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?”
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.
SOLUTION CLASS EXAMPLE 1 (RICO)
Workings
1. Production overhead (PO) analysis:
Alternative working: R’000
Quarter 3 Actual: R Total actual PO (21 x 100 000) 2 100
FOAR 1 600 000 / 100 000 = 16 - Absorbed fixed PO (16 x 100 000)1 600
Variable overhead (balance) 5 Total variable PO 500
Total 21 Variable PO per unit (/ 100 000)R5.00
Quarter 4 Budget and Actual:
FOAR 1 500 000 / 100 000 = 15
Variable overhead (per Quarter 3) 5
Total per budget 20

2. Selling costs: R
Total budget (3 x 100 000 units) 300 000
Less: variable cost (b = 2 x 100 000) 200 000
Budgeted fixed cost per quarter (a) 100 000

3. Admin costs: R
Total budgeted (2 x 100 000) 200 000

4. Product costs:
Quarter 3 Actual (to value closing stock of 25 000 units):
Prime R60
Variable overhead 5
Variable costing 65
FOAR 16
Absorption costing 81

Quarter 4 Budget & Actual: R

5. Quarter 4’s actual volume:

REPORT
To: The Directors of Rico (Pty) Ltd.
From: The Management Accountant
Date: xxxxxxxxx
Performance for the Quarter ended 31 March 2007
As you know, we planned to produce and sell 100 000 units for the quarter. At this volume, we anticipated
to make a profit of R200 000 as can be seen from the attached appendix.
You will note in the appendix that the profit calculation has been done on a basis consistent with cost-
volume-profit (CVP) analysis, in which fixed production overheads are treated as period costs and are thus
not capitalised in stock. Had we reported the quarter’s results using the same CVP basis 1, the profit would
have been exactly as budgeted i.e. R200 000 (refer to the appendix for the detailed income statement). This
is the outcome we expected, given that sales volumes, prices and cost structures were in line with budget,
even though there was a significant drop in production. What this demonstrates, is that profits are driven by
sales volumes when reporting on a variable costing basis and are unaffected by stock level changes.
However, since we report our results using absorption costing, the outcome for the quarter was a loss of -
R125 000 (refer again to the appendix). The difference in profit under the alternative reporting methods is
reconciled as follows:
R
Variable costing profit 200 000
Less: Fixed overhead in opening stock (400 000) (25 000 x 16)
Add: Fixed overhead in closing stock 75 000 (5 000 x 15)
Absorption costing loss (125 000)

Under absorption costing, R400 000 of last quarter’s fixed cost was capitalised in stock and brought forward
to the current quarter. Using variable costing, this cost would have been expensed last quarter. Then because
stock levels fell dramatically during the current quarter (in anticipation of weaker demand), a much smaller
portion of fixed cost was carried forward to next quarter using absorption costing, namely R75 000. Not
only did stock levels fall, but the fixed overhead absorption rate was R1.00 lower in the current quarter,
reducing the fixed cost deferred to next [Link], whereas R1 500 000 fixed production overhead would
have been expensed under variable costing this quarter, R1 825 0002 was actually charged against revenue

1
Note: CVP analysis is consistent with a variable costing approach
2
1500 + 400 – 75 = 1825
using the absorption costing method. This difference of R325 000 accounts for the difference in the
absorption and variable costing profit.
If we anticipate ongoing significant changes in quarterly stock levels, I recommend that we change our basis
of reporting to variable costing. In this way, profits would be driven by changes in sales volume and not
distorted by the impact that stock level changes have on the amount of fixed cost recognised in a period.
Signed

Appendices to Report:
(a) i) Budgeted profit for quarter 4 ending 31 March 2007 – CVP principles
R
Selling price 87
Variable product cost W4 65
Variable selling cost W2 2
Contribution per unit 20
Sales x 100 000
Contribution 2 000 000
Fixed costs:
Production W1 1 500 000
Selling W2 100 000
Admin W3 200 000
Total 1 800 000
Budgeted profit 200 000

(a) ii) Actual Income Statement quarter ended 31 March 2007 – Variable Costing
R’000 R’000
Sales (100 000 x 87) 8 700
Less Variable costs:
Opening stock (25 000 x 65) 1 625
Prime costs (80 000 x 60) 4 800
Production overhead (80 000 x 5) 400
Less: Closing stock (5 000 x 65) 325
Cost of sales 6 500
Selling costs (100 000 x 2) 200 6 700
Contribution 2 000
Fixed costs:
Production 1 500
Selling 100
 Admin 200 1 800
Net profit 200

(b) Actual Income Statement quarter ended 31 March 2007 – Absorption Costing
R’000 R’000
Sales 8 700
Less Costs of sales:
Opening stock (25 000 x 81) 2 025
Prime costs 4 800
Production overhead (80 000 x 20) 1 600
Less: Closing stock (5 000 x 80) 400 (8 025)
Normal Gross Profit 675
Under-absorbed fixed Actual – absorbed
overhead 150000 – (80000 x (300)
15)
Actual Gross Profit 375
Selling costs (300)
Admin (200)
Net profit - 125