1 Starfax, Incorporated, manufactures a small part that is widely used in various electronic products such as home computers. Results for the first three years of operations were as follows (absorption costing basis): Sales Cost of goods sold Year 1 $ 819,200 593,920 Year 2 $ 655,360 409,600 Year 3 $ 819,200 634,880 Gross margin Selling and administrative expenses 225,280 194,560 245,760 184,320 184,320 174,080 Net operating income (loss) $ 30,720 $ 61,440 $ \10,240\ 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 51,200 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 it had excess inventory and that spurts in demand were unlikely. To reduce the excessive inventories, Starfax cut back production during Year 3, as shown below: Production in units Sales in units Year 1 51,200 51,200 Year 2 61,440 40,960 Year 3 40,960 51,200 Additional information about the company follows: a. The company's plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $2.00 per unit, and fixed manufacturing overhead expenses total $491,520 per year. b. A new fixed manufacturing overhead rate is computed each year based on that year's actual fixed manufacturing overhead costs divided by the actual number of units produced. c. Variable selling and administrative expenses were $1 per unit sold in each year. Fixed selling and administrative expenses totaled $140,960 per year. d. The company uses a FIFO inventory flow assumption. (FIFO means first-in first-out. In other words, it assumes that the oldest units in inventory are sold first.) 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 variable costing income statement for each year. 2. Refer to the absorption costing income statements above.