Dana Baird was manager of a new Medical Supplies Division. She had just finished her second year and had been visiting with the companys vice president of operations. In the first year, the operating income for the division had shown a substantial increase over the prior year. Her second year saw an even greater increase. The vice president was extremely pleased and promised Dana a $5,000 bonus if the division showed a similar increase in profits for the upcoming year. Dana was elated. She was completely confident that the goal could be met. Sales contracts were already well ahead of last years performance, and she knew that there would be no increases in costs. At the end of the third year, Dana received the following data regarding operations for the first three years:

Upon examining the operating data, Dana was pleased. Sales had increased by 20 percent over the previous year, and costs had remained stable. However, when she saw the yearly income statements, she was dismayed and perplexed. Instead of seeing a significant increase in income for the third year, she saw a small decrease. Surely, the Accounting Department had made an error. Required: 2. Prepare variable-costing income statements for each of the three years. Reconcile the differences between the absorption-costing and variable-costing incomes.

Year 1 Year 3 Year 2 10,000 11,000 Production 9,000 Sales (in units) 8.000 10,000 12,000 S10 $10 $10 Unit selling price Unit costs: Fixed overhead $3.00 $3.00 $2.90 Variable overhead S1.00 S1.00 $1.00 S1.90 $2.00 $2.00 Direct materials S1.00 $1.00 Direct labor $1.00 $0.40 S0.50 $0.50 Variable selling $29,000 $30,000 $30,000 Actual fixed overhead Other fixed costs 9,000 $10,000 $10,000 The predetermined fixed overhead rate is based on expected actual units of production and expected fixed overhead. Expected production each year was 10,000 units. Any under- or overapplied fixed overhead is closed to Cost of Goods Sold. Yearly Income Statements Year 1 Year 2 Year 3 Sales revenue $80,000 S100,000 $120,000 Less: Cost of goods sold* 54,400 67,000 86,600 $25,600 33,000 33,400 Gross margin 16,000 Less: Selling and administrative expenses 12,200 15,000 $13,400 18,000 17,400 Operating income Assumes a LIFO inventory flow