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	$	1,000,000		$	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		230,000			200,000			230,000
Net operating income (loss)	$	30,000		$	60,000		$	(15,000	)

  

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, Starfox'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:

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.

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

Starfox'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

1	Absorption costing	Year 1	Year 2	Year 3
	Variable manufacturing cost	4	4	4
	Fixed manufacturing	10.8	9	13.5
	Total product cost	14.8	13	17.5
	Units produced	50000	60000	40000
	Units sold	50,000	40,000	50000
	Income statement	1st year	2nd year	3rd year
	Sales revenue	1000000	800000	1000000
	cost of goods sold
	Beginning inventory	0	0	260000
	cost of goods manufactured	740000	780000	700000
Add	Goods available for sale	740000	780000	960000
	Ending inventory	0	260000	175000
Less	Cost of goods sold	740000	520000	785000
	Gross profit	260000	280000	215000
	Selling and admin expenses
Less	Variable selling and admin expense	150000	120000	150000
	Fixed Admin expense	80000	80000	80000
	Total Selling and admin expenses	230000	200000	230000
	Net operating income	30000	80000	-15000
2	Variable costing	Year 1	Year 2	Year 3
	Variable manufacturing cost	4	4	4
	Units manufactured	50000	60000	40000
	Units sold	50,000	40,000	50,000
	Income statement
	Sales revenue	1000000	800000	1000000
Less	Variable expense
	Variable cost of goods sold	200000	160000	200000
	Variable selling and admin expense	150000	120000	150000
	Total variable expense	350000	280000	350000
	Contribution margin	650000	520000	650000
Less	Fixed cost
	Fixed manufacturing expense	540000	540000	540000
	Fixed Admin expense	80000	80000	80000
	Total fixed expenses	620000	620000	620000
	Net operating income	30000	-100000	30000
3	Reconciliation
	Net operating income variable costing	30000	-100000	30000
Add	Ending inventory Fixed manufacturing	0	180000	-45000
	Net operating income absorption costing	30000	80000	-15000