Problem

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):

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:

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 $4.00 per unit, and fixed manufacturing overhead expenses total $540,000 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 $3 per unit sold in each year. Fixed selling and administrative expenses totaled $70,000 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.

a. Reconcile the variable costing and absorption costing net operating income for each year.