MAFM3A 2021
CLASS EXAMPLE 1 (35 marks)
Rico (Pty) Ltd produces and sells a single product at present but has plans to widen its product range. The
company values stock and reports profits quarterly using a fully integrated absorption costing system (FIFO
based). For quarter 3 (ended 31 December 2006), and the forthcoming quarter 4 (ending 31 March 2007), the
fixed overhead absorption rate was and will be based on normal quarterly production of 100 000 units.
The following data was extracted from the actual results of quarter 3:
Actual results for quarter 3 ended 31 December 2006:
Sales and production 100 000 units as budgeted.
Per unit data: Note R
Selling price 87
Prime cost 60
Production overhead 1 21
Selling costs 2 3
Admin. overheads 2 2
Notes:
1. Production overhead comprises both fixed and variable costs. Fixed costs actually incurred amounted to
R1 600 000 as budgeted.
2. Administration costs are fixed in nature and the unit cost was based on budgeted production volumes.
Selling costs include fixed cost of R1 per unit.
3. Only finished goods stock of 25 000 units was on hand at 31 December 2006.
Despite using absorption costing to report actual results, budgets are always presented at management
meetings in a manner consistent with cost-volume-profit (CVP) principles. The following applies to the budget
for quarter 4, ending 31 March 2007:
1. Although there was concern that demand may weaken due to rising interest rates, it was decided to plan
for the same sales and production volumes as were achieved in the previous quarter.
2. No change in selling price, variable cost per unit and total fixed costs from the above actual results was
anticipated, other than fixed production overheads which management planned to reduce by R100 000.
The actual results for quarter 4, ended 31 March 2007, were rather disappointing, as is evident from the
managing director’s comments to his fellow directors:
“What is going on here, we met the sales target without having to discount prices and the cost structure was
in accordance with budget. We even achieved the planned fixed cost saving yet we ended up with a loss as
opposed to a planned profit.”
The production director commented: “As anticipated, the order book going forward is looking a bit thin and
accordingly we cut back 20% on scheduled production. But surely that shouldn’t result in a loss?”
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MAFM3A 2021
The management accountant was asked to investigate the matter and urgently draft a report for the following
day addressing the concerns expressed above.
YOU ARE REQUIRED TO:
Draft a report for the management meeting in which you explain why the company failed to achieve the
budgeted profit for the quarter ended 31 March 2007 and briefly comment on the appropriateness of using
absorption costing for internal reporting. Your report must include:
(a) Consistent with variable costing principles:
i) A calculation of budgeted profit for quarter 4;
ii) A detailed actual income statement for quarter 4 (including stock values). Compare and comment
on the budgeted and actual net profits determined in i) and ii).
Note: In answering requirement (a), ignore any prior period adjustment arising from a change in the
basis of valuing stock from absorption to variable costing.
(b) A detailed actual absorption costing income statement for quarter 4 (including stock values).
(c) A reconciliation of the absorption and variable costing net profits as calculated in (a) ii) and (b)
above and a detailed explanation of how the profit differences arose.
Note: You are not required to calculate or comment on budgeted profit for quarter 4 determined
using absorption costing.
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MAFM3A 2021
CLASS EXAMPLE 2
Annabella Limited manufactures and sells, as a price setter, a single specialized product ‘Trashcon’. The
company uses a raw material, called ‘Trashy’ in the production of ‘Trashcon’. Trashy is supplied by an
independent supplier who produces various grades (i.e. quality) of trashy as one of its joint products and in
sufficient quantities to meet the demand on the open market as well as that of Annabella Limited.
Trashcon, however, requires the highest quality of trashy raw material which is specially selected by the
supplier immediately after split off. As a result of this special selection the supplier of trashy sells this raw
material to Annabella Limited at its cost allocation per kilogram at split-off plus a 50% profit on cost. The
supplier uses the open market net realizable value of joint products to allocate joint cost. Net by-product
revenue is deducted from total joint costs. The supplier’s 2007 price per kilogram of trashy sold to Annabella
Limited was based on the supplier’s total joint process cost of R4 160 000 and the following information:
Trashy Other joint By-Products
Products
Average open market price per kilogram R 30 R 20 R2
Separable (i.e. further processing) costs R 0 R510 000 R20 000
Production – kilograms 150 000 kg 100 500 kg 90 000 kg
Annabella Limited uses the weighted average absorption product cost to value inventory and to add a mark-
up to set its product selling price, resulting in a gross margin of 25%. Fixed production overheads are absorbed
at a predetermined rate per unit. Budgeted production for 2007 was 120 000 units while budgeted and actual
sales were 100 000 units. Budgeted fixed production overheads for 2007 were R1 440 000 and, apart from
fixed production overheads, actual selling prices, variable costs per unit and non-production fixed costs for
2007 were the same as those budgeted for the year. Budgeted costs for 2007 are as follows:
R
Raw material – 1 kilogram of trash per unit ?
Direct labour per unit 20
Production overheads per unit 22
Administration costs for year (60% fixed) 600 000
Selling costs for the year 450 000
Annabella Limited pays a fixed sales commission per unit, which, like other fixed selling costs remained
unchanged from 2006, when the company sold 70 000 units and incurred total selling costs of R330 000.
Variable administration costs vary with units sold.
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MAFM3A 2021
There was no opening inventory in 2007 and Annabella Limited produced 110 000 units, incurring total actual
fixed production overheads of R1 520 000 for that year. Budgeted sales units, variable cost per unit and total
fixed costs for 2008 are all expected to remain at the same level as the 2007 actuals, though closing inventory
of finished goods for 2008 is expected to be half that of the 2007 closing units. As in 2007, there will be no
opening or closing raw material inventory in 2008.
YOU ARE REQUIRED TO:
a. Prepare Annabella Limited’s detailed actual absorption costing income statement for 2007.
(13 marks)
b. Prepare Annabella Limited’s detailed budgeted absorption costing income statement for 2008.
( 7 marks)
c. Write a report to Annabella Limited’s management in which you:
i Reconcile the 2007 actual profit and the 2008 budgeted profit; ( 4 marks)
ii Analyse the 2007 under/over recovery of fixed production overheads into its volume and expenditure
variances; ( 2 marks)
iii Use the projected information given below for the 2009 year to determine the 2009 expected profit,
breakeven point and the sensitivity of the company’s profit to changes in all the different sales and
cost elements:
Sales units 120 000 units
Selling price per unit R 120
Profit-volume ratio 40%
Total fixed cost Same as 2007 and 2008 actuals (10 marks)
iv Assume the company’s 2007 budgeted production and ‘normal’ production capacity was 120 000
units per annum while its 2007 actual production was 110 000 units. Evaluate and comment on the
value of the company’s 2007 closing inventory above as regards the requirement in IAS2 (AC108)
that:
“The allocation of fixed production overheads to the costs of conversion is based on the normal
capacity of the production facilities. The actual level of production may be used if it approximates
normal capacity. The amount of fixed overhead allocated to each unit of production is not increased
as a consequence of low production or idle plant. Unallocated overheads are recognised as an
expense in the period in which they are incurred. In periods of abnormally high production, the
amount of fixed overhead allocated to each unit of production is decreased [as a result of the higher
production] so that inventories are not measured above cost.” ( 4 marks)