A clothing manufacturer makes a specific brand of jeans which it sells at a standard price of $100 per pair. The manufacturer’s costs are as follows.
Standard variable production cost: $16 per pair
Total fixed production cost per month: $240,000 (10,000 pairs are planned to be produced per month) Total fixed non-production costs: $300,000 per month
In Month 1, when the opening inventory is 1,000 pairs, production of 10,000 pairs is planned and sales of 8,000 pairs are expected.
In Month 2, sales are planned to be 9,000 pairs and production is still 10,000 pairs.
Required
(a) What would be the net profit for Months 1 and 2 under
(i) Absorption costing
(ii) Marginal costing
(b) What comments could you make about the performance of this business?
The correct answer and explanation is :
To calculate the net profit for Months 1 and 2 under both absorption costing and marginal costing, we need to break down the costs and calculations based on the given information.
Information Given:
- Selling Price per pair = $100
- Standard Variable Production Cost per pair = $16
- Fixed Production Costs per month = $240,000 (fixed, for 10,000 pairs of planned production)
- Fixed Non-Production Costs per month = $300,000
- Planned Production per month = 10,000 pairs
- Opening Inventory for Month 1 = 1,000 pairs
- Sales for Month 1 = 8,000 pairs
- Sales for Month 2 = 9,000 pairs
(a) Net Profit Calculation
(i) Absorption Costing:
Under absorption costing, both variable production costs and fixed production costs are included in the cost of goods sold (COGS).
- Cost per unit under absorption costing:
- Variable production cost = $16 per unit
- Fixed production cost per unit = Total fixed production cost / Planned production = $240,000 / 10,000 pairs = $24 per unit
- Total production cost per unit = $16 + $24 = $40 per unit
- Net Profit for Month 1:
- Sales Revenue = 8,000 pairs × $100 = $800,000
- COGS = 8,000 pairs × $40 = $320,000
- Fixed Non-Production Costs = $300,000
- Opening Inventory = 1,000 pairs with a cost of $40 per unit, so the cost of opening inventory = 1,000 × $40 = $40,000
- Closing Inventory = 1,000 pairs (since production was 10,000 and sales were 8,000), and their cost = 1,000 × $40 = $40,000 The profit calculation for Month 1 (Absorption Costing):
[
\text{Net Profit for Month 1} = (\text{Sales Revenue} – \text{COGS} – \text{Fixed Non-Production Costs})
= (800,000 – 320,000 – 300,000) = 180,000
]
- Net Profit for Month 2:
- Sales Revenue = 9,000 pairs × $100 = $900,000
- COGS = 9,000 pairs × $40 = $360,000
- Fixed Non-Production Costs = $300,000
- Opening Inventory = 1,000 pairs × $40 = $40,000
- Closing Inventory = 2,000 pairs (10,000 produced, 9,000 sold), with cost = 2,000 × $40 = $80,000 The profit calculation for Month 2 (Absorption Costing):
[
\text{Net Profit for Month 2} = (\text{Sales Revenue} – \text{COGS} – \text{Fixed Non-Production Costs})
= (900,000 – 360,000 – 300,000) = 240,000
]
(ii) Marginal Costing:
Under marginal costing, only variable production costs are included in the COGS. Fixed production costs are treated as period costs and are not allocated to the cost of goods sold.
- Variable cost per unit = $16 per unit (no fixed production cost included).
- Net Profit for Month 1:
- Sales Revenue = 8,000 pairs × $100 = $800,000
- Variable COGS = 8,000 pairs × $16 = $128,000
- Fixed Production Costs = $240,000
- Fixed Non-Production Costs = $300,000 The profit calculation for Month 1 (Marginal Costing):
[
\text{Net Profit for Month 1} = (\text{Sales Revenue} – \text{Variable COGS} – \text{Fixed Costs})
= (800,000 – 128,000 – 240,000 – 300,000) = 132,000
]
- Net Profit for Month 2:
- Sales Revenue = 9,000 pairs × $100 = $900,000
- Variable COGS = 9,000 pairs × $16 = $144,000
- Fixed Production Costs = $240,000
- Fixed Non-Production Costs = $300,000 The profit calculation for Month 2 (Marginal Costing):
[
\text{Net Profit for Month 2} = (\text{Sales Revenue} – \text{Variable COGS} – \text{Fixed Costs})
= (900,000 – 144,000 – 240,000 – 300,000) = 216,000
]
(b) Comments on Performance:
- Month 1:
- Under Absorption Costing, the net profit is $180,000. Under Marginal Costing, the net profit is $132,000. This difference arises because absorption costing includes both fixed and variable production costs in the product cost, whereas marginal costing considers fixed production costs separately.
- The business appears profitable, with a good sales performance of 8,000 units, considering the expected sales of 10,000 units for the period.
- The company managed to cover both its fixed production costs and non-production costs, which suggests efficient production and a healthy margin from each unit sold.
- Month 2:
- Net profit increases under both costing methods: $240,000 under absorption costing and $216,000 under marginal costing. This is due to an increase in sales from 8,000 units to 9,000 units.
- The increase in sales volume helps to absorb more of the fixed production costs, increasing profitability.
- The closing inventory in Month 2 under absorption costing also shows an increase, which means more costs were capitalized into the inventory, reflecting higher profitability due to the fixed costs being absorbed into a larger inventory.
- Overall Business Performance:
- The business is performing well as it is able to maintain profitability despite having high fixed production and non-production costs. The increase in sales from Month 1 to Month 2 is a positive sign, and the business seems to be managing its inventory levels effectively.
- However, the fixed costs are still a large component of the total costs, and any fluctuations in sales could have a significant impact on profitability.
In conclusion, absorption costing shows higher profitability due to the treatment of fixed costs in inventory, while marginal costing provides a clearer view of the contribution of variable costs to profitability. Both methods reveal that the business is healthy, but the reliance on fixed costs means managing production and sales efficiently is crucial for maintaining profitability.