Manufacturing Cost, Inventory Valuation and Marginal-Cost Proposal
Chipego Ltd makes a single product. For the year ended 31 March 2025: production was 5,000 units and sales were 4,500 units at $40 each. Opening finished goods inventory was 300 units valued at $30 each. Costs were direct materials $60,000, direct labour $45,000, variable production overhead $15,000 and fixed production overhead $30,000. Fixed production overhead is absorbed on the basis of normal capacity of 5,000 units. Selling and administration costs were $22,000. Closing inventory included 200 units that had been damaged; their cost is $30 each but they can be sold for $20 each after minor repairs costing $2 each. The accountant wants to value all closing inventory at variable cost of $24 per unit so that profit is not affected by production volume, and to treat the damaged units at their original cost.
1. Calculate the absorption cost per unit and the value of closing inventory at 31 March 2025, applying the lower of cost and net realisable value rule to the damaged units.
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Total production cost = direct materials 60,000 + direct labour 45,000 + variable production overhead 15,000 + fixed production overhead 30,000 = $150,000.
Absorption cost per unit = 150,000 ÷ 5,000 = $30 per unit. This includes fixed overhead of 30,000 ÷ 5,000 = $6 per unit. Since actual production equals normal capacity, there is no under- or over-absorption.
Closing inventory = 300 opening + 5,000 produced − 4,500 sold = 800 units.
- Undamaged: 600 units × $30 = $18,000.
- Damaged: 200 units. Cost = $30; NRV = selling price 20 − repairs 2 = $18. Lower of cost and NRV is $18, so value = 200 × 18 = $3,600.
- Total closing inventory = 18,000 + 3,600 = $21,600.
2. Prepare a statement showing gross profit and profit for the year under absorption costing.
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Absorption costing profit statement
| $ | |
|---|---|
| Sales (4,500 × $40) | 180,000 |
| Opening finished goods (300 × $30) | 9,000 |
| Production cost | 150,000 |
| Less closing finished goods | (21,600) |
| Cost of sales | (137,400) |
| Gross profit | 42,600 |
| Selling and administration costs | (22,000) |
| Profit for the year | 20,600 |
Check: cost of sales = 9,000 + 150,000 − 21,600 = 137,400. Gross profit = 180,000 − 137,400 = 42,600. Profit = 42,600 − 22,000 = 20,600.
3. Evaluate the accountant's proposal to value the 600 undamaged closing units at $24 each and the damaged units at original cost. Quantify the effect on profit of each element.
Read the worked answer
Neither proposal is acceptable under normal inventory valuation rules.
- Valuing the 600 undamaged units at $24 excludes the fixed production overhead of $6 per unit. Fixed production overhead is a cost of production and must be absorbed into inventory based on normal capacity. Using $24 would reduce closing inventory by 600 × (30 − 24) = $3,600 and reduce profit by $3,600.
- Valuing the 200 damaged units at original cost of $30 ignores that their NRV is only $18. This would overstate inventory by 200 × (30 − 18) = $2,400 and overstate profit by $2,400.
Correct closing inventory remains $21,600. The accountant's variable-cost argument may be useful for internal marginal-cost decisions, but it is not acceptable for external financial statements.