Question

Problem 5-25 Prepare and Interpret Income Statements; Changes in Both Sales and Production; Lean Production [LO5-1, LO5-2, LO5-3]

Starfax, Inc., manufactures a small part that is widely used in various electronic products such as home computers. Operating results for the first three years of activity were as follows (absorption costing basis):

	Year 1		Year 2		Year 3
Sales	$	1,000,000	$	800,000	$	1,000,000
Cost of goods sold		740,000		520,000		785,000
Gross margin		260,000		280,000		215,000
Selling and administrative expenses		220,000		190,000		220,000
Net operating income (loss)	$	40,000	$	90,000	$	(5,000)

In the latter part of Year 2, a competitor went out of business and in the process dumped a large number of units on the market. As a result, Starfax’s Sales dropped by 20% during Year 2 even though production increased during the year. Management had expected sales to remain constant at 50,000 units; the increased production was designed to provide the company with a buffer of protection against unexpected spurts in demand. By the start of Year 3, management could see that inventory was excessive and that spurts in demand were unlikely. To reduce the excessive inventories, Starfax cut back production during Year 3, as shown below:

	Year 1				Year 2				Year 3
Production in units	$	50,000			$	60,000				40,000
Sales in units		50,000				40,000				50,000

Additional information about the company follows:

1. The company’s plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $4.00 per unit, and fixed manufacturing overhead expenses total $540,000 per year.  
2. Fixed manufacturing overhead costs are applied to units of product on the basis of each year’s production. That is, a new fixed manufacturing overhead rate is computed each year.
3. Variable selling and administrative expenses were $3 per unit sold in each year. Fixed selling and administrative expenses totaled $70,000 per year.
4. The company uses a FIFO inventory flow assumption.

     

Starfax’s management can’t understand why profits more than doubled during Year 2 when sales dropped by 20%, and why a loss was incurred during Year 3 when sales recovered to previous levels.

Required:

1. Prepare a contribution format variable costing income statement for each year.

2a. Compute the unit product cost in each year under absorption costing. (Round your answers to 2 decimal places.)

2b. Reconcile the variable costing and absorption costing net operating income (loss) figures for each year.

5b. If Lean Production had been used during Year 2 and Year 3 and the predetermined overhead rate is based on 50,000 units per year, what would the company's net operating income (loss) have been in each year under absorption costing? (Losses should be indicated by a minus sign.)

Answer 1