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	$	1,000,000	$	800,000	$	1,000,000
Cost of goods sold		780,000		540,000		832,500
Gross margin		220,000		260,000		167,500
Selling and administrative expenses		170,000		150,000		170,000
Net operating income (loss)	$	50,000	$	110,000	$	(2,500)

  

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 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 $3.00 per unit, and fixed manufacturing overhead expenses total $630,000 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 $2 per unit sold in each year. Fixed selling and administrative expenses totaled $70,000 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. Reconcile the variable costing and absorption costing net operating income for each year. Reconciliation of Variable Costing and Absorption Net Operating Incomes Year One Year Two Year three Variable costing net operating income (loss) Add (Deduct) fixed manufacturing overhead cost deffered in (release from) Year 2 and released in year 3 Add (Deduct) fixed manufacturing overhead cost deferred in (released from) inventory from Year 3 to the future under absorption costing Absorption costing net operating income (loss)

Answer 1

Calclation of variable costing net operating income / (loss)
	Year 1	Year 2	Year 3
Sales	$1,000,000.00	$800,000.00	$1,000,000.00
Less : Variable cost
Manufacturing cost ($3 per unit)	$150,000.00	$120,000.00	$150,000.00
Selling and administrative cost ($2 per unit)	$100,000.00	$80,000.00	$100,000.00
Contribution Margin	$750,000.00	$600,000.00	$750,000.00
Less : Fixed Cost
Fixed manufacturing overhead	$630,000.00	$630,000.00	$630,000.00
Fixed selling and administrative expenses	$70,000.00	$70,000.00	$70,000.00
Net Operating Income (loss)	$50,000.00	-$100,000.00	$50,000.00
Reconcile the variable costing and absorption costing net operating income for each year.
Reconciliation of Variable Costing and Absorption Net Operating Incomes
	Year 1	Year 2	Year 3
Variable costing net operating income (loss)	$50,000.00	-$100,000.00	$50,000.00
Add (Deduct) fixed manufacturing overhead cost deffered in (release from) Year 2 and released in year 3 [$10.50 per unit * 20000 units]	$0.00	$210,000.00	-$210,000.00
Add (Deduct) fixed manufacturing overhead cost deferred in (released from) inventory from Year 3 to the future under absorption costing [$15.75 per unit * 10000 units]	$0.00	$0.00	$157,500.00
Absorption costing net operating income (loss)	$50,000.00	$110,000.00	-$2,500.00
Fixed manufacturing overhead cost per unit in Year 2 = Fixed manufacturing overhead cost/Production units in year 2 = $630000/60000 units = $10.50 per unit
Fixed manufacturing overhead cost per unit in Year 3 = Fixed manufacturing overhead cost/Production units in year 3 = $630000/40000 units = $15.75 per unit