Prepare and Interpret Income Statements; Changes in Both Sales and Production; Lean Production 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 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:

 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 fixed 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 fixed 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 flow assumption.

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.

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 I 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 profit 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 aero.

 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 figures and the figures reported by the company in the statements above.

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Year 2 Year 3 Year 1 Sales $800,000 $640,000 $800,000 Cost of goods sold Gross margin Selling and administrative expenses Net operating income (loss) 400,000 580,000 220,000 620,000 240,000 180,000 190,000 $ 30,000 180,000 190,000 $ 60,000 $ (10,000)