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		750,000		540,000		787,500
Gross margin		250,000		260,000		212,500
Selling and administrative expenses		230,000		200,000		230,000
Net operating income (loss)	$	20,000	$	60,000	$	(17,500)

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:

The company’s plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $6.00 per unit, and fixed manufacturing overhead expenses total $450,000 per year.  

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.

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.

Starfax’s management can’t understand why profits more than 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.

	Starfax, Inc., Variable Costing Income Statement Year 1 Year 2 Year 3 Unit sales 50,000 40,000 50,000 Variable expenses: Total variable expenses Fixed expenses: Total fixed expenses Net operating income (loss)

2a. Compute the unit product cost in each year under absorption costing. (Round your answers to 2 decimal places.)

	Year 1 Year 2 Year 3 Unit product cost

2b. Reconcile the variable costing and absorption costing net operating income (loss) figures for each year.

Reconciliation of Variable Costing and Absorption Costing Net Operating Incomes (Losses) Year 1 Year 2 Year 3 Variable costing net operating income (loss) Add (Deduct) fixed manufacturing overhead cost deferred in (released from) Year 2 and released in year 3 Add (Deduct) fixed manufacturing overhead cost deferred in (released from) Year 3 and released in future under absorption costing Absorption costing net operating income (loss)

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 (loss) have been in each year under absorption costing? (Losses should be indicated by a minus sign.)

	Year 1 Net operating income (loss) Year 2 Net operating income (loss) Year 3 Net operating income (loss)

Answer 1

Requirement 1
		Starfax Inc.
		Variable costing Income statement with FIFO
			Year 1	Year 2	Year 3	Per unit
		Unit produced	50000	60000	40000
		Unit Sales	50000	40000	50000
		Sales Revenue	1000000	800000	1000000	20
		Variable cost of goods manufactured
		Opening inventory	0	0	120000
		Variable manufacturing overhead	300000	360000	240000	6
		Variable cost of goods available for sale	300000	360000	360000	6
		Less : Closing Inventory	0	120000	60000	6
		Cost of goods sold	300000	240000	300000	6
		Gross Contribution Margin	700000	560000	700000	14
		Less : Variable selling and administrative	150000	120000	150000	3
		Contribution Margin	550000	440000	550000	11
		Fixed expenses
		Fixed manufacturing overhead	450000	450000	450000
		Fixed selling and administrative expenses	80000	80000	80000
		Total fixed expenses	530000	530000	530000
		Net Operating Income(Loss)	20000	-90000	20000
Requirement 2a)
	Unit product cost under each of the three year under absoprtion costing
			Year 1	Unit product cost	Year 2	Unit Product cost	Year 3	Unit Product cost
		Unit produced	50000		60000		40000
		Cost of goods manufactured
		Variable manufacturing overhead	300000	6	360000	6	240000	6
		Fixed manufacturing overhead	450000	9	450000	7.5	450000	11.25
		Unit Product cost		15		13.5		17.25
Requirement 2b)
	Reconciliation of variable costing and absorption costing net operating Income
			Year 1	Year 2	Year 3
	Variable costing net operating Income/(loss)		20000	-90000	20000
	Add(Deduct) : Fixed Fixed manufactured cost deferred in (released from) year 2 and released in year 3		0	150000	-150000
	Add(Deduct) : Fixed Fixed manufactured cost deferred in (released from) year 3 and released in future under absorption costing		0		112500
	Absorption costing Net Operating Income/(loss)		20000	60000	-17500
Requirement 5b)
	If lean productin is used during the year 2 & 3 and predetermined overhead rate is based on
	50000 units per year, the company's net operating Income and loss would have been in each year
	under absorption costing
		Starfax Inc.
		Absoprtion costing Income statement with FIFO
			Year 1	Year 2	Year 3
		Unit Sales	50000	40000	50000
		Sales Revenue	1000000	800000	1000000
		Cost of goods sold
		Cost of goods manufactured	750000	600000	750000
		Add : Underapplied overhead		90000
		Cost of goods sold	750000	690000	750000
		Gross profit	250000	110000	250000
		Selling and administrative expenses
		Less : Variable selling and administrative	150000	120000	150000
		Fixed selling and administrative expenses	80000	80000	80000
		Total Selling and administrative expenses	230000	200000	230000
		Net Operating Income(Loss)	20000	-90000	20000