Problem 2 (25 Points)

Electrics Company manufactures and sells a unique electronic part. The company's plant is highly automated with low variable and high fixed manufacturing costs. Operating results on an absorption costing basis for the first three years of activity were as follows:

	Year 1	Year 2	Year 3
Sales	$704,000	$528,000	$704,000
Cost of goods sold:
Beginning inventory	0	0	220,000
Cost of goods manufactured	520,000	550,000	496,000
Goods available for sale	520,000	550,000	716,000
Less ending inventory	0	220,000	186,000
Cost of goods sold	520,000	330,000	530,000
Gross margin	184,000	198,000	174,000
Less selling and administrative expense	180,000	160,000	180,000
Operating income (loss)	$4,000	$38,000	$(6,000)

Additional information about the company is as follows:

• Variable manufacturing costs (direct labour, direct materials, and variable manufacturing overhead) total $3 per unit, and fixed manufacturing overhead costs total $400,000.
• Fixed manufacturing costs are applied to units of product on the basis of the number of units produced each year (i.e., a new fixed overhead rate is computed each year).
• The company uses a FIFO inventory flow assumption.
• Variable selling and administrative expenses are $2 per unit sold. Fixed selling and administrative expenses total $100,000.
• Production and sales information for the three years is as follows:

	Year 1	Year 2	Year 3
Production in units	40,000	50,000	32,000
Sales in units	40,000	30,000	40,000

Required:

1. Compute operating income for each year under the variable costing approach. Prepare the full income statement using the contribution margin format. (10 points)
2. Prepare a reconciliation from your Operating Income (loss) under variable costing to Absorption Costing operating income for years 1 through 3. (6 points)
3. Referring to the absorption costing income statements above, explain why operating income was higher in Year 2 than in Year 1 under absorption costing, in light of the fact that fewer units were sold in Year 2 than in Year 1. (3 points)
4. Referring again to the absorption costing income statements, explain why the company suffered an operating loss in Year 3 but reported a positive operating income in Year 1, although the same number of units was sold in each year. (3 points)
5. If the company had used just-in-time (JIT) during Year 2 and Year 3 and produced only what could be sold, what would have been the company's operating income (loss) for each year under absorption costing. Explain. (3 points)