Reference no: EM13948889

Kathy Wise is manager of a new medical supplies division. She has just finished her second year and had been visiting with the company's vice-president of operations. In the first year, the operating income for the division had shown a substantial increase over the prior year. Her second year saw an even greater increase. The vice- president was extremely pleased and promised Kathy a $15,000 bonus if the divi- sion showed a similar increase in profit for the upcoming year. Kathy was elated. She was completely confident that the goal could be met. Sales contracts were already well ahead of last year's performance, and she knew that there would be no increases in costs. At the end of the third year, Kathy received the following data regarding operations for the first three years:

	Year 1	Year 2	Year 3
Production	10,000	11,000	9,000
Sales (in units)	8,000	10,000	12,000
Unit selling price	$       10	$       10	$       10
Unit costs:
Fixed overhead*	$    2.90	$    3.00	$    3.00
Variable overhead	1.00	1.00	1.00
Direct materials	1.90	2.00	2.00
Direct labor	1.00	1.00	1.00
Variable selling	0.40	0.50	0.50
Actual fixed overhead	$29,000	$30,000	$30,000
Other fixed costs	$ 9,000	$10,000	$10,000

*The predetermined fixed overhead rate is based on expected actual units of production and expected fixed overhead. Expected production each year was 10,000 units. Any under or overapplied fixed overhead is closed to Cost of Goods Sold.

Yearly  Income Statements

	Year 1	Year 2	Year 3
Sales revenue	$80,000	$100,000	$120,000
Less: Cost of goods sold*	54,400	67,000	86,600
Gross margin	$25,600	$ 33,000	$ 33,400
Less: Selling and administrative	12,200	15,000	16,000
Operating income	$13,400	$ 18,000	$ 17,400

*Assumes a LIFO inventory flow.

Recall that Kathy was pleased with the operating data, but she was dismayed and perplexed by the income statements. Instead of seeing a significant increase in income for the third year, she saw a small decrease. Kathy's initial reaction was that the Accounting Department had made an error.

Required

1. Explain to Kathy why she lost her $15,000 bonus.

2. Prepare variable-costing income statements for each of the three years. Reconcile the differences between the absorption-costing and variable-costing incomes.

3. If you were the vice president of Kathy's company, which income statement (variable costing or absorption costing) would you prefer to use for evaluating Kathy's performance? Why?