3. Variable costing appears to provide a much better picture of economic
reality than absorption costing in the examples above. In the first case,
absorption costing net operating income fluctuates wildly even though
unit sales are the same each year and there are no changes in unit sell-
ing prices, unit variable costs, or total fixed costs. In the second case,
absorption costing net operating income is rock steady from year to year
even though unit sales fluctuate significantly. Absorption costing is much
more subject to manipulation than variable costing. Simply by changing
production levels (and thereby deferring or releasing costs from inven-
tory) absorption costing net operating income can be manipulated up-
ward or downward.
Note: This exercise is based on the following data:
Common data:
Annual fixed manufacturing costs ... $1,436,400
Contribution margin per unit ... $130
Annual fixed SGA costs... $653,000
Part 1:
Year 1 Year 2 Year 3 Year 4
Beginning inventory... 500 1,500 3,500 2,500
Production ... 21,000 22,000 19,000 18,000
Sales... 20,000 20,000 20,000 20,000
Ending ... 1,500 3,500 2,500 500
Variable costing net
operating income .. $510,600 $510,600 $510,600 $510,600
Fixed manufacturing
overhead in begin-
ning inventory*... $35,910 $102,600 $228,518 $189,000
overhead in ending
inventory... $102,600 $228,518 $189,000 $39,900
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