Starfax, Inc., manufactures a small part that is widely used in various electronic products such as

home computers. Operating results for the fi rst three years of activity were as follows (absorption
costing basis):
In the latter part of Year 2, a competitor went out of business and in the process dumped a
large number of units on the market. As a result, Starfax’s sales dropped by 20% during Year 2
even though production increased during the year. Management had expected sales to remain
constant at 50,000 units; the increased production was designed to provide the company with a
buffer of protection against unexpected spurts in demand. By the start of Year 3, management
could see that inventory was excessive and that spurts in demand were unlikely. To reduce the
excessive inventories, Starfax cut back production during Year 3, as shown below:
Year 1 Year 2 Year 3
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 $640,000 $800,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 580,000 400,000 620,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 240,000 180,000
Selling and administrative expenses . . . . . . . . . . . 190,000 180,000 190,000
Net operating income (loss) . . . . . . . . . . . . . . . . . . $ 30,000 $ 60,000 $ (10,000)
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:
a. The company’s plant is highly automated. Variable manufacturing costs (direct materials, direct
labor, and variable manufacturing overhead) total only $2 per unit, and fi xed manufacturing
overhead costs total $480,000 per year.
b. Fixed manufacturing overhead costs are applied to units of product on the basis of each year’s
production. That is, a new fi xed manufacturing overhead rate is computed each year.
c. Variable selling and administrative expenses were $1 per unit sold in each year. Fixed selling
and administrative expenses totaled $140,000 per year.
d. The company uses a FIFO inventory fl ow assumption.
Starfax’s management can’t understand why profi ts doubled during Year 2 when sales dropped by
20% and why a loss was incurred during Year 3 when sales recovered to previous levels.
Required:
1. Prepare a contribution format variable costing income statement for each year.
2. Refer to the absorption costing income statements above.
a. Compute the unit product cost in each year under absorption costing. (Show how much
of this cost is variable and how much is fixed.)
b. Reconcile the variable costing and absorption costing net operating income figures for
each year.
3. Refer again to the absorption costing income statements. Explain why net operating income
was higher in Year 2 than it was in Year 1 under the absorption approach, in light of the fact
that fewer units were sold in Year 2 than in Year 1.
4. Refer again to the absorption costing income statements. Explain why the company suffered a loss
in Year 3 but reported a profi t in Year 1 although the same number of units was sold in each year.
5. a. Explain how operations would have differed in Year 2 and Year 3 if the company had
been using Lean Production, with the result that ending inventory was zero.
b. If Lean Production had been used during Year 2 and Year 3 and the predetermined overhead
rate is based on 50,000 units per year, what would the company’s net operating income (or loss)
have been in each year under absorption costing? Explain the reason for any differences between
these income fi gures and the fi gures reported by the company in the statements above.

1. To prepare a contribution format variable costing income statement for each year, we need to determine the variable costs and fixed costs for each year.

Year 1 Variable Costs:
- Cost of goods sold: $580,000 (from the information given)
- Variable selling and administrative expenses: $50,000 (50,000 units x $1 per unit)
- Total variable costs: $630,000

Year 1 Fixed Costs:
- Fixed manufacturing overhead: $480,000
- Fixed selling and administrative expenses: $140,000
- Total fixed costs: $620,000

Year 1 Contribution Margin:
- Sales: $800,000
- Total variable costs: $630,000
- Contribution margin: $170,000

Year 1 Variable Costing Income Statement:
Sales: $800,000
Variable costs:
- Cost of goods sold: $580,000
- Variable selling and administrative expenses: $50,000
Total variable costs: $630,000
Contribution margin: $170,000
Fixed costs:
- Fixed manufacturing overhead: $480,000
- Fixed selling and administrative expenses: $140,000
Total fixed costs: $620,000
Net operating income: $30,000

Repeat the same calculation process for Year 2 and Year 3 to prepare the variable costing income statements for each year.

2a. To compute the unit product cost in each year under absorption costing, we need to divide the total manufacturing costs by the number of units produced.

Unit product cost in Year 1:
- Total manufacturing costs: $1,060,000 (Variable costs: $580,000 + Fixed manufacturing overhead: $480,000)
- Number of units produced: 50,000
- Unit product cost: $21.20 ($1,060,000 / 50,000)

Similarly, calculate the unit product cost in Year 2 and Year 3 using the respective total manufacturing costs and number of units produced.

2b. To reconcile the variable costing and absorption costing net operating income figures for each year, we need to look at the differences in fixed manufacturing overhead costs between the two costing methods.

In the absorption costing approach, fixed manufacturing overhead costs are included in the cost of goods sold, along with variable manufacturing costs. This means that when production exceeds sales, more fixed manufacturing overhead costs are allocated to each unit produced, resulting in higher net operating income.

In Year 2, sales dropped by 20%, but production increased. This led to excess inventory and more fixed manufacturing overhead costs being allocated to each unit sold, resulting in a higher net operating income under absorption costing.

In Year 3, production was reduced to match expected sales, resulting in a decrease in the allocation of fixed manufacturing overhead costs to each unit sold. As a result, the net operating income under absorption costing became negative.

3. Net operating income was higher in Year 2 than in Year 1 under the absorption approach because production increased while sales dropped. This led to excess inventory, and more fixed manufacturing overhead costs were allocated to each unit produced, thereby increasing net operating income.

4. The company suffered a loss in Year 3 but reported a profit in Year 1, although the same number of units were sold in each year because the production costs under absorption costing were allocated differently in each year. In Year 1, all production costs were absorbed into the cost of goods sold, while in Year 3, production costs were not fully absorbed due to the reduction in production to match expected sales.

5a. If the company had been using Lean Production, with zero ending inventory, operations in Year 2 and Year 3 would have been different. Lean Production focuses on reducing waste and increasing efficiency, which could have resulted in more accurate production planning and reduced excess inventory.

b. If Lean Production had been used during Year 2 and Year 3, and the predetermined overhead rate was based on 50,000 units per year, the company's net operating income (or loss) under absorption costing may differ from the figures reported above.

Since Lean Production aims to eliminate excess inventory, the fixed manufacturing overhead costs might have been lower than when excess inventory was present. This would result in a lower allocation of fixed manufacturing overhead costs to each unit sold, potentially reducing the net operating income (or increasing the loss) reported in the statements above.