Costs & Revenues-- practice assessment 2, task 5

Nie

I'm hoping someone can explain this one to me. The first part of the question is in relation to costs per mile on a bus route and I'm fine with those calculations.

But, I don't understand how using prime cost will give you the lowest reported profit and using full absorption cost will give you the highest reported profit.

Thanks for your help.

CeeJaySix

I haven't looked at the question, but the general principle (not sure how this would relate to a bus route off the top of my head, is it a separate part of the task or is it meant to follow on somehow):

Gross profit = revenue - cost of sales
CoS = opening stock plus purchases less closing stock

Now (as long as I'm reading your question right) the reported profits aren't actually different overall, it's just a timing difference - so in one period the profit will be higher using one method, but sticking with that method will make it lower in another period.

1. Stock valued at prime cost will be cheapest as it only includes direct variable costs. Let's say £2/unit.
2. Stock valued at marginal cost also includes variable production overheads, and will be middling. Let's say £4/unit.
3. Stock valued at absorption cost also includes fixed production overheads, and will therefore be highest. Let's say £6/unit.

Lets also say revenue was £200, purchases were £100, there's no opening stock and 5 units of closing stock.

Option 1: profit = 200 - (0 + 100 - 5x2) = 110
Option 2: profit = 200 - (0 + 100 - 5x4) = 120
Option 3: profit = 200 - (0 + 100 - 5x6) = 130

This is because absorption costing transfers more of the costs incurred into the next reporting period in the stock valuation, thus increasing profits in the current period. Does that make sense?

Now if we stick with our example into the next period and carry our closing stock forward, lets say we have revenue of 500, purchases of 200 and closing stock of 10 units.

Option 1: profit = 500 - (5x2 + 200 - 10x2) = 310
Option 2: profit = 500 - (5x4 + 200 - 10x4) = 320
Option 3: profit = 500 - (5x6 + 200 - 10x6) = 330

You can see the same principle holds; the difference in profit is the same as we are increasing our stock level by the same amount. If opening stock and closing stock were the same, any method of costing would produce the same level of profit (try it).

If we carry forward again and reduce our closing stock to zero with each method, assuming sales of 400 and purchases of 150:

Option 1: profit = 400 - (10x2 + 150 - 0) = 230
Option 2: profit = 400 - (10x4 + 150 - 0) = 210
Option 3: profit = 400 - (10x6 + 150 - 0) = 190

Now absorption costing gives the lowest reported profit - this is because those extra costs 'stored' in the inventory valuation have been released to the profit and loss via the reducing stock level. If you add up the profit for each option, you will find that now stock has returned to it's opening level, the profit over the three periods is the same for every option - that's what's meant by timing differences.

Nie

Thanks for that. When I was looking at the question your thought process was pretty much what I followed, which left me confused as to how the profit could actually be different in a scenario where there was no inventory involved. Your example is great for illustrating how useful writing out a simple example can be :001_smile:

Honestly, I still don't understand the question/answer in the exam, but at this point I'm thinking that it's a flaw in their question (or possibly my understanding of their question) rather than a gap in my knowledge of the topic.

CeeJaySix

Nie,

I've just had a quick look, it's been a while since I studied costs & revenue so I may be forgetting something, but from the way the question's laid out (there seems to be a line under the bus bit before they start asking this) I'd say it's a theoretical question with no direct link to the first part; I can't think of any other relationship the type of costing has to reported profit...anybody else??

SandyHood

I have a concern about the question.
CeeJaySix has produced an excellent example
But the sample exam task makes no reference to any changes in stocks
I'm not convinced that any of the methods (in this scenario) produce more or less profit than the others