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. 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? (Losses should be indicated with a minus sign.) Year 1 Net Operating Income/loss      ? Year 2 Net Operating Income/loss      ? Year 3 Net Operating Income/loss      ?

Answer 1

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 = $630,000 (Fixed MOH) / 50,000 Units (Estimated Sales)
Predetermined Overhead Rate = $12.60
So, Cost Per Unit
	Year 1	Year 2	Year 3
Variable Manufacturing Overhead	3.00	3.00	3.00
Fixed MOH	12.60	12.60	12.60
Total cost per Unit	15.60	15.60	15.60
No. of Units Sold	50,000.00	40,000.00	50,000.00
Cost of Goods Sold	780,000.00	624,000.00	780,000.00
Calculation of Overapplied / Underapplied Overhead:
	Year 1	Year 2	Year 3
Actual Fixed MOH	630,000.00	630,000.00	630,000.00
Applied Fixed MOH	630,000.00	504,000.00	630,000.00
Underapplied Overhead	-	126,000.00	-
Income Statement
	Year 1	Year 2	Year 3
Sales	1,000,000.00	800,000.00	1,000,000.00
Cost of Goods Sold:
Cost of Goods Manufactured	780,000.00	624,000.00	780,000.00
Add: Underapplied Overhead	-	126,000.00	-
Adjusted Cost of Goods Sold	780,000.00	750,000.00	780,000.00
Gross Margin	220,000.00	50,000.00	220,000.00
Selling & Administrative Expenses	170,000.00	150,000.00	170,000.00
Net Operating Income (Loss)	50,000.00	(100,000.00)	50,000.00