On 1 October Bland Ltd opened a plant for making verniers. Data for the first two months’ operations are shown below:
At 31 October the units in closing work in progress were 100 per cent complete for materials and 80 per cent complete for labour. At 30 November the units in closing work in progress were 100 per cent complete for materials and 50 per cent complete for labour.
The company’s policy for valuation of work in progress is under review. The board of directors decided that two alternative profit and loss statements should be prepared for October and November. One statement would value work in progress on a weighted average cost basis and the other would adopt a first-in, first-out basis. Fixed costs would be absorbed in proportion to actual labour costs in both cases.
For October both bases gave a closing work in progress valuation of £55 500 and a profit of £10 800. When the statements for November
were presented to the board the following suggestions were made:
1 ‘We wouldn’t have a problem over the valuation basis if we used standard costs.’
2 ‘Standard cost valuation could be misleading for an operation facing volatile costs; all data should be on a current cost basis for management purposes.’
3 ‘It would be simpler and more informative to go to a direct cost valuation basis for management use.’
4 ‘All that management needs is a cash flow report; leave the work in progress valuation to the year-end financial accounts.’
Requirements:
(a) Prepare profit and loss statements for November on the two alternative bases decided by the board of directors, showing workings.
(b) Explain, with supporting calculations, the differences between the results shown by each statement you have prepared.
(c) Assess the main strengths and weaknesses of each of the suggestions made by the directors, confining your assessment to matters relating to the effects of work in progress valuation on performance measurement.
SOLUTION
(a) The closing stock valuation for October which is given in the question does not distinguish between materials and conversion cost. It is therefore necessary to prepare the following statement for October:
October cost schedule (weighted average basis)
November cost schedule (weighted average basis)
November cost schedule (FIFO basis)
Profit statements
(b) The difference in profits is due entirely to the difference between the average cost and FIFO stock valuations. Unit costs increased from £42.50 in October to £58 in November. With the average cost method, the stock valuation is based on both October and November costs. This is because the opening WIP value for November is merged with the current costs to calculate the average cost per unit. With the FIFO method, the cost per unit is based entirely on November costs. The closing WIP is assumed to come from the new units which have been started during the period.
(c)
1. Use of standard costs: The statement is correct. Standard costs per equivalent unit produced would be used to value stocks, and costs per unit would be the same each period (except for where standards are periodically changed). Consequently standard cost per equivalent unit for the opening WIP would be identical to the standard cost per equivalent unit for the current period, and the two alternative methods of allocating opening WIP to the current period would result in the calculation of identical unit costs. The use of standard costs would also provide useful information for cost control purposes. Periodic comparisons of actual and standard performance could be made to determine whether the process was running efficiently. The standard costing system should pinpoint costs which may be out of control. It is necessary to ensure that standards set are attainable and that variances are not a result of unreasonable standards.
2. Use of current costs: If current costs are used for stock valuation purposes, it will be necessary to adjust this valuation for financial accounting purposes. Therefore using current costs is likely to involve additional work. In addition, profit will be affected by temporary price changes. The comparison of actual costs with standard costs can be inappropriate when costs change frequently throughout the year. The standard cost is likely to represent an average target cost for the year. If costs increase rapidly throughout the year then favourable variances will arise in the early part of the year and these variances will be compensated by adverse variances in the later part of the year. A possible solution is to change the standards each month or to separate the variances into their planning and operational elements.
3. Use of direct cost valuation: Variable costing is preferable to absorption costing for managerial purposes. Monthly profit is a function of sales with a variable costing system, whereas monthly profit will be a function of sales and production with an absorption costing system. Managers might also be motivated to increase stocks in order to reduce the amount of fixed overheads allocated to an accounting period. The disadvantage of variable costing is that the control of fixed costs might be ignored. If a variable costing system is used, it will be necessary to convert the stock valuation to an absorption costing basis for financial accounting. Note that if a variable costing system is used, a decision will still have to be made whether to use the FIFO or the weighted average stock valuations.
4. Use of cash flow reports: It is important that profit statements be prepared at frequent intervals for control purposes. Annual profit statements are inadequate for control purposes. If stock levels change significantly during a period, cash flow statements will not provide an indication of profit and production performance for the period. Management should receive periodic profit statements and cash flow statements. It is important that both cash flows and profits be monitored at frequent intervals.