Question

Problem 6-25 Prepare and Interpret Income Statements; Changes in Both Sales and Production; Lean Production [LO6-1, LO6-2, LO6-3]

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

	Year 1			Year 2			Year 3
Sales	$	1,000,000		$	780,000		$	1,000,000
Cost of goods sold		750,000			540,000			787,500
Gross margin		250,000			240,000			212,500
Selling and administrative expenses		230,000			200,000			230,000
Net operating income (loss)	$	20,000		$	40,000		$	(17,500	)

  

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 it had excess inventory 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 $6.00 per unit, and fixed manufacturing overhead expenses total $450,000 per year.

2. A new fixed manufacturing overhead rate is computed each year based that year's actual fixed manufacturing overhead costs divided by the actual number of units produced.

3. Variable selling and administrative expenses were $3 per unit sold in each year. Fixed selling and administrative expenses totaled $80,000 per year.

4. The company uses a FIFO inventory flow assumption. (FIFO means first-in first-out. In other words, it assumes that the oldest units in inventory are sold first.)

Starfax’s management can’t understand why profits 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.

2. Refer to the absorption costing income statements above.

a. Compute the unit product cost in each year under absorption costing. Show how much of this cost is variable and how much is fixed.

b. Reconcile the variable costing and absorption costing net operating income figures for each year.

5b. If Lean Production had been used during Year 2 and Year 3, what would the company’s net operating income (or loss) have been in each year under absorption costing?

Answer 1

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Part 1
			Year 1	Year 2	Year 3
Sales Revenue		A	$1,000,000	$ 780,000	$1,000,000
Less: Variable Expense
Variable Cost of Goods Sold	$6 Per unit of Sale		$   300,000	$ 240,000	$   300,000
Variable Selling and Admin Expense	$3 Per unit of Sale		$   150,000	$ 120,000	$   150,000
Total Variable Expense		B	$   450,000	$ 360,000	$   450,000
Contribution Margin		A-B=C	$   550,000	$ 420,000	$   550,000
Less:Fixed Expense
Fixed Cost of Goods Sold		D	$   450,000	$ 450,000	$   450,000
Fixed Selling and Admin Expense		E	$     80,000	$    80,000	$     80,000
Total Fixed Expense		D+E=F	$   530,000	$ 530,000	$   530,000
Net Operaing Income/(Loss)		C-F	$     20,000	$-110,000	$     20,000
Part 2a
			Year 1	Year 2	Year 3
Variable Manufacturing Cost			$               2	$             2	$               2
Fixed Manufacturing Cost
$450,000/50,000			$          9.00
$450,000/60,000				$        7.50
$450,000/40,000					$        11.25
Absorption Costing per unit			$       11.00	$        9.50	$       13.25
Part 2b
			Year 1	Year 2	Year 3
Units in Beginning Inventory			-	-	20,000
Add: Units Produced			50,000	60,000	40,000
Less: Unit Sold			-50,000	-40,000	-50,000
Units in Ending Inventory			-	20,000	10,000
Fixed Manufacturing Overhead in Ending Inventory	$7.5*20,000 and $11.25*10,000			$ 150,000	$   112,500
Less: Fixed Manufacturing Overhead in Begining Inventory					$ -150,000
Manufacturing overhead deferred in inventory				$ 150,000	$    -37,500
Variable Costing Net Operating Net Income/(Loss)			$     20,000	$-110,000	$     20,000
Add: Fixed Manufacturing Overhead Deferred in inventory				$ 150,000
Deduct: Fixed Manufacturing overhead released					$    -37,500
Absorption Costing Net Operaing Net Income/(Loss)			$     20,000	$    40,000	$    -17,500
Part 5b
In case of Lean production, Net Operaing income under absorption costing and Variable costing will be same in all three years.
Since production would be tied to sale, there would not be any ending inventory and hence no fixed overhead would be deferred in inventoyr to other years