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Item 4

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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	$	1,100,000		$	838,000		$	1,100,000
Cost of goods sold		860,000			608,000			910,000
Gross margin		240,000			230,000			190,000
Selling and administrative expenses		220,000			190,000			220,000
Net operating income (loss)	$	20,000		$	40,000		$	(30,000	)

  

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 $5.20 per unit, and fixed manufacturing overhead expenses total $600,000 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 $3 per unit sold in each year. Fixed selling and administrative expenses totaled $70,000 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 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

Values given
Variable manufacturing expenses = $ 5.20 per unit
Fixed manufacturing overheads = $ 60,0000
Variable selling and administrative expense = $ 3.00 per unit
Fixed selling and administrative expense = $ 70,000
Computation of sales price per unit
	Particulars	Year 1	Year 2	Year 3
	Sales	$1,100,000	$838,000	$1,100,000
	Sales in units	50,000	40,000	50,000
	Sales price per unit	$22.00	$20.95	$22.00
1.
Contribution format Variable costing Income statement
	Particulars	Year 1	Year 2	Year 3
	Sales	$1,100,000	$838,000	$1,100,000
Less:	Variable Cost of Goods Sold	$260,000	$208,000	$260,000
	Gross Contribution Margin	$840,000	$630,000	$840,000
Less:	Variable selling and administrative expense	$150,000	$120,000	$150,000
	Contribution Margin	$690,000	$510,000	$690,000
Less:	Fixed Manufacturing overheads	$600,000	$600,000	$600,000
Less:	Fixed Selling and Administrative overheads	$70,000	$70,000	$70,000
	Net operating income	$20,000	($160,000)	$20,000
Note- Computation of Variable Cost of Goods Sold
	Particulars	Year 1	Year 2	Year 3
	Opening Inventory	$0	$0	$104,000
Add:	Variable Cost of Goods Produced	$260,000	$312,000	$208,000
Less:	Closing Inventory	$0	$104,000	$52,000
	Variable Cost of Goods Sold	$260,000	$208,000	$260,000
2a.
	Computation of unit product cost under absorption costing
	Particulars	Year 1	Year 2	Year 3
	Variable Manufacturing Overheads	$5.20	$5.20	$5.20
	Variable Selling and Administrative Overheads	$3.00	$3.00	$3.00
	Fixed Manufacturing Overheads (total costs-variable costs / units produced)	$12.00	$10.00	$15.00
	Product cost per unit	$20.20	$18.20	$23.20
	Variable Costs	$8.20	$8.20	$8.20
	Fixed Costs	$12.00	$10.00	$15.00
	Note - Selling and administrative expenses are not included in the unit product cost as they are
	not considered while computing the contribution margin per unit
2b.
Reconciliation the Net operating income under the Variable costing and Absorption costing method
	Particulars	Year 1	Year 2	Year 3
	Net operating income/(loss) under Variable costing	$20,000	($160,000)	$20,000
	Fixed manufacturing overheads deferred in closing inventory	$0	$200,000	$150,000
	Fixed manufacturing overheads released from opening inventory	$0	$0	($200,000)
	Net operating income/(loss) under Absorption costing	$20,000	$40,000	($30,000)
	Note
	Particulars	Year 1	Year 2	Year 3
	Total units in the opening inventory	0	0	20000
	Fixed cost per unit(fixed cost of the year in which the units are produced)			$10
	Opening inventory value			$200,000
	Total units in the closing inventory	0	20000	10000
	Fixed cost per unit		$10	$15
	Closing inventory value		$200,000	$150,000
	Change in inventory (opening - closing)		($200,000)	$50,000
5b.
	In lean production, the fixed manufacturing overheads rate is calculated on the basis of the total
	installed capacity.If the actual capacity utilized is less than the total capacity installed,then the
	instead of allocating the total fixed overheads over the number of units produced,the unabsorbed
	fixed overheads are treated as idle capacity costs under indirect overheads.In this way the
	marginal cost of the product is not affected by the variance in production.
	If Starfax Inc., uses lean production the fixed overhead rate and the idle capacity costs for the three
	years would be as under:
	Particulars	Year 1	Year 2	Year 3
	Total Capacity	60,000	60,000	60,000
	Total Fixed Manufacturing Overheads	$600,000	$600,000	$600,000
	Fixed manufacturing overhead per installed capacity units	$10	$10	$10
	Used Capacity ( Units produced)	50,000	60,000	40,000
	Idle capacity (Total Capacity - Used Capacity)	10,000	-	20,000
	Cost of idle capacity	$100,000	$0	$200,000
	Cost per unit	Year 1	Year 2	Year 3
	Variable manufacturing cost per unit	$5.20	$5.20	$5.20
	Fixed manufacturing cost per unit	$10.00	$10.00	$10.00
		$15.20	$15.20	$15.20
	Absorption Costing Income Statement using Lean production
	Particulars	Year 1	Year 2	Year 3
	Sales	$1,100,000	$838,000	$1,100,000
Less:	Cost of Goods Sold (see note)	$760,000	$608,000	$760,000
	Contribution Margin	$340,000	$230,000	$340,000
Less:	Cost of Idle Capacity	$100,000	$0	$200,000
Less:	Variable Selling & Admn Exp (Sales Qty * $ 3)	$150,000	$120,000	$150,000
Less:	Fixed Selling Overheads	$70,000	$70,000	$70,000
	Net Operating Income	$20,000	$40,000	($80,000)
	Note- Computation of Cost of Goods Sold
	Particulars	Year 1	Year 2	Year 3
	Opening Inventory	$0	$0	$304,000
Add:	Cost of Goods Produced	$760,000	$912,000	$608,000
Less:	Closing Inventory	$0	$304,000	$152,000
	Cost of Goods Sold	$760,000	$608,000	$760,000
	Unit cost under lean production
	Particulars	Year 1	Year 2	Year 3
	Manufacturing cost per unit	$15.20	$15.20	$15.20
	Units produced	50,000	60,000	40,000
	Cost of Goods Produced	$760,000	$912,000	$608,000