Starfax, Inc., manufactures a small part that is widely used in various electronic products such as home computers. Operating results for the first three years of activity were as follows (absorption costing basis): Year 2 $ 800,000 $ 640,000 $800,000 400,000 Year 1 Year 3 Sales Cost of goods sold 580,000 620,000 Gross margin Selling and administrative expenses 220,000 190,000 240,000 180,000 180,000 190,000 Net operating income (loss) $ 30,000 $ 60,000 $(10,000) 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 50,00o '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 50,000 50,000 Year 2 Year 3 Production in units 60,000 40,000 40,000 50,000 Sales in units Additional information about the company follows: a. The company's plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $2 per unit, and fixed manufacturing overhead expenses 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 fixed 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 flow assumption. Starfax's management can't understand why profits doubled during Year 2 when sales dropped by 20% and why a loss was incurred during Year 3 when sales recovered to previous levels.

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Refer again to the absorption costing income statements. Explain why the company suffered a loss in Year 3 but reported a profit in Year 1 although the same number of units was sold each year.

Ending inventory units
20000
10000
200000 | 140000
Ending inventory value under
absorption costing
Variable manufacturing cost per unit
2
2
2
Ending inventory value under variable
costing
40000
20000
Cost of production carried over to next
month
under absorption costing
160000
120000
Transcribed Image Text:Ending inventory units 20000 10000 200000 | 140000 Ending inventory value under absorption costing Variable manufacturing cost per unit 2 2 2 Ending inventory value under variable costing 40000 20000 Cost of production carried over to next month under absorption costing 160000 120000
Starfax, Inc., manufactures a small part that is widely used in various electronic products such as home
computers. Operating results for the first three years of activity were as follows (absorption
costing basis):
Year 2
$ 800,000 $ 640,000 $800,000
400,000
Year 1
Year 3
Sales
Cost of goods sold
580,000
620,000
Gross margin
Selling and administrative expenses
220,000
190,000
240,000
180,000
180,000
190,000
Net operating income (loss)
$ 30,000 $ 60,000 $(10,000)
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 2
Year 1
50,000
50,000
60,000
40,000
Year 3
40,000
50,000
Production in units
Sales in units
Additional information about the company follows:
a. The company's plant is highly automated. Variable manufacturing expenses (direct materials, direct
labor, and variable manufacturing overhead) total only $2 per unit, and fixed manufacturing overhead
expenses 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 fixed 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 flow assumption.
Starfax's management can't understand why profits doubled during Year 2 when sales dropped by 20% and
why a loss was incurred during Year 3 when sales recovered to previous levels.
Transcribed Image Text:Starfax, Inc., manufactures a small part that is widely used in various electronic products such as home computers. Operating results for the first three years of activity were as follows (absorption costing basis): Year 2 $ 800,000 $ 640,000 $800,000 400,000 Year 1 Year 3 Sales Cost of goods sold 580,000 620,000 Gross margin Selling and administrative expenses 220,000 190,000 240,000 180,000 180,000 190,000 Net operating income (loss) $ 30,000 $ 60,000 $(10,000) 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 2 Year 1 50,000 50,000 60,000 40,000 Year 3 40,000 50,000 Production in units Sales in units Additional information about the company follows: a. The company's plant is highly automated. Variable manufacturing expenses (direct materials, direct labor, and variable manufacturing overhead) total only $2 per unit, and fixed manufacturing overhead expenses 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 fixed 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 flow assumption. Starfax's management can't understand why profits doubled during Year 2 when sales dropped by 20% and why a loss was incurred during Year 3 when sales recovered to previous levels.
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