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	$	1,000,000		$	790,000		$	1,000,000
Cost of goods sold		705,000			500,000			745,000
Gross margin		295,000			290,000			255,000
Selling and administrative expenses		260,000			220,000			260,000
Net operating income (loss)	$	35,000		$	70,000		$	(5,000	)

  

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:

1. The company’s plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $4.50 per unit, and fixed manufacturing overhead expenses total $480,000 per year.

2. 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.

3. Variable selling and administrative expenses were $4 per unit sold in each year. Fixed selling and administrative expenses totaled $60,000 per year.

4. 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 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

Requirement 1: Prepare the variable costing income statement as follows

Particulars	Year 1	Year 2	Year 3
Units sales	50,000	40,000	50,000
Sales revenue (a)	$1,000,000	$790,000	$1,000,000
Variable Expenses:
Variable cost of goods sold (@ $4.50 per unit)	$225,000	$180,000	$225,000
Variable selling and administrative expenses (@ $4 per unit)	$200,000	$160,000	$200,000
Total variable expenses (b)	$425,000	$340,000	$425,000
(c) Contribution margin (a) − (b)	$575,000	$450,000	$575,000
Fixed Expenses:
Fixed manufacturing overhead	$480,000	$480,000	$480,000
Fixed selling and administrative expenses	$60,000	$60,000	$60,000
Total fixed expenses (d)	$540,000	$540,000	$540,000
Net operating income / (loss) (c) − (d)	$35,000	($90,000)	$35,000

Notes: Compute total variable cost of goods sold as follows

Particulars	Year 1	Year 2	Year 3
Units sales	50,000	40,000	50,000
× Variable cost of goods sold per unit	$4.50	$4.50	$4.50
Total variable cost of goods sold	$225,000	$180,000	$225,000

Compute total variable selling and administrative expenses as follows

Particulars	Year 1	Year 2	Year 3
Units sales	50,000	40,000	50,000
× Variable selling and administrative expenses per unit	$4.00	$4.00	$4.00
Total variable selling and administrative expenses	$200,000	$160,000	$200,000

Requirement 2a: Compute unit product as follows

Particulars	Year 1	Year 2	Year 3
Variable manufacturing cost	$4.50	$4.50	$4.50
Fixed manufacturing cost	$9.60	$8.00	$12.00
Absorption costing - cost per unit	$14.10	$12.50	$16.50

Note: Compute fixed manufacturing cost per unit as follows

Particulars	Year 1	Year 2	Year 3
Total fixed manufacturing cost	$480,000	$480,000	$480,000
÷ Production in units	50,000	60,000	40,000
Fixed manufacturing cost per unit	$9.60	$8.00	$12.00

Requirement 2b: Reconcile the variable and absorption net operating income as follows

Particulars	Year 1	Year 2	Year 3
Net operating income / (loss) - Variable costing	$35,000	($90,000)	$35,000
Add: Fixed manufacturing overhead deferred in inventory		$160,000
Deduct: Fixed manufacturing overhead released from inventory			($40,000)
Net operating income / (loss) - Absorption costing	$35,000	$70,000	($5,000)

Notes: Compute fixed manufacturing overhead deferred or released as follows

Particulars	Year 1	Year 2	Year 3
Beginning inventory in units	0	0	20,000
Add: Number of units produced	50,000	60,000	40,000
Deduct: Number of units sold	-50,000	-40,000	-50,000
Ending inventory in units	0	20,000	10,000
× Fixed manufacturing cost	$9.60	$8.00	$12.00
Fixed manufacturing overhead in ending inventory	$0	$160,000	$120,000
Deduct: Fixed manufacturing overhead in beginning inventory	$0	0	($160,000)
Fixed manufacturing overhead deferred / (released )	$0	$160,000	($40,000)

Requirement 5b: Compute net operating income or loss under lean production as follows

Particulars	Year 1	Year 2	Year 3
Units sales	50,000	40,000	50,000
Sales revenue	$1,000,000	$790,000	$1,000,000
Deduct: Cost of goods sold
Cost of goods manufactured	$705,000	$564,000	$705,000
Add: Overhead under applied (10,000 × $9.60)	$0	$96,000	$0
Cost of goods sold	$705,000	$660,000	$705,000
Gross margin	$295,000	$130,000	$295,000
Selling and administrative expenses	$260,000	$220,000	$260,000
Net operating income / (loss)	$35,000	($90,000)	$35,000

Notes: Compute cost of goods manufactured as follows

Particulars	Year 1	Year 2	Year 3
Units sales	50,000	40,000	50,000
× Cost of goods manufactured per unit	$14.10	$14.10	$14.10
Cost of goods manufactured	$705,000	$564,000	$705,000