The Management Accountant’s Profit Statement – Absorption Costing

YouTube video

1 Introduction

In the previous chapter we stated that the cost per unit is normally calculated in advance using estimated or budgeted figures. This is for several reasons. For instance, we need an estimate of the cost before we can fix a selling price. In addition, the estimated cost per unit provides a benchmark for control purposes. The Management Accountant can check regularly whether or not units are costing more or less than estimated and attempt to take corrective action if necessary.

As a result, the Management Accountant’s Profit Statement (or Operating Statement) takes a different form than that of the Financial Accountant’s Income Statement

The statement is usually prepared monthly, and its objective is to show whether the profit is higher or lower than that expected, and to list the reasons for any differences.

The statement starts with the profit that should have been made if all the costs had been the same as on the standard cost card.

It then lists all the reasons for any differences in profit (or variances) to end with the actual profit.

However, in calculating the budgeted profit for individual months, absorption costing causes a problem when the expected production in a month differs from that used to absorb fixed overheads for the cost card.

This problem is illustrated in the following example

2 Illustration

X plc produces one product – desks.

Each desk is budgeted to require 4 kg of wood at $3 per kg, 4 hours of labour at $2 per hour, and variable production overheads of $5 per unit.

Fixed production overheads are budgeted at $20,000 per month and average production is estimated to be 10,000 units per month.

The selling price is fixed at $35 per unit.

There is also a variable selling cost of $1 per unit and fixed selling cost of $2,000 per month.

During the first two months X plc expects the following levels of activity:

	January	February
Production	11,000 units	9,500 units
Sales	9,000 units	11,500 units

(a) Prepare a cost card using absorption costing

(b) Set out budget Profit Statements for the months of January and February.

(a) Cost cards:

	$ p.u
Materials (4kg × $3)	12
Labour (4hrs × $2)	8
Var. overheads	5
Fixed overheads
($20,000/10,000)	2
	$27	p.u
Selling price	$35	p.u
Standard profit	$8	p.u

(b) Income Statements

		January		February
Sales	(9,000 × $35)	315,000	(11,500 × $35)	402,500
Cost of sales:
Opening inventory		–	(2,000 × $27)	54,000
Materials	(11,000 × $12)	132,000	(9,500 × $12)	114,000
Labour	(11,000 × $8)	88,000	(9,500 × $8)	76,000
Variable o/h	(11,000 × $5)	55,000	(9,500 × $5)	47,500
Fixed o/h	(11,000 × $2)	22,000	(9,500 × $2)	19,000
		297,000		310,500
Less: Closing inventory	(2,000 × $27)	(54,000)		–
		243,000		310,500
Standard Gross Profit	(9,000 × $8)	72,000	(11,500 × $8)	92,000
Adjustment for over/(under) absorption of fixed overheads		2,000		(1,000)
Actual fixed o/h’s: 20,000			Actual: 20,000
Absorbed: 22,000			Absorbed: 19,000
Actual Gross Profit		74,000		91,000

Less: selling costs
Variable	(9,000 × $1)	(9,000)	(11,500 × $1)	(11,500)
Fixed		(2,000)		(2,000)
Actual Net Profit		$63,000		$77,500

3 Hourly absorption rates

The previous example assumed that fixed overheads were absorbed on a unit basis. A popular question in the exam is to be asked to calculate the amount of any over or under - absorption when fixed overheads are absorbed on an hourly basis

Y plc budgets on working 80,000 hours per month and having fixed overheads of $320,000. During April, the actual hours worked are 78,000 and the actual fixed overheads are $315,500.

Calculate:

(a) the overhead absorption rate per hour.

(b) the amount of any over or under-absorption of fixed overheads in April

(b) Amount absorbed =78,000 × $4 = $312,000

Actual overheads = $315,500

Amount under absorbed = 315,500 – 312,000 = $3,500

Answer the questions one at a time. Your progress is saved so you can leave and come back.

Open chapter practice