Operating Statements- Notes

Equity Professional
(Accountancy & Financial Tutors) PM
Operating Statements
This is also known as income statement. It is use for the presentation of operating result
or performance of an organization for a particular period. Basically, there are two
methods of presenting income statement, and these include:
▪ Marginal Costing Approach

▪ Absorption Costing Approach
Marginal Costing Approach

This is a costing technique that charged all direct or variable cost of production such
as direct material, direct labour, direct expenses, and variable part of overhead to
cost unit of a product. It is the accounting system in which variable costs are charged
to cost units and fixed costs of the period are written off in full against the aggregate
contribution.
Marginal costing is the principal costing technique designed to aid managerial

decisions. The key reason for this is that the marginal costing approach allows
management's attention to be focused on the changes which result from the decision
under consideration.
Advantages of Marginal Costing

1. Contribution per unit is constant unlike profit per unit which varies with changes
in sales volume.
2. There is no under or over absorption of overheads (and hence no adjustment
is required in the income statement).
3. Fixed costs are a period cost and are charged in full to the period under
consideration.
4. Marginal costing is useful in the decision-making process.
5. It is simple to operate.
The main disadvantages of marginal costing include:

➢ Closing inventory is not valued in accordance with accounting standards.
➢ Fixed production overheads are not 'shared' out between units of production
but written off in full instead.
Format:
Income Statement Using Marginal Costing Approach
N N
Sales xx
Production Costs:
Opening Stock (Valued at TVC per unit) x
Direct Material x
Direct Labour x
Direct Expenses x
Variable Overhead x
Cost of Goods Available for Sale (COGAS) x
Closing Stock (Valued at TVC per unit) (x)
Cost of Goods Sold (COGS) x
Add: Variable Non-Production Costs:
Selling & Distribution Expenses x
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Administrative Expenses x (x)
Contribution xx
Period Costs:
Fixed Production Overhead x
Fixed Selling & Distribution Expenses x
Fixed Administrative Expenses x (x)
Profit Before Tax (PBT) xx
Income Tax (Tax Rate x PBT) (x)
Net Profit / (Loss) xx / (xx)
Points to note under Marginal Costing Method:

▪ Opening and closing stocks are valued using total variable cost (i.e. direct
material, direct labour, direct expenses and variable production overhead)
per unit
▪ Fixed production overhead is written off from contribution in determining net
profit. In this case, fixed production overhead is calculated as budgeted
output or normal capacity multiply by fixed overhead absorption rate
▪ Under / (over) absorbed overhead is not considered.
Absorption Costing Approach

This is a costing technique that charged total cost of production (i.e. variable and
fixed costs) to unit cost of a product. It is also known as full costing or total costing
method. Absorption costing is a managerial accounting method of charging all costs
associated with manufacturing a particular product and is required for generally
accepted accounting principles (GAAP) external reporting. Some of the direct costs
associated with manufacturing a product includes wages for workers physically
manufacturing a product, the raw materials used in producing a product, and all of
the overhead costs, such as rent and rates, heat and light, building insurance etc.,
used in producing the good.
Advantages
1. Absorption costing includes an element of fixed overheads in inventory values.
2. Analyzing under/over absorption of overheads is a useful exercise in controlling
costs of an organization.
3. In small organizations, absorbing overheads into the costs of products is the
best way of estimating job costs and profits on jobs.
4. It will result in more accurate accounting regarding ending inventory.
Disadvantages
1. Fixed overheads cannot be easily attributable to each unit because it is based
on apportionment which is subjective.
2. The cost allocated to each unit of production is based on the cost incurred
relative to volume of production.

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Format:
Income Statement Using Absorption Costing Approach
N N
Sales xx
Production Costs:
Opening Stock (Valued at TC per unit) x
Direct Material x
Direct Labour x
Direct Expenses x
Variable Overhead x
Fixed Production Overhead x
Cost of Goods Available for Sale (COGAS) x
Closing Stock (Valued at TC Per Unit) (x)
Cost of Good Sold (COGS) (x)
(Under) / Over Absorption x/(x) (x)
Gross Profit xx
Non-Production Expenses:
Selling & Distribution Expenses x
Administrative Expenses x (x)
Profit Before Tax xx
Income Tax (Tax Rate x PBT) (x)
Net Profit xx / (xx)
Points to note under Absorption Costing Method:

▪ Opening and closing stocks are valued at total cost (i.e. variable cost + fixed
production overhead) per unit.
▪ Fixed production overhead is considered part of production cost in
determining unit cost of a product. In this case, fixed production overhead is
calculated as number of units produced multiply by fixed overhead absorption
rate.
▪ Under / over absorbed overhead is adjusted from cost of goods sold.
Note:
• Under-absorbed overhead occurs when budgeted overhead or output is lower
than the actual overhead incurred, or actual unit produced. In this case, the
under absorbed overhead is deducted from cost of goods sold.
• Over-absorbed overhead arises when the budgeted overhead or output is
higher than the actual overhead incurred, or actual unit produced. Under this
situation, the most important thing to do is to add the over-absorbed overhead
to the cost of goods sold.
Fixed overhead absorption rate can be calculated as follows:
Fixed Production Overhead

FOAR =
Normal Capacity or budgeted Output

3
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Reconciliation Statement
Income statement prepared using marginal and absorption costing techniques will
usually bring about conflicting results. This is due to the treatment of stock valuation
under each method. Opening and closing stocks are valued at variable cost per unit
under marginal costing method while absorption costing method valued stocks at
total cost per unit.
Therefore, the difference in net profit before tax can be reconciled from the
difference in stock values under the two methods (i.e. the difference in net profit
before tax will equate the difference in stock values under the two methods).
This can be shown as follows:
Reconciliation Statement
Profit Before Tax: N N
Absorption Costing Method xx
Marginal Costing Method (xx)
Difference in Profit (a) xx
Stock Valuation:
Closing Stock:
Marginal Costing Method (xx)
xx
Opening Stock:
Marginal Costing Method (xx) (xx)
Difference in Stock Valuation (b) xx
a=b=0

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Illustrations

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Illustration 1
Fernandez Company Ltd manufactured face towel, the standard unit costs of its
production are given below:
N
Direct Material 1.60
Direct Labour 1.50
Variable Manufacturing Overheads 1.20
Fixed Manufacturing Overheads 3.00
7.30
At normal operating capacity, 200,000 units of product should be manufactured.

Variable selling and administrative expenses amount to 50kobo per unit and fixed
selling and administrative expenses amount to N75,000 a year. Income taxes at 40%
of net income before taxes.
Production and sales data for year 2008 and 2009 in unit:
Inventory on hand, January 2008 28,000

Production for year 2008 200,000
Sales for year 2008 160,000
Production for year 2009 150,000
Sales for year 2009 180,000
In both years each towel is sold for N10.50
Required:
Prepare income statement for the years by:

a. Absorption Costing Method
b. Variable Costing Method
c. Prepare a reconciliation statement to show why there is difference between
the results of the two methods.
Illustration 2
Panama Ltd makes and sells one product, which has the following standard
production cost.
N
Direct Labour 3 hours at N6 per hour 18
Direct Material 4 kilograms at N7 per kg 28
Variable Production Overhead 3
Fixed Production Overhead 20
Standard Production Cost per unit 69
Normal output is 16,000 units per annum. Variable selling, distribution, and
administration costs are 20% of sales value. Fixed selling, distribution, and
administration costs are N180,000 per annum. There are no units in finished goods
inventory on 1 October 2021. The fixed overhead expenditure is spread evenly
throughout the year.

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Equity Professional
The selling price per unit is N140. Production and sales budgets are shown in the table
below:
Six months ending Six months ending

31st March 2022 30th September 2022
Production 8,500 7,000
Sales 7,000 8,000
Required:
Prepare operating statement for each of the six-monthly periods using:
a. Marginal Costing Technique

b. Absorption Costing Technique

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Operating Statements- Notes

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Equity Professional

(Accountancy & Financial Tutors) PM

▪ Marginal Costing Approach

Marginal Costing Approach

Marginal costing is the principal costing technique designed to aid managerial

Advantages of Marginal Costing

The main disadvantages of marginal costing include:

Victoria Island Centre Isolo Centre

Points to note under Marginal Costing Method:

Absorption Costing Approach

Victoria Island Centre Isolo Centre

Points to note under Absorption Costing Method:

Fixed overhead absorption rate can be calculated as follows:

Fixed Production Overhead

Victoria Island Centre Isolo Centre

This can be shown as follows:

Victoria Island Centre Isolo Centre

Victoria Island Centre Isolo Centre

At normal operating capacity, 200,000 units of product should be manufactured.

Inventory on hand, January 2008 28,000

In both years each towel is sold for N10.50

Prepare income statement for the years by:

Victoria Island Centre Isolo Centre

Six months ending Six months ending

a. Marginal Costing Technique

Victoria Island Centre Isolo Centre

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