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)