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:

  

  

  

The company’s plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $3.00 per unit, and fixed manufacturing overhead expenses total $630,000 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 $2 per unit sold in each year. Fixed selling and administrative expenses totaled $70,000 per year.

  

    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.

Reconcile the variable costing and absorption costing net operating income for each year.

Year 1 Year 2 Year 3   Sales $ 1,000,000   $ 800,000 $ 1,000,000      Cost of goods sold 780,000   540,000 832,500      Gross margin 220,000 260,000 167,500      Selling and administrative expenses 170,000   150,000 170,000      Net operating income (loss) $ 50,000 $ 110,000 $ (2,500)   

Explanation / Answer

Calclation of variable costing net operating income / (loss) Year 1 Year 2 Year 3 Sales $1,000,000.00 $800,000.00 $1,000,000.00 Less : Variable cost Manufacturing cost ($3 per unit) $150,000.00 $120,000.00 $150,000.00 Selling and administrative cost ($2 per unit) $100,000.00 $80,000.00 $100,000.00 Contribution Margin $750,000.00 $600,000.00 $750,000.00 Less : Fixed Cost Fixed manufacturing overhead $630,000.00 $630,000.00 $630,000.00 Fixed selling and administrative expenses $70,000.00 $70,000.00 $70,000.00 Net Operating Income (loss) $50,000.00 -$100,000.00 $50,000.00 Reconcile the variable costing and absorption costing net operating income for each year. Reconciliation of Variable Costing and Absorption Net Operating Incomes Year 1 Year 2 Year 3 Variable costing net operating income (loss) $50,000.00 -$100,000.00 $50,000.00 Add (Deduct) fixed manufacturing overhead cost deffered in (release from) Year 2 and released in year 3 [$10.50 per unit * 20000 units] $0.00 $210,000.00 -$210,000.00 Add (Deduct) fixed manufacturing overhead cost deferred in (released from) inventory from Year 3 to the future under absorption costing [$15.75 per unit * 10000 units] $0.00 $0.00 $157,500.00 Absorption costing net operating income (loss) $50,000.00 $110,000.00 -$2,500.00 Fixed manufacturing overhead cost per unit in Year 2 = Fixed manufacturing overhead cost/Production units in year 2 = $630000/60000 units = $10.50 per unit Fixed manufacturing overhead cost per unit in Year 3 = Fixed manufacturing overhead cost/Production units in year 3 = $630000/40000 units = $15.75 per unit

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