Question

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	$	1,100,000	$	880,000	$	1,100,000
Cost of goods sold		835,000		588,000		885,000
Gross margin		265,000		292,000		215,000
Selling and administrative expenses		260,000		220,000		260,000
Net operating income (loss)	$	5,000	$	72,000	$	(45,000)

  

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:

a.	The company’s plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $4.70 per unit, and fixed manufacturing overhead expenses total $600,000 per year.
b.	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.
c.	Variable selling and administrative expenses were $4 per unit sold in each year. Fixed selling and administrative expenses totaled $60,000 per year.
d.	The company uses a FIFO inventory flow assumption.

  

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. 2a. Compute the unit product cost in each year under absorption costing. 2b. Reconcile the variable costing and absorption costing net operating income 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 (or loss) have been in each year under absorption costing?

Answer 1

Answer 2-a.
Unit Product Cost
Under Absorption Costing
	Year 1	Year 2	Year 3
Production in Units	50,000.00	60,000.00	40,000.00
Variable Manufacturing Expense per Unit	4.70	4.70	4.70
Fixed Manufacturing Overhead
Year 1 - $600,000 / 50,000 Units	12.00
Year 2 - $600,000 / 60,000 Units		10.00
Year 3 - $600,000 / 40,000 Units			15.00
Total Cost per Unit	16.70	14.70	19.70
Note: Selling and administrative expenses (both variable and fixed) are not relevant for the computation of unit product cost in both absorption costing & variable costing.
Answer 2-b.
Unit Product Cost
Under Variable Costing
	Year 1	Year 2	Year 3
Production in Units	50,000.00	60,000.00	40,000.00
Variable Manufacturing Expense per Unit	4.70	4.70	4.70
Total Cost per Unit	4.70	4.70	4.70
Income Statement
Under Variable Costing
	Year 1	Year 2	Year 3
Sales in Units	50,000.00	40,000.00	50,000.00
Sales	1,100,000.00	880,000.00	1,100,000.00
Variable Expenses:
Cost of Goods Sold	235,000.00	188,000.00	235,000.00
Selling & Admn Expenses	200,000.00	160,000.00	200,000.00
Total Variable Costs	435,000.00	348,000.00	435,000.00
Contribution Margin	665,000.00	532,000.00	665,000.00
Fixed Costs
Manufacturing Costs	600,000.00	600,000.00	600,000.00
Selling & Admn Expenses	60,000.00	60,000.00	60,000.00
Total Fixed Costs	660,000.00	660,000.00	660,000.00
Net Operating Income	5,000.00	(128,000.00)	5,000.00
Reconciliation Statement
	Year 1	Year 2	Year 3
Variable Costing Operating Income (Loss)	5,000.00	(128,000.00)	5,000.00
Add: Fixed MOH deferred in inventory Under Absorption Costing
Year 2- 20,000 Units X $10		200,000.00
Year 3- 10,000 Units X $15			150,000.00
Less: Fixed MOH released from inventory Under Absorption Costing
Year 3 - 20,000 Units X $10			(200,000.00)
	-
Absorption Costing Operating Income (Loss)	5,000.00	72,000.00	(45,000.00)
Answer 5.
If Lean Production had been used in Year 2 and Year 3 means that there will be no inventory have been build up in year 2 and Year 3
So,
	Year 1	Year 2	Year 3
Sales In Units	50,000	40,000	50,000
Production in Units	50,000	40,000	50,000
Predetermined Overhead Rate = $600,000 (Fixed MOH) / 50,000 Units (Estimated Sales)
Predetermined Overhead Rate = $12per unit
So, Cost Per Unit
	Year 1	Year 2	Year 3
Variable Manufacturing Overhead	4.70	4.70	4.70
Fixed MOH	12.00	12.00	12.00
Total cost per Unit	16.70	16.70	16.70
No. of Units Sold	50,000.00	40,000.00	50,000.00
Cost of Goods Sold	835,000.00	668,000.00	835,000.00
Calculation of Overapplied / Underapplied Overhead:
	Year 1	Year 2	Year 3
Actual Fixed MOH	600,000.00	600,000.00	600,000.00
Applied Fixed MOH	600,000.00	480,000.00	600,000.00
Underapplied Overhead	-	120,000.00	-
Income Statement
	Year 1	Year 2	Year 3
Sales	1,100,000.00	880,000.00	1,100,000.00
Cost of Goods Sold:
Cost of Goods Manufactured	835,000.00	668,000.00	835,000.00
Add: Underapplied Overhead	-	120,000.00	-
Adjusted Cost of Goods Sold	835,000.00	788,000.00	835,000.00
Gross Margin	265,000.00	92,000.00	265,000.00
Selling & Administrative Expenses	260,000.00	220,000.00	260,000.00
Net Operating Income (Loss)	5,000.00	(128,000.00)	5,000.00