"There must be something wrong with these statements!" exclaimed Hugh Richards, president of Ajax Inc. $$They just don't make sense. We sold the same number of units this year as we did last year, yet our profits have tripled! Who messed up the calculations?"

Ajax Inc. Is a medium size supplier of plastic components to the automobile industry and has been in business for $25$ years. Sales forecasting has been relatively easy to do in the past since Ajax has had long$-$term, single$-$sourcing relationships with most of its customers. In $2018,$ however, there was a threat of a strike at one of Ajax Inc.$\text{'}$s major raw materials suppliers. For that reason, Ajax management decided to purchase more raw materials and produce more components in $2018$ than required, in anticipation of raw materials shortages in $2019.$ Manufacturing equipment was typically operated below capacity, so this boost in production was possible without incurring significantly increased fixed manufacturing costs. The income statement and production reports to which Richards was referring are shown below:

$2017$

$2018$

Sales $(40,000$ units each year$).$ $$1,250,000$

$$1,250,000$

Cost of goods sold

Gross margin

$$840,000$

$$410,000$

$$720,000$

Selling and administrative expenses

Operating income.

$$350,000$

$ $530,000$

$$,350,000$

$$,180,000$

$2017$

$2018$

Production in units.

Sales in units.

Variable manufacturing cost per unit produced

Variable selling and administrative expense per unit sold

Fixed manufacturing overhead costs $($total$).$

Ajax Inc. Uses absorption costing and applies fixed manufacturing overhead costs to its only product on the basis of each year's production. $($Thus$,$ a new fixed manufacturing overhead rate is computed each year.$)$

Required:

Take on the role of the CFO of Ajax Inc. Write a memo to Richards to explain why the operating income for $2018$ was higher than for $2017$ under absorption costing, although the same number of units was sold each year. Make sure to include the following:

A contribution format income statement for each year, using variable costing. Be sure to reconcile the variable costing and absorption costing operation income figures for each year. $10$ Marks

A brief discussion of the advantages and disadvantages of a variable over absorption costing for internal reporting purposes. $10$ Marks

A discussion of the ramifications of returning to the "normal" level of production in the coming year. $10$ Marks

A recommendation: Should the company continue to "overproduce" in coming years to boost operating income? $15$ Marks