Question

Sales Cost of goods sold Gross margin Selling and administrative expenses Net operating income (loss) Year 1 $1,000,000 740,000 260,000 230,000 $ 30,000 Year 2 $ 780,000 520,000 260,000 200,000 $ 60,000 Year 3 $1,000,000 785,000 215,000 230,000 $ (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. result, Starfax's sales dropped by 20% during Year 2 even though production increased during the year. Management had expec sales to remain constant at 50,000 units; the increased production was designed to provide the company with a buffer of protect against unexpected spurts in demand. By the start of Year 3, management could see that it had excess inventory and that spurts demand were unlikely. To reduce the excessive inventories, Starfax cut back production during Year 3, as shown below: Production in units Sales in units Year 1 50,000 50,000 Year 2 60.000 60,000 40,000 Year 3 40.000 50,000 Additional information about the company follows: a. 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. b. 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. c. Variable selling and administrative expenses were $3 per unit sold in each year. Fixed selling and administrative expenses totale $80,000 per year. d. The company uses a FIFO inventory flow assumption (FIFO means first in first-Out In other words, it assumes that the oldest unit: 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.

Answer 1

From the information given above, I have answered the first question Reconciliation of variable costing and absorption costing Net Operating Income with detailed working.

Net operating Income under Absorbtion costing 2 3 4 Given Information in the problem: 1 Variable Manufacturing expenses $4 per unit (direct materials, direct labour and variable manufacturing overhead) 2 Fixed Manufacturing overhead expenses $540000 per year 3 Variable Selling & Administrative expenses $3 per unit 4 Fixed Selling & Administrative expenses $80000 per year 5 Sales Less: Cost of goods sold Gross Margin Selling & Administrative expenses Net Operating Income/(loss) Year 1 1000000 740000 260000 230000 30000 Year Year 2 780000 520000 260000 200000 60000 Year 3 1000000 785000 215000 230000 15000 7 Year 1 50000 10 Year 2 60000 40000 Production in units Sales in units Year 3 40000 50000 Net operating Income under Variable costing 11 Year 2 Year 1 50000 1000000 40000 Year 3 50000 1000000 780000 Calculation of fixed manufacturing overhead rate Fixed manufacturing overhead rate is computed based on years's actual fixed manufacturing overhead cost divided by the actual number of units produced Year 1 Year 2 Year 3 Fixed manufacturing overhead cost 540000 540000 540000 Actual number of units produced 50000 60000 40000 Sales in units Sales Less: Variable expenses Variable manufacturing overhead expenses $4 per unit Variable Selling and Administrative expenses $3 per unit Contribution Less: Fixed expenses Fixed manufacturing overhead expenses Fixed Selling and Administrative expenses Net Operating Income/(loss) 200000 160000 200000 (50000*4) (40000*4) (50000*4) 150000 120000 150000 (50000*3) 40000*3) (50000*3) 650000 500000 650000 Fixed manufacturing overhead rate 10.8 9 13.5 540000 80000 30000 540000 80000 -120000 540000 80000 30000

Reconciliation of Variable Costing and Absorption Costing Net Operating Income Year 1 30000 Variable Costing Net Operating Income/(loss) Add: Fixed Manufacturing expenses overhead deferred in inventory (Year's closing balance*fixed manufacturing overhead rate) Less: Fixed Manufacturing overhead expenses released from inventory (Year 2 closing balance fixed manufacturing overhead cost released) Absorption Costing Net Operating Income/(loss) Year 2 Year 3 -120000 30000 180000 135000 (20000*9) (10000*13.5) 180000 (20000*9) 60000 -15000 30000 10 Note: In year 1, production is equal to sales and there is no opening & closing balance, hence Net operating income is same under Variable Costing and Absorption Costing. 13 14 Note: Calculation of Closing inventory 1.5 Yearl Year 2 Year 3 16 20000 17 50000 Opening inventory Production in units Less: Sales in units Closing inventory in units Fixed manufacturing overhead rate 60000 40000 40000 50000 18 50000 20000 10000 10.8 13.5 71 22 23