Starfax, Inc., manufactures a small part that is widely used in various electron

Question

Starfax, Inc., manufactures a small part that is widely used in various electronic products such as home computers. Operating results for the first 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:

Additional information about the company follows:

The company’s plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $6.00 per unit, and fixed manufacturing overhead expenses total $450,000 per year.  

Fixed manufacturing overhead costs are applied to units of product on the basis of each year’s production. That is, a new fixed manufacturing overhead rate is computed each year.

Variable selling and administrative expenses were $3 per unit sold in each year. Fixed selling and administrative expenses totaled $80,000 per year.

The company uses a FIFO inventory flow assumption.

Starfax’s management can’t understand why profits more than 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.

2a. Compute the unit product cost in each year under absorption costing. (Round your answers to 2 decimal places.)

2b. Reconcile the variable costing and absorption costing net operating income (loss) figures for each year.

5b. 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 (loss) have been in each year under absorption costing? (Losses should be indicated by a minus sign.)

Year 1 Year 2 Year 3 Sales $ 1,000,000 $ 800,000 $ 1,000,000 Cost of goods sold 750,000 540,000 787,500 Gross margin 250,000 260,000 212,500 Selling and administrative expenses 230,000 200,000 230,000 Net operating income (loss) $ 20,000 $ 60,000 $ (17,500)

Explanation / Answer

Requirement 1 Starfax Inc. Variable costing Income statement with FIFO Year 1 Year 2 Year 3 Per unit Unit produced 50000 60000 40000 Unit Sales 50000 40000 50000 Sales Revenue 1000000 800000 1000000 20 Variable cost of goods manufactured Opening inventory 0 0 120000 Variable manufacturing overhead 300000 360000 240000 6 Variable cost of goods available for sale 300000 360000 360000 6 Less : Closing Inventory 0 120000 60000 6 Cost of goods sold 300000 240000 300000 6 Gross Contribution Margin 700000 560000 700000 14 Less : Variable selling and administrative 150000 120000 150000 3 Contribution Margin 550000 440000 550000 11 Fixed expenses Fixed manufacturing overhead 450000 450000 450000 Fixed selling and administrative expenses 80000 80000 80000 Total fixed expenses 530000 530000 530000 Net Operating Income(Loss) 20000 -90000 20000 Requirement 2a) Unit product cost under each of the three year under absoprtion costing Year 1 Unit product cost Year 2 Unit Product cost Year 3 Unit Product cost Unit produced 50000 60000 40000 Cost of goods manufactured Variable manufacturing overhead 300000 6 360000 6 240000 6 Fixed manufacturing overhead 450000 9 450000 7.5 450000 11.25 Unit Product cost 15 13.5 17.25 Requirement 2b) Reconciliation of variable costing and absorption costing net operating Income Year 1 Year 2 Year 3 Variable costing net operating Income/(loss) 20000 -90000 20000 Add(Deduct) : Fixed Fixed manufactured cost deferred in (released from) year 2 and released in year 3 0 150000 -150000 Add(Deduct) : Fixed Fixed manufactured cost deferred in (released from) year 3 and released in future under absorption costing 0 112500 Absorption costing Net Operating Income/(loss) 20000 60000 -17500 Requirement 5b) If lean productin is used during the year 2 & 3 and predetermined overhead rate is based on 50000 units per year, the company's net operating Income and loss would have been in each year under absorption costing Starfax Inc. Absoprtion costing Income statement with FIFO Year 1 Year 2 Year 3 Unit Sales 50000 40000 50000 Sales Revenue 1000000 800000 1000000 Cost of goods sold Cost of goods manufactured 750000 600000 750000 Add : Underapplied overhead 90000 Cost of goods sold 750000 690000 750000 Gross profit 250000 110000 250000 Selling and administrative expenses Less : Variable selling and administrative 150000 120000 150000 Fixed selling and administrative expenses 80000 80000 80000 Total Selling and administrative expenses 230000 200000 230000 Net Operating Income(Loss) 20000 -90000 20000

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