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In: Accounting

Starfax, Inc., manufactures a small part that is widely used in various electronic products such as...

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?

Solutions

Expert Solution

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

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