EXERCISE 7-4 (CONTINUED)

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