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	$	1,040,000		$	936,000		$	1,040,000
Cost of goods sold		880,000			720,000			924,000
Gross margin		160,000			216,000			116,000
Selling and administrative expenses		150,000			142,000			150,000
Net operating income (loss)	$	10,000		$	20,000		$	(34,000	)

  

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 10% during Year 2 even though production increased during the year. Management had expected sales to remain constant at 40,000 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	40,000	45,000	36,000
Sales in units	40,000	36,000	40,000

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 $720,000 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 $2 per unit sold in each year. Fixed selling and administrative expenses totaled $70,000 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.)

Starfax’s management can’t understand why profits doubled during Year 2 when sales dropped by 10% 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. Statement Showing Income Statement
	Year-1	Year-2	Year-3
Sales Unit	40000	36000	40000
Sales (1)	1040000	936000	1040000
Variable Expense (2)
Variable cost of Goods Sold @ $4/Unit	160000	144000	160000
Variable Selling & Admininstration Expense @ $2/Unit	80000	72000	80000
Total Variable Expense	240000	216000	240000
Contribution Margin 3=(1-2)	800000	720000	800000
Fixed Expense (4)
Fixed Manufacturing Overhead	720000	720000	720000
Fixed Selling & Adminstrative expense	70000	70000	70000
Ttoal Fixed Expense	790000	790000	790000
Net Operating Income ( loss) (3-4)	10000	-70000	10000
2.a. Statement Showing Unit Product Cost ( Absorption Costing)
	Year-1	Year-2	Year-3
Production unit	40000	45000	36000
Variable manufactuirng Cost (1)	4	4	4
Fixed Manufacturing Cost (2)	18	16	20
$720000/Production unit)
Unit Product Cost (1+2)	22	20	24
2.a. Statement Showing Unit Product Cost ( Absorption Costing)
	Year-1	Year-2	Year-3
Variable Costing net operating income (Loss)	10000	-70000	10000
Add (Deduct): Fixed Manufacturing Overhead Cost deferred in inventory from year-2 to Year-3 as per absorption costing ( 9000 Unit*$20)		180000	-180000
Add (Deduct): Fixed Manufacturing Overhead Cost deferred in inventory from year-3 to the future under absorption costing ( 4000 Unit*$24)			135000
Absorption Costing net Operating income (Loss)	10000	110000	-35000