or FIFO or weighted average. We
discussed these methods in greater detail in Learning Unit 9.
3) Will all input costs or only variable costs be included in the cost of products, i.e., will the absorption
costing method or variable costing method be applied? These methods are discussed in this
learning unit.
In the next two learning units we shall take a closer look at
4) how overhead apportionment rates will be determined, i.e., will the traditional pre-determined rates
per volume of production be applied or will activity-based rates per activity be applied.
5) where costs will be accumulated, i.e., will work-in-progress be recorded per job or per
process/department?

Before you proceed with this Learning Unit, we advise that you read paragraph 3.2.2.1 in Learning Unit
3 again.

10.2 EFFECT OF ABSORPTION - AND VARIABLE COSTING ON PROFIT AND INVENTORY

The absorption costing method is also called the full costing method and the variable costing method
is also known as the direct costing method and the marginal costing method. The focus of the variable
costing method is on the behaviour of costs, i.e., is the cost variable or fixed? The focus of the
absorption costing method is on the nature and traceability of costs, i.e., is the cost direct or indirect?
Usually (but not always) a variable cost is also a direct cost, as is the case with direct material and
direct labour costs, while fixed costs are usually also indirect costs.

The variable costing method treats only manufacturing costs that vary with output as product costs.
This would include direct materials cost and direct labour costs as well as the variable portion of indirect
costs (variable manufacturing overheads). Fixed manufacturing costs are treated as a period cost, i.e.,
an expense that is, along with administration and marketing and distribution expenses, taken directly
to the income statement. In calculating the unit cost of manufactured goods, you will include the prime
costs as well as variable overheads, but not include any apportionment for fixed overheads. (You will
recall that the variable costing method is also called the direct costing method; but since the method
also includes variable indirect costs, calling it the direct method may lead to some confusion.)

The absorption method absorbs all manufacturing costs in the cost of inventory. The absorption costing
method treats all variable production costs as well as fixed production costs as product costs. In

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calculating the unit cost of manufactured goods, you will include the prime costs, variable overheads as
well as a portion for fixed overheads. By now you should be well acquainted with this method. When the
absorption costing method is used, fixed manufacturing overhead costs are recovered by applying a rate
based on budgeted production capacity to actual production output. The budgeted production capacity
can be one of the theoretical maximum capacity or the practical capacity or the normal average capacity
or the budgeted capacity. There may be an over- or under-recovery of fixed costs which is treated as a
period cost. Under the absorption costing method, fixed production cost is included in inventory which is
taken to the statement of financial position. Only once the inventory is sold, are the costs associated with
the units sold are taken to the income statement as cost of sales.

Example 10.1
The production figures for March of product KLM of The Productive Company appear below:
Number of units manufactured 60 000
R
Direct materials 1 200 000
Direct labour 1 800 000
Variable overheads 360 000
Fixed overheads (apportioned on a basis of units manufactured 500 000
3 860 000
The manufacturing cost per unit is: R
Direct materials 20 (1 200 000 / 60 000)
Direct labour 30 (1 800 000 / 60 000)
Total prime costs per unit 50
Variable overheads 6 (360 000 / 60 000)
Cost per unit according to the variable method 56
Applied fixed overheads 8,3̇ (500 000 / 60 000) *
Cost per unit according to the absorption method 64,3
* R500 000 / 60 000 = R8,333333333; the 3 will keep on repeating in infinity. Putting a dot over the 3 means "3
repeating". For more accurate calculations, you should use 8,33333 rather than only 8,3.
_______________________________________________________________________________

If we assume that total fixed production overhead costs are fixed, i.e., the cost will be the same
regardless of the volume of production, then the unit cost calculated according to the variable method
will tell us how much it will cost to manufacture each additional unit of output. If, for example, if an
additional 10 000 units are manufactured, then total cost will increase by 10 000 × R56 = R560 000.

R
Total production cost of 60 000 units 3 860 000
Cost of additional 10 000 units (R56 × 10 000 units) 560 000
Total production cost of 70 000 units 4 420 000

Direct materials (70 000 × R20) 1 400 000

Direct labour (70 000 × R30) 2 100 000
Variable overheads (70 000 × R6) 420 000
Fixed overheads 500 000
4 420 000

You must not confuse the variable method with the contribution margin calculated as part of a CVP
analysis. The purpose of the contribution margin is to explain how much a specific product contributes
towards covering to companies total fixed costs. The contribution margin is the difference between
sales and all variable costs, i.e., variable period costs as well as variable production costs. The purpose
of the variable method of product costing is to determine the variable production cost of a product and
it can be used as a basis to determine the contribution margin.

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Cost per unit according to the variable method R56

Variable period costs (assumed) 24
Total variable costs 80
Selling price per unit (assumed) 100
Contribution margin per unit R20

Administration as well as marketing, selling and distribution expenses are never treated as product
costs; they are always treated as period costs and taken to the income statement for the period in
which they are incurred.

10.2.1 No opening and closing inventories

Where there is no opening or closing inventory of finished goods, the profit under the absorption
method will be the same as the profit under the variable method. All goods manufactured are sold and
therefore total fixed production overheads are expensed under both methods; under the variable
methods as a period cost and under the absorption method as cost of sales.

Example 10.2
Use the same information in Example 10.1 and assume that 60 000 units were manufactured and sold
in March. Further assume that the selling price per unit is R150, variable period cost per unit is R24 per
unit sold and that total fixed period expenses amount to R600 000. The income statements under the two
methods are presented below (the treatment of fixed overhead costs is shown in cursive bold type).
Unit Units Variable Absorption
R 60 000 R R
Selling price 150 9 000 000 9 000 000 (60 000 × R150)
Direct materials 20
Direct labour 30
Variable overheads 6
Cost of sales -3 360 000 -3 860 000
Variable 56 -3 360 000 -3 360 000 (60 000 × R56)
Fixed production costs 8,3̇ -500 000 (60 000 × R8,3̇ )
Contribution/Gross profit 5 640 000 5 140 000
Fixed production costs -500 000
Variable period cost 24 -1 440 000 -1 440 000 (60 000 × R24)
Fixed period costs -600 000 -600 000
Net profit 3 100 000 3 100 000
________________________________________________________________________________

Clearly then, when there are no inventories of finished goods, the net profit will be the same, although
the presentation in the income statement will be different. Because all the units manufactured were
sold, the total fixed production overheads were expensed (expired) as cost of sales under the
absorption method, resulting in a lower gross profit than the variable method. (In applying the variable
method, we speak of the contribution rather than the gross profit.) The variable method expenses the
fixed production overheads as a period (operating) cost, hence the net profit under the two methods is
the same.

10.2.2 No opening inventory but there is closing inventory

Where there is no opening inventory but there is closing inventory, the profit under the absorption
method will be higher than under the variable method. This is so because under the absorption method
part of the fixed production overhead cost is capitalised in closing inventory, while the full amount is
expensed under the variable method.

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Example 10.3
Use the same information as in Example 10.2 and assume that only 55 000 of the units that were
manufactured were sold, i.e., leaving a closing inventory of 5 000 units.

Units Unit Variable Absorption Unit

55 000 R R R R
Selling price 150 8 250 000 8 250 000 150
Direct materials 20
Direct labour 30
Variable cost 6
Cost of sales 56 3 080 000 3 538 333 64,3
3 080 000 3 080 000 56
Fixed production costs 458 333 8,3̇
Contribution / Gross profit 5 170 000 4 711 667
Fixed production costs 500 000
Variable period cost 24 1 320 000 1 320 000 24
Fixed period costs 600 000 600 000
Net profit 2 750 000 2 791 667

In this example there was no opening inventory, but there was closing inventory. The profit under the
absorption method is R41 667 higher than under the variable method. Under the absorption method,
the fixed overheads portion in the closing inventory (5 000 × R8,3̇ = R41 667) is not expensed but
deferred to a future period, resulting in a higher profit. The difference in profits is therefore attributable
to the fixed cost element in the value of closing inventories under the absorption method:

Difference in profit = difference in inventory: (R2 791 667 – R2 750 000) = 5 000 × R8,33333 = R41 667.

The reconciliation between the profits: Variable Absorption

R R
Profit per income statement 2 750 000 2 791 667
Fixed cost in closing inventory under absorption costing 41 667 (41 667)
Profit per other method 2 791 667 2 750 000
________________________________________________________________________________

10.2.3 There are both opening and closing inventories

The profit under the variable costing method will be the higher than the profit under the absorption costing
method if the number of units in opening inventory is more that the number of units in closing inventory.
If the number of units in opening inventory is fewer that the number of units in closing inventory, the profit
under absorption costing will be higher. This is as a result of the portion of fixed overheads included in
the value of inventory under the absorption method. The higher the number of units in opening inventory,
the higher the fixed overheads portion expensed in the current year. The higher the number of units in
closing inventory, the higher the fixed overheads portion deferred to future periods.

Example 10.4
Use the same information as in Example 10.3. Assume that there were 5 000 units in opening
inventory, 60 000 units manufactured during the month, 2 000 units in closing inventory (i.e., 63 000
units were sold) and that production cost was constant. Cost of sales will be as follows:

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Variable Absorption
R R
Opening inventory 5 000 units × R56 280 000
5 000 units × R64,3̇ 321 667
Manufactured (from Example 10.3) 60 000 units × R56 3 360 000
60 000 units × R64,3̇ 3 860 000
Closing inventory * 2 000 units × R56 (112 000)
2 000 units × R64,3̇ (128 667)
Cost of sales 3 528 000 4 053 000
* Because production costs are assumed to be constant, the cost formula is irrelevant.

The income statements under the two methods will be as follows:

Variable Absorption
R R
Sales (63 000 × R150) 8 250 000 8 250 000
less: Cost of Sales 3 528 000 4 053 000
Contribution / Gross profit 4 722 000 4 197 000
Period costs: 2 612 000 2 112 000
Fixed period 600 000 600 000
Variable period (63 000 × R24) 1 512 000 1 512 000
Fixed production 500 000
Net profit 2 110 000 2 085 000
The profit under the variable method is R25 000 higher than under the absorption method.
The difference in profits is the result of the fixed overhead component included in inventory under the
absorption method. The opening inventory was higher than the closing inventory, thus more fixed costs
expired (were expensed) during the period.
R
Opening inventory: 5 000 × R8,3 (now expensed, thus lower profit) (41 667)
Closing inventory: 2 000 × R8,3 (deferred in inventory, thus higher profit) 16 667
Net difference between opening and closing inventories) • (25 000)

Summary of inventories: Variable Absorption Difference

R R R
Opening inventory 5 000 units 280 000 321 667 (41 667)
Closing inventory 2 000 units 112 000 128 667 16 667
168 000 193 000 • (25 000)
• net difference between opening and closing inventories = difference in profits
Reconciliation of profits (starting with variable method):
Profit per variable method R2 110 000
Add: Opening inventory 280 000
Subtract: Closing inventory (112 000) 168 000
Add: Absorption closing inventory 128 667
Subtract: Absorption opening inventory (321 667) (193 000)
Profit per absorption method R2 085 000
Reconciliation of profits (starting with absorption method):
Profit per absorption method R2 085 000
Add: Opening inventory 321 667
Deduct: Closing inventory (128 667) 193 000
Add: Variable closing inventory 112 000
Deduct: Variable opening inventory (280 000) (168 000)
Profit per variable method R2 110 000
________________________________________________________________________________

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We shall now look at the effect on profit and inventory where opening inventory is lower than closing
inventory.

Example 10.5
Use the same information as in Example 10.4, except that there are 2 000 units in opening inventory,
60 000 units were manufactured and 5 000 units in closing inventory, i.e., 57 000 units were sold.
Cost of sales: Variable Absorption
R R
Opening inventory 2 000 units × R56 112 000
2 000 units × R64,3̇ 128 667
Manufactured 60 000 units × R56 3 360 000
60 000 units × R64,3̇ 3 860 000
Closing inventory * 5 000 units × R56 (280 000)
5 000 units × R64,3̇ (321 667)
Cost of sales 3 192 000 3 667 000

Income statements under the two methods Variable Absorption

R R
Sales (57 000 × R150) 8 550 000 8 550 000
less: Cost of Sales 3 192 000 3 667 000
Gross profit 5 358 000 4 883 000
Period costs: 2 468 000 1 968 000
Fixed period 600 000 600 000
Variable period (57 000 × R24) 1 368 000 1 368 000
Fixed production 500 000
Net profit 2 890 000 2 915 000

Now the profit under the absorption method is R25 000 higher than under the variable method. This is
as a result of the fixed overhead component included in inventory under the absorption method; more
fixed cost was deferred (in closing inventory) than fixed costs that expired and were expenses (in
opening inventory).
Closing inventory: 5 000 × R8,3̇ (deferred in inventory, thus higher profit) 41 667
Opening inventory: 2 000 × R8,3̇ (now expensed, thus lower profit) (16 667)
Overall effect is an increase in profit R25 000

The reconciliation of profits will be as in Example 10.4.

________________________________________________________________________________

We shall now consider how the selected cost formula will impact on the profit and value of inventory
under the variable and absorption costing methods. For this purpose, we shall assume different
production costs for the opening inventory. We shall not be considering the specific identification
method, because under that method, specific costs are assigned to specific units.

Example 10.6

Use the information in Example 10.4 and assume there were 2 000 units in opening inventory and
5 000 units in closing inventory. During the period 60 000 units were manufactured, thus 57 000 units
were sold. Information per unit of opening inventory (OI) and production for the month (PM) appears
below:

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OI PM
R R
Direct materials 15,00 20,00
Direct labour 28,00 30,00
Variable manufacturing cost 5,00 6,00
Variable production cost 48,00 56,00
Fixed manufacturing overheads 7,00 8,33̇ R500 000 / 60 000 = R8,333
Absorption production cost 55,00 64,33̇
Selling price per unit 150,00 150,00
Variable period cost is R24 per unit sold and fixed period cost is R600 000.

FIFO

Cost of sales: Variable Absorption

R R
Opening inventory 2 000 units × R48 96 000
2 000 units × R55 110 000
Manufactured 60 000 units × R56 3 360 000
60 000 units × R64,3̇ 3 860 000
Closing inventory * 5 000 units × R56 (280 000)
5 000 units × R64,3̇ (321 667)
Cost of sales 57 000 units 3 176 000 3 648 333

* Under FIFO oldest costs flow out first; thus, closing inventory will be at the latest cost for the number
of units in inventory.

Income statements under the two methods: Variable Absorption

R R
Sales (57 000 × R150) 8 550 000 8 550 000
less: Cost of Sales 3 176 000 3 648 333
Contribution / Gross profit 5 374 000 4 901 667
Period costs: 2 468 000 1 968 000
Fixed period 600 000 600 000
Variable period (57 000 × R24) 1 368 000 1 368 000
Fixed production 500 000
Net profit 2 906 000 2 933 667

The profit under the absorption method is R27 667 higher (R2 933 667 – R2 906 000). This is as a
result of the fixed overhead component included in inventory under absorption costing:
R
Fixed cost in closing inventory deferred, thus decreasing cost of sales (5 000 units × R8,333)
and increasing profit 41 667
Fixed cost in opening inventory now expired, thus increasing cost of (2 000 units × R7)
sales and decreasing profit - 14 000
27 667
Weighted average

Although a new average unit cost will be calculated after each transfer into finished goods inventory,
we shall use the available information for opening inventory and total production in our calculation:

Units Calculations Variable Absorption Calculations

Opening inventory 2 000 2 000 × 48 96 000 110 000 2 000 × R55
Manufactured 60 000 60 000 × 56 3 360 000 3 860 000 60 000 × R64,3̇
62 000 3 456 000 3 970 000
Weighted average 3 456 000 / 62 000 R55,742 R64,032 3 970 000 / 62 000

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Income statements under the two methods: Variable Absorption

R R
Sales (57 000 × R150) 8 550 000 8 550 000
less: Cost of Sales 57 000 × 55,741935 3 177 290 3 649 839 57 000 × 64,032258

Contribution / Gross profit 5 372 706 4 900 161

Period costs: 2 468 000 1 968 000
Fixed period 600 000 600 000
Variable period (57 000 × R24) 1 368 000 1 368 000
Fixed production 500 000
Net profit 2 904 706 2 932 161

The profit under the absorption method is R27 455 (R2 932 161 – R2 904 706) higher than under the
variable method. This is as a result of the fixed overhead component included in inventory under
absorption costing.
R
Fixed cost in closing inventory deferred, thus decreasing cost of sales and increasing profit
(5 000 units × R8,290323 *) 41 452
Fixed cost in opening inventory now expired, thus increasing cost of sales and decreasing
profit (2 000 units × R7) - 14 000
(R3 difference due to rounding) 27 452

* The difference between the unit cost of closing inventory under the variable and absorption methods
is due to the inclusion of fixed cost under the absorption method: 64,032258 - 55,741935 = R8,290323.

Clearly the method selected for the treatment of fixed production costs as well as the cost formula
applied, will have an effect on the profit and value of closing inventory.
Profit applying → FIFO Weighted average
Variable costing R2 906 000 R2 904 706
Absorption costing R2 933 667 R2 932 161
________________________________________________________________________________

In the examples above, it was purposely assumed that fixed production overheads were fully recovered
in each instance, i.e., that there was no over- or under-recovery that had to be adjusted against cost
of sales. This was done so that the difference between the two methods could be clearly demonstrated.

ACTIVITY 10.1

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 Under variable costing the cost per unit remains the same, irrespective of the volume of
production.
1.2 Under absorption costing, the cost per unit increases as the volume of production increases,
because it includes fixed manufacturing overhead costs.
1.3 The cost data of variable costing represents the profit per unit, while the cost data of absorption
costing represents the contribution per unit.
1.4 A company uses the absorption costing method. Its budgeted cost data for the production of
10 000 units of its single product appear below:
Direct materials R3 per unit
Direct labour R5 per unit
Variable production overheads R4 per unit
Fixed production overheads R6 per unit
If 20 000 units were manufactured, the total production cost assigned under absorption costing
would be R18 × 20 000 = R360 000.

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1.5 If direct materials costs and direct labour costs are both R15 per unit and variable production
overheads and fixed production overheads are R90 000 and R500 000 respectively, the total
production cost per unit transferred to finished goods will be R118 greater under absorption
costing than under variable costing, if 5 000 units were budgeted and manufactured.
1.6 A contribution income statement (based on variable costing) classifies costs according to its
function rather than its behaviour.
1.7 When units manufactured and sold are equal, the net profit under absorption costing and variable
costing will be the same.
1.8 When more units were manufactured than sold, net profit under absorption costing will be higher
than under variable costing.
1.9 When more units were manufactured than sold, net profit under absorption costing will be higher
than under variable costing.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 You overheard a discussion between fellow students about the effect on the statement of
comprehensive income where there is neither opening nor closing inventories. The students had
different opinions of the effect if the absorption method or variable costing was applied. Which
opinion is correct?
(a) Absorption costing will result in a higher profit.
(b) Variable costing will result in a lower profit.
(c) Both methods will result in the same profit.
(d) There will be a negligible difference between the two methods.
2.2 Which of the following statements is true about variable selling and distribution costs in a variable
costing system?
(a) The costs are included in the valuation of inventory to comply with JSE listing requirements.
(b) The costs are included in the valuation of inventory to make the marketing department more
efficient.
(c) The costs are not included in the valuation of inventory because they are incurred with the selling
of the product.
(d) The costs are not included in the valuation of inventory unless the product line is discontinued.
2.3 Under variable costing …
(a) net operating income will tend to move up and down in response to changes in levels of
production.
(b) inventory costs will be lower than under absorption costing.
(c) net operating income will tend to vary inversely with production changes.
(d) net operating income will always be higher than under absorption costing.
2.4 If the absorption costing method is applied, …
(a) net income fluctuates in direct proportion with changes in sales volume.
(b) fixed production and fixed selling costs are considered to be product costs.
(c) unit product costs can change as a result of changes in the number of units manufactured.
(d) variable selling expenses are included in product costs.
2.5 You are presented with the following information:
Direct material cost per unit R6 (variable)
Direct labour cost per unit R5 (variable)
Production overhead cost per unit R2 (variable) and R7 (fixed)
Selling & administrative cost per unit R4 (variable) and R3 (fixed)
The unit cost of production under variable costing is …
(a) R13.

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(b) R20.
(c) R17.
(d) R27.
2.6 A company produces a single product. You are presented with the following information:
Absorption Variable
Net profit R6 400 R9 100
Production cost per unit R20 R17
Closing inventory in units 2 100 2 100
The opening inventory would have been … units.
(a) 1 200
(b) 2 100
(c) 3 000
(d) 4 800
2.7 A company manufactures a single product. During December 7 000 unts were sold. Variable
cost of R7 per unit includes R3 in respect of selling expenses. Absorption production cost
includes R2 per unit. The net profit for the month under absorption costing was R3 500 less than
the profit under variable costing. During December, … units were manufactured.
(a) 5 250
(b) 8 750
(c) 6 500
(d) 6 125
2.8 A company manufactures a single product. Opening and closing inventories were 13 000 units and
18 000 units, respectively. Net profit under variable costing was R50 000. If the fixed production
overhead cost was R2 per unit, the net profit under absorption costing would be …
(a) R40 000.
(b) R50 000.
(c) R60 000.
(d) R86 000.
2.9 You are supplied with the following information:
Opening inventory 0
Sales 6100 units
Closing inventory 200 units
Variable cost per unit:
Direct materials R32
Direct labour R50
Variable production cost R5
Variable selling and administrative R11
Total fixed production cost R88 200
Total fixed selling and administrative R97 600
The production cost per unit under absorption costing is …
(a) R112.
(b) R98.
(c) R87.
(d) R101.

QUESTION 3

The following information is available for Gairib (Pty) Ltd, the manufacturer of a popular fashion
accessory, for the months March, April and May:

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March
Opening inventory (units) Nil
Production (units) 81 000
Sales (units) ?
April
Opening inventory (units) 9 000
Opening inventory value based on variable costing principles (FIFO) R166 500
Opening inventory value based on absorption costing principles (FIFO) R209 000
Additional information relating to April:
Fixed manufacturing costs remained the same as in March.
Variable manufacturing costs per unit remained the same as in March.
Production units increased by 10% and sales units by 5% from March figures.
May
Opening inventory (units)
Production costs
– variable (increased by R3 per unit from April) R2 171 500
– fixed R405 515
Sales (units) 118 500
Selling price per unit (May only) R30
Variable sales commission in May was R1,50 per unit sold.

For the purposes of this question, you may assume that Gairib bases the fixed cost recovery rate in
each period on the actual fixed costs and the actual production for the period, i.e., a budgeted annual
recovery rate is not used.
REQUIRED
3.1 Calculate the closing inventory (in units) at 31 May.
3.2 Draft the contribution income statement for the month ended 31 May according to the variable
costing method, using the weighted average cost formula.
3.3 Draft the contribution income statement for the month ended 31 May according to the variable
costing method, using the FIFO cost formula.
3.4 Draft the income statement for the month ended 31 May according to the absorption costing
method, using the weighted average cost formula.
3.5 Draft the income statement for the month ended 31 May according to the absorption costing
method, using the FIFO cost formula.

QUESTION 4- THIS IS A FORUM DISCUSSION QUESTION – see 4.5 below

The following income statement for the year ended 31 December was prepared for Xammi Ltd:

R
Sales (45 000 × R67,50) 3 037 500
Cost of sales 1 880 000
Opening inventory (5 000 × R40) 200 000
Goods manufactured (50 000 × R42) 2 100 000
Available for sales 2 300 000
Closing inventory (10 000 × R42) - 420 000
Gross profit 1 157 500
Selling and Administration 840 000
Net profit 317 500
Additional information:
Variable selling and administration expenses are R6 per unit sold.

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Fixed production overheads for the year amounted to R500 000. There was no over or under
recovery. Fixed production overheads in the previous was equal to 90% of the current years fixed
production overheads.
REQUIRED
4.1 Explain which cost formula was applied in the preparation of the above income statement;
4.2 Explain if the above income statement was prepared on the absorption or direct costing method;
4.3 Prepare a variable costing contribution income statement for Xammi Ltd for the current year.
4.4 Reconcile any difference in net profit between the income statement above and the contribution
income statement.
4.5 Discuss in the forum what your approach was in answering parts 4.1 and 4.2 of this question.

QUESTION 5

!Khaos Limited manufactures a single product. Production cost information for its first year of operation,
appears below:
Units manufactured 80 000 units
Units sold 64 000 units
Direct labour R40 per unit
Direct materials R16 per unit
Variable overheads R1 200 000
Fixed overheads R4 400 000
REQUIRED:
5.1 Determine, under both the absorption and variable costing methods, the -
5.1.1 production cost per unit;
5.1.2 profit for the year at a selling price of R180 per unit;
5.1.3 cost of closing inventory.
5.2 Reconcile the profits calculated in 5.1.3.

10.3 PURPOSE OF ABSORPTION COSTING AND VARIABLE COSTING

The matching principle is a cornerstone of accrual accounting. Accrual accounting means that income
and expenses must be recognised in the period in which they were incurred rather than in the period
that they are paid; the matching principle says that expenses must be matched to the income they
helped to generate, i.e., the income and related expenses must be reported in the same period. The
fixed production costs incurred in Year 1 (Y 1) relate to the goods manufactured in Y 1. If some of
those goods are sold in Year 2 (Y 2) only, it means that the income in Y 2 relate to costs incurred in
Y 1. To satisfy the matching principle, the costs of the goods unsold at the end of Y 1 must be
transferred (as part of inventory) to Y 2; in Y 2 the costs will be matched with the income (as cost of
sales) from the sale. If the variable costing method is applied, some of the costs (fixed costs) incurred
in Y 1 would be expensed in Y 1, instead of being matched with income and expensed in Y 2.

Indeed, International Financial Reporting Standards determine that, for purposes of external reporting,
the absorption costing method must be used, as shown by the following extracts from IAS 2:
IAS2.8: Inventories encompass … finished goods produced
IAS 2.10: The cost of inventories shall comprise all costs of purchase, costs of conversion …
IAS2.12: The costs of conversion … include a systematic allocation of fixed and variable production
overheads that are incurred in converting materials into finished goods.

The purpose of the absorption costing method is first and foremost to satisfy external reporting
requirements, while the variable costing method is internally focused. Variable costing assists
management in planning and decision-making such as decisions about limiting factor analysis, which
products to discontinue, whether to accept special orders, determining the product mix to manufacture
and promote, or to make or buy a product. Also, variable product costs are used as the basis for
determining the contribution margin which, in turn leads to the determination of breakeven, margin of
safety, target profit, etc.

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Therefore, even if the absorption costing method has been selected for the valuation of inventory, the
variable method can also be used for purposes indicated above. The variable method can however not
be used as a basis for determining selling prices (fixed production cost must also be recovered in the
selling price), but can serve as a guideline in conjunction with other CVP analyses. Variable costing is
especially useful in presenting information to managers and directors with no financial background to
enable them to make informed decisions on issues such as the expansion or reduction of output or the
utilisation of idle capacity. Variable costing is especially useful in determining prices for special or one-
off orders.

10.4 ADVANTAGES AND DISADVANTAGES

Some of the advantages of the variable costing method are

• fixed production overheads and other fixed costs are to a very large extent managed and controlled
by senior management. By avoiding the rather arbitrary apportionment of fixed costs, management
can focus their cost control on achieving a more consistent (with volume of output) variable cost of
production.
• variable costing is of great benefit in short-term planning as it is easily understood. Separating
fixed and variable costs provides more relevant information for decision-making such as make or
buy decisions or optimal product mixes. Operating results calculated according to the variable
costing method are of particular importance in terms of the effect of changes of output volume and
product mix on the organisation’s profitability; the calculation and adjustment of special-order
selling prices; and the significance of fixed cost as a percentage of total cost.
• variable costing obviates the need for a fixed production overheads recovery rate and over and
under recoveries. It limits or eliminates the dangers attached to the over or under allocation of fixed
overheads to certain products.
Some of the disadvantages and limitations of variable costing are
• variable costing cannot be used for external financial reporting.
• it is also not easy to accurately separate all costs into their fixed and variable components.
Misclassification may give misleading results.
• a great disadvantage of variable costing, which is an advantage of absorption costing, can be
explained by means of the seasonality of certain products, e.g., swimwear. The manufacturer may
build up inventories during winter months to be able to meet summer demands. Under variable
costing, the winter months could register fictitious losses by debiting large amounts of fixed
production overheads to the income statement when there is little revenue and then report
unrealistic profits in summer with large revenues and low cost of sales.
Advantages of absorption costing are
• it matches costs and revenues; e.g., swimwear manufacturing; during winter months fixed
production overheads will be capitalised as inventory and expensed only once inventory is sold.
• it recognises the importance of fixed costs in price determination and decision-making.
• reporting standards and revenue authorities prescribe that fixed production overheads be included
in the cost of inventory.
Disadvantages of absorption costing are
• the apportionment of fixed costs to production is based on best estimates; there is a danger of over
or under costing if the basis of apportionment is inappropriate.
• absorption costing is also not helpful for short-term decision-making purposes.

Fortunately, the choice between absorption costing and variable costing need not be an either-or
choice; a company may choose both: absorption costing for external reporting purposes and variable
costing for internal reporting and planning purposes.

ACTIVITY 10.2

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).

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1.1 International Financial Reporting Standards require companies to use only one factory overhead
rate to apportion fixed production overheads to inventories.
1.2 Under absorption costing, it is possible to defer a portion of the fixed manufacturing overhead
costs of the current period to future periods through the inventory account.
1.3 Under absorption costing, the cost of manufactured products constitutes the cost of fixed
production overheads, direct materials as well as direct labour.
1.4 There is only one difference between the absorption and variable costing methods and that is
how they account for fixed production overheads.

QUESTION 2

For the following question, read carefully through the information provided and select only the most
correct option as your answer.
2.1 Which one of the following is not an advantage of the variable costing method?
(a) It helps to overcome the problem of allocating fixed costs.
(b) Its importance to management on calculation and adjustment of special-order selling prices.
(c) It recognises the importance of fixed cost in price determination and decision-making.
(d) Operating profit can be presented in a readily understandable form.

QUESTION 3

Moale (Pty) Ltd manufactures proudly South African hand-crafted wood statuettes of Madiba and then
sells them to curio shops. Miss Moale, the founding member, has always had a passion for the arts
and crafts and combining that passion with her idol has turned into a successful business. The selling
price per statue in 2019 was R500 and is expected to increase by 10% per year from 2020. There was
no opening inventory at the beginning of 2019. The following additional information is available:
Year Manufactured Sold
2019 1 400 1 000
2020 1 500 1 600

Cost information for the years ending 30 September 2019 2020

R R
Variable cost per unit:
Direct materials 120,00 132,00
Direct labour 36,00 39,60
Variable production overheads 24,00 26,40
Variable selling costs 2,40 2,64
Total fixed costs:
Fixed production overheads 72 000 79 200
Fixed selling costs 112 800 124 080
Fixed administrative overheads 55 200 60 720
Moale uses the weighted average method of inventory valuation.

REQUIRED

Prepare a budgeted Statement of Comprehensive Income for the year ended 30 September 2019 in
accordance with
a. the direct cost method 10 marks
b. the absorption method 10 marks
TOTAL 20 marks
(Examination: January/February 2020)

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QUESTION 4

Fitness Fanatics (Pty) Ltd was established in 2011 by Ms Thembi Mutsamayi and is based in
Krugersdorp. The company is a processor and distributor of a popular type of protein energy bar called
Pumpkin Seed. The company has a 30 June year-end.
Budgeted data for the year ended 30 June 2020 are as follows:
Sales units 1 500 000
Selling price per unit R38,50
Direct material costs per unit R12,00

Some of the company costs in total for the 2020 financial year were as follows:
Budgeted Actual
R R
Fixed manufacturing overheads 22 644 000 24 000 000
Direct labour 12 520 800 ?
Fixed administrative salaries 777 000 777 000
Selling and distribution costs 2 140 000 2 000 000

The senior management accountant provided the following information with regard to the actual figures
for the year ended 30 June 2020:
Selling price per unit R39,00
Direct material costs per unit R9,70
Direct labour rate per hour R24,00

Inventories of Pumpkin Seed:

Actual inventory – 1 July 2019 R3 000 000
Actual inventory – 30 June 2020 ?

Additional information:
1. Quantity schedule – actual units of Pumpkin Seed:
Sales 1 400 000
Opening inventory 100 000
Closing inventory 80 000
2. No inventory of direct materials or work-in-progress is held. The company used the first-in-first-out
(FIFO) method of inventory valuation.
3. All completed protein energy bars are packaged and taken into inventory.
4. Assume that the opening and closing budgeted inventories in units are equivalent to the respective
opening and closing actual inventories in units (per the above quantity schedule).
5. The actual cost of inventory on 1 July 2019 also includes absorbed fixed manufacturing overheads.
6. Fixed production overheads (FPO) are absorbed based on normal capacity of 503 200 direct labour
hours per year. FPO are allocated to production based on direct labour hours worked.
7. The actual direct labour hours for the 2020 financial year were 483 000.

REQUIRED
a. Calculate the over/under recovered fixed manufacturing overhead for the year ended (3)
30 June 2020 assuming that the company uses an absorption costing system.
b. Prepare the actual Statement of Profit or Loss (income statement) for the year ended 30 (12)
June 2020 for the company using absorption costing method.
c. State a reason why the profit you have calculated in (b) would, in principle, be different from (2)
the profit if the direct costing system was used. Note: no calculations are required in (c).
TOTAL [17]
(Examination: October/November 2020)

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QUESTION 5

Great Progress (Pty) Ltd (“Great Progress”) manufactures and sells a single product, a low-cost step
counter called a pedometer. The company has a 31 August year-end.

The following information about fixed manufacturing overheads (“FMO”) is available for the year
ended 31 August 2020, with FMO being allocated based on pedometers (units) produced:

R
Total budgeted FMO 2 450 000
Total applied FMO absorbed by 165 000 pedometers actually produced 2 640 000
Over applied FMO 120 000

Some of the actual information for the year ended 31 August 2020 are as follows:

• Inventory

Details Units Rand value in terms of direct costing

Opening inventory (1 September 2019) 5 000 R425 000
Closing inventory (31 August 2020) 30 000 ?

• Variable costs per unit

Details Notes R
Per pedometer manufactured:
Direct materials 3 ?
Direct labour (at a rate of R30 per direct labour hour) 15
Variable manufacturing overheads (“VMO”) 4 ?
Per pedometer sold:
Variable selling costs 3

• Fixed administration costs amounted to R300 000 in total for the 2020 financial year.
• The selling price per pedometer was R150 throughout the 2020 financial year.

Notes and additional information for the year ended 31 August 2020:

1. The company uses the first-in-first-out (FIFO) method of inventory valuation.

2. No inventory of direct materials or work-in-progress is held.
3. Each pedometer requires all of the following direct material inputs:
• One mechanical switch (at a cost price of R20 per switch),
• Ten centimetres of wire at R1,30 per centimetre, and
• Other direct materials of which the total cost amount to R22 per pedometer.
4. VMO vary with direct labour hours worked and a VMO rate of R40 per direct labour hour applies.

REQUIRED Marks
(a) Calculate the following figures for the year ended 31 August 2020 assuming that the
company uses an absorption costing system:
(i) Predetermined (budgeted) FMO absorption rate per pedometer; (2)
(ii) Budgeted production units; and (2)
(iii) Actual FMO. (2)
(b) Prepare the actual Statement of Profit or Loss (income statement) for the year ended
31 August 2020 for the company using direct costing principles. (13)
(c) Draft a journal entry showing how the given over applied FMO would normally be dealt with
in Great Progress’s books at the end of the 2020 financial year assuming that the company
uses an absorption costing system. (2)
Journal entry narration is not required.
TOTAL 21

(Examination January/February 2021)

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QUESTION 6

New-build (Pty) Ltd is a company that operates in the construction industry and New-build specialises
in building of modern apartments and operates in the City of Tshwane, Gauteng province. New-build
had two projects during the 2021 financial year, named project Gezina and project Franzina. New-build
uses an absorption costing system and all its inventory are valued using the first-in-first-out (FIFO)
method. The company’s 2021 financial year ended on the 28th of February 2021.

Budgeted information for the 2021 financial year

The budgeted normal production capacity was 1 200 units for project Gezina and 800 units for project
Franzina. Total budgeted fixed manufacturing overheads cost was R120 000 000. Fixed manufacturing
overheads are allocated to units based on normal production capacity.

Actual information for the 2021 financial year

• The total number of constructed and completed apartment units were 1 600, of which 450 units
related to project Franzina.
• The number of units sold for the 2021 financial year were 300 and 950 for Franzina and Gezina
respectively.
• On the 1st of March 2020 there was no opening inventory for project Franzina; however, project
Gezina had 150 completed units to the value of R72 000 000.
• The actual fixed manufacturing overheads cost for the company were:
Fixed manufacturing overheads costs R
Depreciation for construction equipment 55 000 000
Construction equipment insurance 25 000 000
Indirect labour (Project managers’ salaries) 30 000 000
• The total actual fixed manufacturing overheads cost is arbitrarily split between projects based on
actual apartments sales volume.

The following actual information relates to Project Gezina:

R %
Selling price per unit 750 000
Direct material per unit 250 000
Direct labour per unit 230 000
Commission on unit sales 7
REQUIRED

(a)Calculate New-build’s total fixed manufacturing overheads over/under recovery amount (7)
for the financial year ended 28 February 2021 and prepare the related journal entry to be
recorded in New-build’s financial records. Note: Provide a journal narration.
(b) Mention three possible causes of over/under applied overheads. (3)
(c) Prepare a direct costing income statement for Project Gezina for the year ended (12)
28 February 2021.
(d) Mention what effect an increase in the in the sale of apartments would have had on each
of the following if all other factors remained constant:
(i) Margin of safety (1)
(ii) Fixed costs (1)
(iii) Break even units (1)
No calculations are required, simply mention whether the effect will be an increase or a
decrease or that there will be no effect, as applicable.
TOTAL [25]
(Examination May/June 2021)

10.5 SUMMARY

In this learning unit, we considered the treatment of fixed production overhead costs in the
determination of the cost of inventory. In paragraph 10.2 the differences between the absorption
costing method and the variable costing method were discussed. By means of several examples, we
demonstrated the effect of the two methods on the income statement and inventory valuation where

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there is no inventory, where there is opening inventory only, and where there are opening and closing
inventories. We also demonstrated the application of the FIFO and weighted average cost formulas
under both absorption costing and variable costing. You were also shown how to reconcile the profits
determined under the two methods.

When production volume is higher than sales volume, profit under the absorption method will be higher
than under the variable method. When sales volume is higher than production volume, profit under the
variable method will be higher profits than profit under the absorption method. Under absorption
costing, fixed manufacturing costs are apportioned to the cost of inventory on a per unit basis, by
dividing the total fixed production overhead costs by an estimated output. You were reminded that,
where actual output differs from the estimated output, there will be an under- or over-recovery of
overheads that must be recorded as a period cost. The profit under absorption costing is therefore
reflected as a consequence of sales as well as production, while under variable costing profit is
reflected as a consequence of sales only.

In paragraph 10.3 we discussed the purpose and each method and the circumstances in which each
would be appropriate. We concluded our discussion with the advantages and disadvantages of each
method in paragraph 10.4.

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