Question

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   $   1,040,000      $   882,000      $   1,040,000     
Cost of goods sold      880,000         720,000         924,000        
Gross margin      160,000         162,000         116,000     
Selling and administrative expenses      150,000         142,000         150,000        
Net operating income (loss)   $   10,000      $   20,000      $   (34,000   )
  

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 10% during Year 2 even though production increased during the year. Management had expected sales to remain constant at 40,000 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   40,000   45,000   36,000
Sales in units   40,000   36,000   40,000

Additional information about the company follows:

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 $720,000 per year.

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.

Variable selling and administrative expenses were $2 per unit sold in each year. Fixed selling and administrative expenses totaled $70,000 per year.

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 10% and why a loss was incurred during Year 3 when sales recovered to previous levels.

Required:

1. Prepare a 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