2.2 Reconciling the profits & Pricing strategies

Question 1

When inventory levels increase / decrease during period

Answer 1

• If inventory levels increase, absorption costing gives the higher profit (some of fixed overhead is included in valuation of closing inventory and carried forward to next accounting period instead of being written off as period cost in current period)
• If inventory levels decrease, absorption costing gives the lower profit (the fixed overhead brought forward in opening inventory is being released, thereby increasing COS and reducing profits)
• If inventory levels remain constant, both methods give the same profit

Question 2

Profit differences in the long term

Answer 2

• In the long term the total reported profit will be the same whichever method is used
• All of the costs incurred will eventually be charged against sales
• It is only the timing of the sales that causes the profit differences from period to period

Question 3

The differences between the two profits can be reconciled as follows

Answer 3

Absorption costing profit
+ / - (Increase) / Decrease in inventory (in units) x Fixed production overheads per unit
= Marginal costing profit

Question 4

In any pricing decision there are four key factors to consider:

Answer 4

• Costs - Price must be sufficient to cover the costs of producing the product (normally key determinant of selling price)
• Competitors - Org will monitor prices of competing products to ensure the price they set for their own products is in line with competitive goals
• Customers - the value placed on the product by customers will often determine how the product is priced (how much the customer is willing to pay)
• Corporate objectives- pricing will often be linked to overall strategic objectives

Question 5

Cost-plus pricing

Answer 5

• This involves adding a mark up to the cost of the product in order to arrive at the selling price
• The profit mark up is calculated as a percentage of costs
• The cost element could be
  
  • Full cost
  • Marginal cost

Question 6

Full cost plus pricing

Answer 6

Selling price = Full cost per unit x (1 + mark up %)

• Full cost of production is used to determine selling price (based on absorption costing principles)
• Full cost will always include full production cost, including absorbed overheads (Some org may also include sales, distribution and admin costs)

Question 7

Marginal cost plus pricing

Answer 7

Selling price = Marginal cost per unit + (1 + mark up %)

• A larger mark up % is added because both fixed costs and profit must be covered
• Particularly useful for determining a minimum acceptable selling price

Question 8

Profit margin

Answer 8

Selling price = Total cost / (1 - required margin)

• An alternative where a profit margin is calculated as a % return of sales (rather than cost)