Assumptions from the Case study: 1.

It is assumed that there was no opening stock in July under both costing systems but 6,300,000 was the closing stock under the absorption costing system and 4,200,000 was the closing stock under the variable costing system. 2. It is also assumed that the 5,700,000 was the closing stock in August for the absorption costing system and 3,800,000 was the closing stock in August for the variable costing system. Based on these assumptions, the working for the various costing systems are as follows: Absorption Costing: JULY 000 9300 9300 6300 3000 AUGUST 000 6300 2700 9000 5700 3300

Opening Stock Add Production Less Closing Stock Cost of sales Variable Costing:

Opening Stock Add Production Less Closing Stock Cost of sales

JULY 000 7700 7700 5700 2000

AUGUST 000 5700 300 6000 3800 2200

Question 1: Provide an explanation to the Divisional Manager why variable and absorption costing systems result in the reporting of different profits using the information shown in Exhibit 1. Answer: The absorption costing and variable costing system results in reporting different profits in Exhibit 1 because the two methods differ in their valuation of stock. By including fixed costs in stock valuation, absorption costing transfers some of the periods fixed costs into the next period where they would be charged against the revenue derived from the stock carried forward; assuming that they were sold.

The Variable costing system on the other hand, always writes off all fixed overhead costs in the period they are incurred.

Question 2: Comment on the various statements made by each of the managers and their implications for management accounting within the division. The new manager- Paul Owen asked the accountant- John Vaughan, if a mistake was possible since the figures did not reflect the anticipated increase in profits from July to August since the sales figures in August was significantly higher than that of July and there was no change in costs or selling price. His assumption that an increase in sales (with a constant selling price and cost) would correspond to an increase in profits might normally be true. However, under the absorption costing system, the cost of sales of July included a closing inventory of GHC6300 which was brought forward to August as opening stock and contained a portion of Julys fixed overhead cost and therefore increased Augusts cost of sales. Vaughans reply that profit declined because Augusts production was significantly less than the average monthly volume was true because when sales is less than production (decreasing stock levels) the absorption costing produces lower profits due to the treatment of fixed costs in stock valuation. This was transferred from Julys closing stock thus increasing Augusts cost of sales; ultimately leading to a decrease in profits. Vaughans addition that the reduction in production staff resulted in production overheads being under-absorbed which resulted in additional fixed overheads when compared with July was assigned as costs within Augusts profit statement was justified. Augusts cost of sales contained an under-absorbed fixed cost which when grossed up resulted in a higher cost of sales and therefore lower profit. As a response to Owens scepticism, Vaughan reproduced the accounts using variable costing. The results pleased Owen (because they reflected an increase in profit) who remarked that at the following management meeting, he (Owen) would propose a change in the costing system; from absorption costing to variable costing. Vaughan supported him. This is because in the absorption system, the stocks value of GHC6300 remaining at the end of July contained absorbed fixed monthly overhead cost transferred to Augusts cost of sales (increasing it). But under the variable costing system, GHC4200 was carried over from July to August and did not contain any fixed overhead cost, thus having no effect on cost of sales and so resulted in a higher profit. Vaughans supportive statement to Owen that the allocation of manufacturing fixed overheads to products would be avoided (by using the variable costing system)because most of these allocations were arbitrary; possessing the ability to distort the profit margins on individual products was a fact.

Question 3: Present a report recommending whether variable or absorption costing should be used for internal monthly profit reporting. REPORT ON RECOMMENDATIONS AS TO WHETHER VARIABLE OR ABSORPTION COSTING SHOULD BE USED FOR THE INTERNAL MONTHLY PROFIT REPORTING: We present our recommendations as to whether variable or absorption costing should be used for internal monthly profit reporting. The variable costing system is simple to operate with no apportionment of fixed costs to products or departments which are often on an arbitrary basis. This costing system avoids both under and over absorption of overheads which is as a result of fixed costs inclusion into the overhead absorption rates and the level of activity being different from that which was planned. Fixed costs are incurred on a time basis (e.g: salaries, rent, rates, etc), and do not relate to activity. Therefore, they are written off in the period in which they are incurred. Accounts prepared using the variable costing system show an almost true picture of the actual cash flows. The absorption costing system also has its advantages. One is that it recognises that the fixed costs are a substantial portion of costs because production cannot be achieved without incurring them. They are inescapable and should therefore be included in stock valuation. The variable costing system gives a different impression- that fixed costs are divorced from production. Where stock building is a vital part of operations, the inclusion of stock valuation is necessary as prudence emphasizes the need to make provision of all costs; the point being not to anticipate profit but provide for losses in the period that income is earned. The The variable costing system and its concentration on contribution may lead the firm to setting prices which are below the total costs despite producing the same contribution. Absorption costing makes this less likely because of the automatic inclusion of fixed costs. In conclusion, no generalization can be made as to the preferred use of one method to the other. Considering the above factors, the accountant should make a judgement as to which technique can be used for internal purposes. SSAP9 (Stocks and Work in Progress) recommends the use of the absorption costing system for financial accounts because costs and revenues must be matched in the period when the revenue arises, not when the costs arise. Although the use of full variable costing in routine cost ascertainment is relatively rare, the behaviour of costs and the implications of contributions is vital for accountants and managers. Thus, variable costing is seen as very useful particularly for short term planning, control and decision making especially in multi product businesses such as ours. Submitted by the Group One Team.