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		740,000			520,000			785,000
Gross margin		260,000			270,000			215,000
Selling and administrative expenses		220,000			190,000			220,000
Net operating income (loss)	$	40,000		$	80,000		$	(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 $4.00 per unit, and fixed manufacturing overhead expenses total $540,000 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 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

Variable Costing Income Statement
Particulars	Year 1	Year 2	Year 3
Sales	1,000,000	790,000	1,000,000
Less : Variable Costs
Variable product Costs	200000	160000	200000
Variable selling & Administrative cost	150000	120000	150000
Contribution	650,000	510,000	650,000
Less: Period Cost
Fixed manufacturing overhead expenses	540000	540000	540000
Fixed selling and administrative expenses	70000	70000	70000
Net Income	40,000	-100,000	40,000

Reconciliation of profit in variable costing and absorption costing

Particulars	Year 1	Year 2	Year 3
Profit as per absorption costing	40,000	80,000	-5,000
Less: Fixed Cost included in Inventory less released from Inventory	0	180,000	-45,000
Profit as per Variable Costing	40,000	-100,000	40,000

Working Notes :

Fixed Overhead rate

Fixed Overhead	540,000	540,000	540,000
Production in units	50,000	60,000	40,000
Fixed Overhead rate	10.8	9	13.5

Variable Product Costs : Only variable cost is included in inventory valuation under variable cost statement

Variable Product Costs	Year 1	Year 2	Year 3
Opening Inventory	-	-	80,000
Manufactured Units	200,000	240,000	160,000
Closing Inventories (e.g. 240000/60000*20000)	-	80,000	40,000
Variable Product Costs	200,000	160,000	200,000

Closing Inventory breakup	Year 1	Year 2	Year 3
Variable Cost	-	80,000	40,000
Fixed Overhead Cost	-	180,000	135,000
Total	-	260,000	175,000

Profitability under lean production :

Lean production tries to reduces wastage and produces goods at right time when customer requires. In simpler words production of units will be equal to expected demand

Particulars	Year 1	Year 2	Year 3
Sales	1,000,000	790,000	1,000,000
Cost of goods sold (Variable Cost*Units produced+Fixed Manufacturing Overhead)	740,000	700,000	740,000
Gross margin	260,000	90,000	260,000
Selling and administrative expenses	220,000	190,000	220,000
Net operating income (loss)	40,000	-100,000	40,000