Question 2: RedSea, Inc., manufactures and sells a unique electronic part. Operating results for the first three years of activity were as follows (absorption costing basis) Sales.. Cost of goods sold. Gross margin.. Selling and administrative expenses Net operating income (loss). . Year 1 $1,000,000 Year 2 Year 3 $800,000 $1,000,000 800,000 560,000 850,000 200,000 240,000 150,000 170,000 150,000 170,000 $ 30,000 $ 90,000 $ (20,000) Sales dropped by 20% during Year 2 due to the entry of several foreign competitors into the market. RedSea had expected sales to remain constant at 50,000 units for the year; production was set at 60,000 units in order to build a buffer of protection against unexpected spurts in demand. By the start of Year 3, management could see that spurts in demand were unlikely and that the inventory was excessive. To work off the excessive inventories, RedSea cut back production during Year 3, as shown below: Year 1 Year 2 Year 3 Production in units 50,000 60,000 40,000 Sales in units 50,000 40,000 50,000 Additional information about the company follows: 1. The company's plant is highly automated. Variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead) total only $4 per unit, and fixed manufacturing overhead costs total $600,000 per year. 2. Fixed manufacturing overhead costs are applied to units of product on the basis of each year's production. That is, a new fixed overhead rate is computed each year. 3. Variable selling and administrative expenses are $2 per unit sold. Fixed selling and administrative expenses total $70,000 per year. RedSea's management can't understand why profits tripled during Year 2 when sales dropped by 20%, and why a loss was incurred during Year 3 when sales recovered to previous levels.