Mark Hancock, Inc., manufactures a specialized surgical instrument called the HAN-20. The firm has grown rapidly in recent years because of the product's low price and high quality. However, sales have declined this year due primarily to increased competition and a decrease in the surgical procedures for which the HAN-20 is used. The firm is concerned about the decline in sales and has hired a consultant to analyze the firm's profitability. The consultant has provided the following information:

Top management at Hancock explained to the consultant that the unfavorable economic climate in 2015 and 2016 had caused the firm to reduce its price and production levels and reduce its fixed manufacturing costs in response to the decline in sales. Even with the price reduction there was a decline in sales in both years. This led to an increase in inventory in 2015, which the firm was able to reduce in 2016 by further reducing the level of production. In both years Hancock's actual production was less than the budgeted level so that the overhead rate for fixed overhead, calculated from budgeted production levels, was too low and a production volume variance was calculated to adjust cost of goods sold for the underapplied fixed overhead (the calculation of the production volume variance is explained fully in Chapter 15, and reviewed briefly below).
The production volume variance for 2015 was determined from the fixed overhead rate of $175 per unit ($700,000/4,000 budgeted units). Since the actual production level was 200 units short of the budgeted level in 2015 (4,000 - 3,800), the amount of the production volume variance in 2015 was 200 × $175 = $35,000. The production volume variance is underapplied (since actual production level is less than budgeted) and is therefore added back to cost of goods sold to determine the amount of cost of goods sold in the full-cost income statement. The full-cost income statement for 2015 is shown below:

Required
1. Using the full-cost method, prepare the income statements for each year.
2. Using variable costing, prepare an income statement for each period, and explain the difference in operating income from that obtained in requirement 1.
3. Write a brief memo to the firm to explain the difference in operating income between variable costing and full costing.

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2015 2016 3,200 3,800 4,000 800 Sales (units) Production Budgeted production and sales Beginning inventory 2,800 2,300 3,400 1,400 Data per unit (all variable) Price Direct materials and labor Selling costs S2,095 1,200 125 $1,995 1,200 125 Fixed costs Manufacturing overhead Selling and administrative $700,000 120,000 $595,000 120,000 Sales Cost of goods sold: $6,704,000 Beginning inventory Cost of goods produced $1,100,000 5,225,000 $6,325,000 1,925,000 Cost of goods available for sale Less ending inventory Cost of goods sold $4400,000 Plus underapplied production volume variance Adjusted cost of goods sold Gross margin Less selling and administrative costs 35,000 $4,435,000 $2,269,000 Variable Fixed $ 400,000 120,000 520,000 $1,749,000 Operating income