This makes no sense at all, said Bill Sharp, president of Essex Company. “We sold the same number of units this year as we did last year, yet our profits have more than doubled. Who made the goof—the computer or the people who operate it?” The statements to which Mr. Sharp was referring are shown below (absorption costing basis):

The statements above show the results of the first two years of operation. In the first year, the company produced and sold 20,000 units; in the second year, the company again sold 20,000 units, but it increased production as shown below:

Essex Company 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:

1          Compute the unit product cost for each year under:

 a.   Absorption costing.

 b.   Variable costing.

2.         Prepare a contribution format variable costing income statement for each year.

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

4.         Explain to the president why, under absorption costing, the net operating income for Year 2 was higher than the net operating income for Year 1, although the same number of units was sold in each year.

5. a.   Explain how operations would have differed in Year 2 if the company had been using Lean Production and ending inventories had been eliminated.

 b.    If Lean Production had been used during Year 2, what would the company’s net operating income have been under absorption costing? Explain the reason for any difference between this income figure and the figure reported by the company in the statements above.

Year 2 Year 1 $700,000 $700,000 Sales (20,000 units each year) Cost of goods sold 460,000 400,000 Gross margin 300,000 240,000 Selling and administrative expenses 200,000 200,000 $ 40,000 $100,000 Net operating income