Madison Company uses an actual cost system to apply all manufacturing costs to the units produced. Although production has a maximum capacity of 40 million units, only 10 million units were produced and sold during Year 1. The Company's variable product cost per unit is $1, and total fixed overhead cost per year is $24,000,000. There were no beginning or ending inventories. Madison's Year 1 Income Statement is presented below:

Year 1 Income Statement

(Production = Sales = 10,000,000 units)

Sales (10,000,000 units @ $3): $30,000,000

Less: Cost of Goods Sold: (34,000,000)

Gross Margin: ($ 4,000,000)

Less: Selling & Adm. Expenses (all fixed): ( 5,000,000)

Net Operating Profit (Loss): ($ 9,000,000)

The board of directors is concerned about the Year 1 loss. A consultant approached the board with the following offer: "I agree to become president for no fixed salary. But I insist on a year-end bonus of 10% of operating profit (before considering the bonus)." The board agreed to these terms, and the consultant was hired.

The new president promptly stepped up production to an annual rate of 30,000,000 units. Sales for Year 2 remained at 10,000,000 units. The resulting Madison Company income statement for Year 2 is reported below:

Year 2 Income Statement

(Production 30,000,000 units; Sales = 10,000,000 units)

Sales (10,000,000 units @ $3): $30,000,000

Less: Cost of Goods Sold: (18,000,000)

Gross Margin: $12,000,000

Less: Selling & Adm. Expenses (all fixed): ( 5,000,000)

Net Operating Profit: $7,000,000

Less: Bonus (10%): (700,000)

Operating Profit after Bonus: $6,300,000

The day after the statement was verified, the president took his check for $700,000 and resigned to take a job with another corporation. He remarked, "I enjoy challenges. Now that Madison Company is in the black, I'd prefer tackling another challenging situation." (His contract with his new employer is similar to the one he had with Madison.)

Required:

1. By looking at Madison Company's income statements, which product costing approach do you think the Company had used in each of the two years, absorption costing or variable costing? How can you tell?

2. Explain why Madison's operating profit increased by $16,000,000 in Year 2 (i.e., from a $9 million loss to a $7 million gain) when sales did not increase at all. (Hint: You should first investigate why cost of goods sold went down in the second year.)

3. Determine the unit product cost at the end of Year 2 under

(a) the absorption costing approach

(b) the variable costing approach

4. Using the variable costing approach, prepare contribution format income statements for both Year 1 and Year 2.

5. Had the board of directors required the use of variable costing approach, would the consultant have been able to earn the bonus? Why?

6. Why do you think the consultant immediately resigned after getting his bonus?