Question

Problem 6-25 Prepare and Interpret Income Statements; Changes in Both Sales and Production; Lean Production [LO6-1, LO6-2, LO6-3] 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 $ 1,000,000 $ 800,000 $ 1,000,000 Cost of goods sold 740,000 520,000 785,000 Gross margin 260,000 280,000 215,000 Selling and administrative expenses 230,000 200,000 230,000 Net operating income (loss) $ 30,000 $ 60,000 $ (15,000 ) 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 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 50,000 60,000 40,000 Sales in units 50,000 40,000 50,000 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 $540,000 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 $3 per unit sold in each year. Fixed selling and administrative expenses totaled $80,000 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 20% 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
		Year 1	Year 2	Year 3
	Unit Sale	50000	40000	50000
	Sales	1000000	800000	1000000
	Variable Expense:
	-Variable Cost of Goods Sold (Unit*4)	200000	160000	200000
	-Variable Selling and Administrative (Unit*3)	150000	120000	150000
	Total Variable Expense	350000	280000	350000
	Contribution Margin (Sale-Variable Exp)	650000	520000	650000
	Fixed Expense:
	-Fixed Manufacturing Overheads	540000	540000	540000
	-Fixed Selling and Administrative	80000	80000	80000
	Total Fixed Expense	620000	620000	620000
	Net Operating Income (margin-Fixed Exp)	30000	-100000	30000

2a		Year 1	Year 2	Year 3
	Unit Sale	50000	40000	50000
	Production	50000	60000	40000
	Fixed Manufacturing Overhead	540000	540000	540000
	Variable Cost of Goods Sold (Given in que)	4	4	4
	Per Unit Fixed (Overhead/Production)	10.8	9	13.5
	Per Unit Produc Cost	14.8	13	17.5

2b		Year 1	Year 2	Year 3
	Unit Sale	50000	40000	50000
	Production	50000	60000	40000
	Fixed Overhead Deferred to Year 3 (60000-40000)		20000
	Fixed Overhead Deferred after Year3 (50000+20000+40000)			-10000
	Per Unit Fixed (Overhead/Production) (From PART 2a)	10.8	9	13.5
	Fixed Overheads Deferred		180000	-135000
	Operating Income as per Variable Costing (From PART 1)	30000	-100000	30000
	Operating Income as per Absorption Costing (From PART 1)	30000	80000	-105000
	(Fixed Ovh deffered+Operating income as per variable costing)

5b	If Lean production has been used during year 2 and Year3, Net Operating income under absorption costing would have been same as under variable costing. Since production and sale would have been equal and hence no inventory and hence no overhead to be deferred to next year
		Year 1	Year 2	Year 3
	Net Operating Income Under absorption	30000	-100000	30000