Lucky Letaba manufactures window frames. He commenced business on 1 June 2019, and during the first year of operations ended 31 May 2020 (the 2020 financial year) he sold 4,000 units at a price of R400 each.

As Lucky has not drawn up any income statements for his company he is a bit uncertain as to whether his company is profitable or not. While he was happy to sell as many units as he did in the 2020 financial year, he believes he can sell double this amount in the future now that his business is better known, and has approached you to assist with calculating his company's budgeted profit for the financial year ended 31 May 2021.

He has provided the following information:

It is expected that sales for the 2021 financial year will be double that of the 2020 financial year (the first year of operations), in spite of the fact that he intends to increase the selling price per unit by 25% on 1 June.

He plans on producing 10,000 units in the 2021 financial year, in order to build up reasonable inventory levels. He only manufactured 1,000 more units than were sold in the 2020 financial year, as cash flow was tight. The closing inventory level represents what Lucky considers to be the appropriate level of inventory for his company going forward.

Lucky is not a great believer in credit (either buying on credit or extending credit to customers) and so almost all of his business is on a cash basis, as regards both revenue and costs. The only exception to this is that Lucky is considering taking out a loan from the bank in a year to 18 month's time in order to allow him to purchase his own machinery sometime in the future, as he will need to replace his existing machinery that is currently rented.

Lucky's cousin, who is studying a B.Comm Acc degree at a popular university in the Western Cape, has tried to explain to Lucky that there are two types of income statement formats:

Absorption costing: this is used for external reporting and the format that Lucky should use if he needs to provide an income statement to the bank should Lucky wish to apply for a loan to expand his business; and

Variable costing:this is the format that Lucky should use to calculate profit for his own purposes, to understand his business better.

Lucky's cousin provided him with the expected cost per unit of opening and closing inventory for the 2021 financial year under these two systems.

Opening inventory

Variable costing basis:

R230 per unit

Closing inventory (variable)

R250 per unit

Opening Inventory

Absorption costing basis:

R390 per unit

Closing (absorption)

R335 per unit

He calculated these costs as follows for the two systems:

- Variable costing: He divided the actual (estimated for 2021) variable manufacturing cost by the actual (estimated for 2021) level of production for the 2020 and 2021 years respectively;

- Absorption costing: He divided the actual (estimated for 2021) total manufacturing cost by the actual (estimated for 2021) level of production for the 2020 and 2021 years respectively.

Lucky does not have a clue what his cousin is talking about, and his cousin is now unhelpfully in the middle of their exam period and refusing to answer any of Lucky's questions as they do not want to lose study time. Lucky also doesn't understand why the cost of inventory is higher per unit than the cost of closing inventory under the absorption costing system.

Non-manufacturing costs for the 2021 financial year are predicted to be as follows:

- Sales commission will amount to 2% of the selling price

- Several months ago Lucky approached the delivery company that he intends to use in the 2021 financial year for a quote on what delivery costs would be. He provided them with what he regarded to be the most pessimistic and optimistic sales levels that he thought could possibly apply to the 2021 financial year. Their quotes for delivery costs at these two sales levels were as follows:

- R45,000 if 5,000 units were to be sold and delivered, and

- R75,000 if 15,000 units were to be sold and delivered

Inventory is valued on the FIFO basis

REQUIRED:

1. Prepare the forecast income statements for Lucky Letaba's business for the 2021 financial year, using the

a) Variable costing system(18 marks)

b) Absorption costing system(7 marks)

2. Reconcile the net profits calculated in 1a) and 1b) above.(4 marks)

3. Lucky is confused about the fact that the two different costing systems have resulted in two different profit figures, and he doesn't know what to make of the results. Which profit figure should he trust more, i.e. which is a better indication of the profit he would earn in future years if the sales level remained the same? Why did his cousin advise him to use the different costing systems for different purposes, and do you agree with this?

Write an email to Lucky addressing his confusion and his two questions above. (4 marks)

4. Explain why, under the absorption costing system, the cost per unit as calculated by his cousin is higher for the units in opening inventory, than for the units in closing inventory. Do you agree that Lucky's cousin has calculated the cost per unit of opening inventory correctly or not in terms of IAS2 requirements? Explain your answer. (3 bonus marks)

Efficient and effective communication(2 marks)