A group of new business graduates is about to embark on a new business adventure. They want to sell personalized embroidery T-shirts online. Manuel was an accounting student and obviously he was left with the responsibility for completing the business accounts. Manuel prepared a profit analysis using both absorption and marginal technique.

The selling price is £22. After briefly studying the set of accounts, Manuel’s business partners were not convinced that the accounts were correct. They did not understand why Manuel was using two different methods and they were confused about the differences in profit each revealed. Moreover, Manuel’s business partners have higher expectations for the business and and also anticipated that the third quarter would be the high season. Manuel explained that the forecast was based on full production capacity (500 units) and that they would need an additional machine and seamstress if they were planning to
expand production. They would also need to build up inventory in the first two quarters.

Required:
1. Identify the fixed, variable, production and non-production costs.
2. Prepare the statement of profit or loss for the first three quarters using variable and absorption costing.
3. Explain the reasons for:
(a) No changes in operating profit in variable and absorption costing in the first quarter.
(b) The difference in operating profit for the second quarter.
(c) The difference in operating profit for the third quarter.
4. According to Manuel’s partners, sales demand will be affected by seasonal variations and they have the option to build up inventory in order to prepare for the high season. Which costing method is more suitable in this case?
5. Assume that Manuel and partners have decided to use JIT inventory. How would this affect the profit and loss statements?

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Sales Production Closing inventory First quarter 500 500 So far, Manuel has listed the following costs: Second quarter 400 500 100 Online service fee Embroidery machines; the machine is rented and paid for monthly. T-shirt purchase cost Labour cost; a seamstress will be paid per T-shirt embroidered. Packaging tools and materials; the package comes in bulk and the finished products are also packed and shipped in bulk. Stationery expenses Advertising fee (a fixed amount charged by an advertising firm) Third quarter 550 500 50 £400/month £1,500/month £3/piece £5/piece £2,000/month £300/month £1,000/month