Starfax, Inc., manufactures a small part that is widely used in various electronic products such as

Question

home computers. Operating results for the fi rst three years of activity were as follows (absorption
costing basis):
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 inventory was excessive 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
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 $640,000 $800,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 580,000 400,000 620,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 240,000 180,000
Selling and administrative expenses . . . . . . . . . . . 190,000 180,000 190,000
Net operating income (loss) . . . . . . . . . . . . . . . . . . $ 30,000 $ 60,000 $ (10,000)
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:
a. The company’s plant is highly automated. Variable manufacturing costs (direct materials, direct
labor, and variable manufacturing overhead) total only $2 per unit, and fi xed manufacturing
overhead costs total $480,000 per year.
b. Fixed manufacturing overhead costs are applied to units of product on the basis of each year’s
production. That is, a new fi xed manufacturing overhead rate is computed each year.
c. Variable selling and administrative expenses were $1 per unit sold in each year. Fixed selling
and administrative expenses totaled $140,000 per year.
d. The company uses a FIFO inventory fl ow assumption.
Starfax’s management can’t understand why profi ts 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.
3. Refer again to the absorption costing income statements. Explain why net operating income
was higher in Year 2 than it was in Year 1 under the absorption approach, in light of the fact
that fewer units were sold in Year 2 than in Year 1.
4. Refer again to the absorption costing income statements. Explain why the company suffered a loss
in Year 3 but reported a profi t in Year 1 although the same number of units was sold in each year.
5. a. Explain how operations would have differed in Year 2 and Year 3 if the company had
been using Lean Production, with the result that ending inventory was zero.
b. If Lean Production had been used during Year 2 and Year 3 and the predetermined overhead
rate is based on 50,000 units per year, what would the company’s net operating income (or loss)
have been in each year under absorption costing? Explain the reason for any differences between
these income fi gures and the fi gures reported by the company in the statements above.