Advanced: Explanation of difference between absorption and variable costing profit statements The accountant of Minerva Ltd, a small company manufacturing only one product, wishes to decide how to present the company’s monthly manage¬ ment accounts. To date only actual information has been presented on an historic cost basis, with stocks valued at average cost. Standard costs have now been derived for the costs of production. The practical capacity (also known as full capacity) for annual production is 160000 units, and this has been used as the basis for the allocation of produc¬ tion overheads. Selling and administration fixed overheads have been allocated assuming all 160000 units are sold. The expected production capacity for 2001 is 140000 units. It is anticipated now that, for the twelve months to 31 December 2001, production and sales volume will equal 120000 units, compared to the forecast sales and production volumes of 140000 units. The standard cost and standard profit per unit based on practical capacity is:

The accountant has prepared the following three drafts (see below) of Minerva Ltd’s profit and loss account for the month of November 2000 using three different accounting methods. The drafts are based on data relating to production, sales and stock for November 2000 which are given below.

The accountant is trying to choose the best method of presenting the financial information to the direc¬ tors. The present method is shown under the Actual costs column; the two other methods are based on the standard costs derived above.
The following estimated figures for the month of December 2000 have just come to hand:

Requirements

(a) Prepare a schedule explaining the main differ¬
ence^) between the net profit figures for November 2000 under the three different allocation methods. (8 marks)

(b) Discuss the relative merits of the two suggested alternative methods as a means of providing useful information to the company’s senior management. (8 marks)

(c) Draw up a short report for senior management presenting your recommendations for the choice of method of preparing the monthly accounts, incorporating in your report the profit and loss account for November and the projected profit and loss account for December 2000 as examples of your recom¬ mendations.

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Selling price Production costs: ( per unit) ( per unit) 25.00 Variable 8.00 Fixed 6.00 14.00 Variable selling costs 1.00 15.00 10.00 Other fixed costs: Administration 2.10 Selling 1.20 3.30 Standard profit per unit 6.70