Starfax Inc manufactures a small part that is widely used in

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 $ 800,000 $ 640,000 $ 800,000 Cost of goods sold 580,000 400,000 620,000 Gross margin 220,000 240,000 180,000 Selling and administrative expenses 190,000 180,000 190,000 Net operating income (loss) $ 30,000 $ 60,000 $ (10,000) 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 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 $2 per unit, and fixed manufacturing overhead expenses total $480,000 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 $1 per unit sold in each year. Fixed selling and administrative expenses totaled $140,000 per year. 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. Required: 1. Prepare a contribution format variable costing income statement for each year. 2-a. Compute the unit product cost in each year under absorption costing. (Round your answers to 2 decimal places.) 2-b. Reconcile the variable costing and absorption costing net operating income (loss) figures for each year. 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? ©2018 McG

Solution

1 2a Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Unit Sale 50000 40000 50000 Unit Sale 50000 40000 50000 Production 50000 60000 40000 Sales 800000 640000 800000 Variable Expense: Fixed Manufacturing Overhead 480000 480000 480000 -Variable Cost of Goods Sold (Unit*2) 100000 80000 100000 -Variable Selling and Administrative (Unit*1) 50000 40000 50000 Variable Cost of Goods Sold (Given in que) 2 2 2 Per Unit Fixed (Overhead/Production) 9.6 8 12 Total Variable Expense 150000 120000 150000 Per Unit Produc Cost 11.6 10 14 Contribution Margin (Sale-Variable Exp) 650000 520000 650000 Fixed Expense: -Fixed Manufacturing Overheads 480000 480000 480000 -Fixed Selling and Administrative 140000 140000 140000 Total Fixed Expense 620000 620000 620000 Net Operating Income (margin-Fixed Exp) 30000 -100000 30000 2b Year 1 Year 2 Year 3 Unit Sale 50000 40000 50000 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 Production 50000 60000 40000 Fixed Overhead Deferred to Year 3 (60000-40000) 20000 -20000 Year 1 Year 2 Year 3 Fixed Overhead Deferred after Year3 (50000-20000-40000) 10000 Net Operating Income Under absorption 30000 -100000 30000 Per Unit Fixed (Overhead/Production) (From PART 2a) 9.6 8 12 Fixed Overheads Deferred-Year 3 160000 120000 Fixed Overheads Deferred-of Year 2 -160000 Operating Income as per Variable Costing (From PART 1) 30000 -100000 30000 Operating Income as per Absorption Costing (From PART 1) 30000 60000 -10000 (Fixed Ovh deffered+Operating income as per variable costing)