Advanced: Explanation of absorption costing changes in profits and preparation of variable costing profit statements The Miozip Company operates an absorption cost¬ ing system which incorporates a factory-wide over¬ head absorption rate per direct labour hour. For 1999 and 2000 this rate was £2.10 per hour. The fixed factory overhead for 2000 was £600 000 and this would have been fully absorbed if the company had operated at full capacity, which is estimated at 400000 direct labour hours. Unfortunately, only 200 000 hours were worked in that year so that the overhead was seriously underabsorbed. Fixed factory overheads are expected to be unchanged in 2001 and 2002.

The outcome for 2000 was a loss of£70 000 and the management believed that a major cause of this loss was the low overhead absorption rate which had led the company to quote selling prices which were uneconomic.

For 2001 the overhead absorption rate was increased to £3.60 per direct labour hour and selling prices were raised in line with the estab¬ lished pricing procedures which involve adding a profit mark-up of 50% onto the full factory cost of the company’s products. The new selling prices were also charged on the stock of finished goods held at the beginning of 2001.

In December 2001 the company’s accountant prepares an estimated Profit and Loss Account for 2001 and a budgeted Profit and Loss Account for 2002. Although sales were considered to be depressed in 2000, they were even lower in 2001 but, nevertheless, it seems that the company will make a profit for that year. A worrying feature of the estimated accounts is the high level of finished goods stock held and the 2002 budget provides for a reduction in the stock level at 31 December 2002 to the (physical) level existing in January 2000. Budgeted sales for 2002 are set at the 2001 sales level.

The summarised profit statements for the three years to 31 December 2002 are as follows:

(a) You are required to write a short report to the board of Miozip explaining why the budgeted outcome for 2002 is so different from that of 2001 when the sales revenue is the same for both years. (6 marks)

(b) Restate the Profit and Loss Account for 2000, the estimated Profit and Loss Account for 2001 and the Budgeted Profit and Loss Account for 2002 using marginal factory cost for stock valuation purposes. (8 marks)

(c) Comment on the problems which may follow from a decision to increase the overhead absorption rate in conditions when cost plus pricing is used and overhead is currently underabsorbed. (3 marks)

(d) Explain why the majority of businesses use full costing systems whilst most management accounting theorists favour marginal costing. NB Assume in your answers to this question that the value of the £ and the efficiency of the company have been constant over the period under review.

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Actual Summarized Profit and Loss Accounts Estimated 2001 Budgeted 2002 Sales Revenue Opening Stock of () 2000 1 350 000 () () () () () 1316 250 1316 250 Finished Goods 100 000 200 000 357 500 Factory Cost of Production 1000 000 975 000 650 000 1 100 000 1175 000 1 007 500 Less: Closing Stock of Finished Goods 200 000 Factory Cost of Goods Sold 357 500 130 000 900 000 817 500 877 500 450 000 498 750 438 750 Less: Factory Overhead Under-Absorbed 300 000 150 000 300 000 150 000 348 750 138 750 Administrative and Financial Costs 220 000 220 000 220 000 Loss (70 000) 128 750 Loss (81 250)