Starfax, Inc., manufactures a small part that is widely used invarious electronic products such as home computers. Results for thefirst three years of operations were as follows (absorption costingbasis):

	Year 1			Year 2			Year 3
Sales	$	1,250,000		$	1,040,000		$	1,250,000
Cost of goods sold		910,000			680,000			1,007,500
Gross margin		340,000			360,000			242,500
Selling and administrative expenses		280,000			240,000			280,000
Net operating income (loss)	$	60,000		$	120,000		$	(37,500	)

  

In the latter part of Year 2, a competitor went out of businessand in the process dumped a large number of units on the market. Asa result, Starfax’s sales dropped by 20% during Year 2 even thoughproduction increased during the year. Management had expected salesto remain constant at 50,000 units; the increased production wasdesigned to provide the company with a buffer of protection againstunexpected spurts in demand. By the start of Year 3, managementcould see that it had excess inventory and that spurts in demandwere unlikely. To reduce the excessive inventories, Starfax cutback production during Year 3, as shown below:

	Year 1	Year 2	Year 3
Production in units	50,000	55,000	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 manufacturingexpenses (direct materials, direct labor, and variablemanufacturing overhead) total only $5.00 per unit, and fixedmanufacturing overhead expenses total $660,000 per year.

2. A new fixed manufacturing overhead rate is computed each yearbased that year's actual fixed manufacturing overhead costs dividedby the actual number of units produced.

3. Variable selling and administrative expenses were $4 per unitsold in each year. Fixed selling and administrative expensestotaled $80,000 per year.

4. The company uses a FIFO inventory flow assumption. (FIFO meansfirst-in first-out. In other words, it assumes that the oldestunits in inventory are sold first.)

Starfax’s management can’t understand why profits doubled duringYear 2 when sales dropped by 20% and why a loss was incurred duringYear 3 when sales recovered to previous levels.

Required:

1. Prepare a variable costing income statement for eachyear.

2. Refer to the absorption costing income statements above.

a. Compute the unit product cost in each year under absorptioncosting. Show how much of this cost is variable and how much isfixed.

b. Reconcile the variable costing and absorption costing netoperating income figures for each year.

5b. If Lean Production had been used during Year 2 and Year 3,what would the company’s net operating income (or loss) have beenin each year under absorption costing?