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): Sales Cost of goods sold Gross margin Selling and administrative expenses Net operating income (loss) Year 1 $ 819,200 593,920 225,280 194,560 $ 30,720 Year 2 $ 655,360 409,600 245, 760 184,320 $ 61,440 Year 3 $ 819,200 634,880 184,320 174,080 $ 110,2401 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 51,200 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 51,200 61,440 40,960 51,200 40,960 51,200 Sales in units 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 $2.00 per unit, and fixed manufacturing overhead expenses total $491,520 per year. b. A new fixed manufacturing overhead rate is computed each year based on that year's actual fixed manufacturing overhead costs divided by the actual number of units produced c. Variable selling and administrative expenses were $1 per unit sold in each year. Fixed selling and administrative expenses totaled $140.960 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 units in Inventory are sold first.) Starfox'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

	Starfax, Inc.
1	Variable costing Income Statement
	Particulars	Year 1 ($)	Year 2 ($)	Year 3 ($)
	Sales (a)	8,19,200	6,55,360	8,19,200
	Variable expenses:
	Variable cost of goods sold (51,200*2=1,02,400); (40,960*2=81,920); (51,200*2=1,02,400)	1,02,400	81,920	1,02,400
	Variable selling and administrative expenses (51,200*1= 51,200); (40,960*1= 40,960); (51,200*1= 51,200)	51,200	40,960	51,200
	Total variable expenses (b)	1,53,600	1,22,880	1,53,600
	Contribution margin (c ) = (a) - (b)	6,65,600	5,32,480	6,65,600
	Fixed expenses:
	Fixed manufacturing overhead	4,91,520	4,91,520	4,91,520
	Fixed selling and administrative expenses	1,40,960	1,40,960	1,40,960
	Total fixed expenses (d)	6,32,480	6,32,480	6,32,480
	Net operating income/(loss) (e ) = (c ) - (d)	33,120	-1,00,000	33,120
2 (a)	Particulars	Year 1 ($)	Year 2 ($)	Year 3 ($)
	Variable manufacturing costs	2	2	2
	Fixed manufacturing costs Year-1= 4,91,520 / 51,200 = 9.60 Year-2 = 4,91,520 / 40,960 = 12 Year-3 = 4,91,520 / 51,200 = 9.60	9.60	12	9.60
	Unit product cost	11.6	14	11.6
2 (b)	Particulars	Year 1 ($)	Year 2 ($)	Year 3 ($)
	Variable costing net operating income (loss)	33,120	-1,00,000	33,120
	Add or (Deduct): Fixed manufacturing overhead cost deferred in inventory from Year 2 to Year 3 under absorption costing (12*(61,440-40,960))	-	2,45,760	-2,45,760
	Add: Fixed manufacturing overhead cost deferred in inventory from Year 3 to the future under absorption costing (40,960+20,480-51,200) = 10,240 units 10,240 units * 9.60$ = 98,304	-	-	98,304
	Absorption costing net operating income or (loss)	33,120	1,45,760	-1,14,336
5 (b)	Particulars	Year 1 ($)	Year 2 ($)	Year 3 ($)
	Unit sales	51,200	40,960	51,200
	Sales (a)	8,19,200	6,55,360	8,19,200
	Cost of goods sold:-
	Cost of goods manufactured (Note-1)	5,93,920	4,75,136	5,93,920
	Add: underapplied overhead (Note-2)	-	98,304	-
	Cost of goods sold (b)	5,93,920	5,73,440	5,93,920
	Gross margin (c ) = (a) - (b)	2,25,280	81,920	2,25,280
	Less: Selling and administrative expenses	1,94,560	1,84,320	1,74,080
	Net operating income or (loss)	30,720	-1,02,400	51,200
Note-1	40,960*11.6 = 4,75,136
Note-2	(51,200-40,960)*9.6 = 98,304